Michael Beaton of Derivatives Risk Solutions explains the Standard Credit Support Annex (SCSA), which is not mandatory for counterparts to derivatives transactions, but is likely to significantly impact the future shape of the derivatives industry.
Introduction
In July 2010 the ISDA Board agreed to investigate the feasibility of a Standard Credit Support Annex (the “SCSA”). The ISDA Collateral Steering Committee has since developed an implementation plan in order to bring the SCSA to the derivatives market. The SCSA project is not a mandatory initiative for counterparties to derivative transactions, but is likely to have a significant impact on the future shape of the industry.
Objectives
The SCSA project has three primary objectives:
1. To standardise market practices by removing embedded optionality in the existing CSA
ISDA notes that the current CSA allows for “literally…millions of combinations of terms”. Amongst other things, the SCSA will seek to:
• eliminate collateral switch options;
• reduce margin disputes attributable to pricing differences; and
• simplify and standardise market processes.
2. To promote the adoption of overnight index swap (OIS) discounting for derivatives by:
• eliminating non-cash collateral;
• aligning interest accruals on cash collateral with discount rates for underlying derivative trades; and
• promoting convergence towards OIS discounting across both central counterparties and bilateral market participants.
3. To align the mechanics and economics of collateralisation between the bilateral and cleared OTC derivative markets by promoting:
• more consistent pricing;
• more liquid transfer of risk; and
• consistent margin terms.
Why standardise the CSA?
ISDA notes a number of factors which support the case for standardisation:
• the complex nature of the CSA itself;
• the belief that many ISDA members have only partially captured the full detail and complexity of their bespoke CSAs in risk and accounting systems;
• the fact that embedded CSA terms have economic consequences that are, in many cases, held at fair value through the income statement;
• the disparate approaches to booking and modelling of CSA terms which can result in collateral disputes, as well as to inconsistent and non-transparent valuations;
• the fact that discounting using OIS rate curves rather than LIBOR for some currencies would be consistent with the London Clearing House (“LCH”) and would facilitate the novation of OTC derivatives to both existing and future CCPs; and
• the general push towards standardisation from regulators and legislators.
How will the new SCSA work?
In a typical CSA, one net collateral requirement is calculated each day and satisfied via the delivery of Eligible Collateral, a concept which includes both cash and securities. Non-zero Thresholds and Minimum Transfer Amounts are common (although non-zero Thresholds have becomes less common in recent years).
In contrast, the SCSA will seek to align the mechanics of collateralisation with those employed by the LCH and other clearing houses. As such, it only contemplates the use of cash collateral with respect to variation margin, although will continue to allow securities to be posted with respect to Independent Amounts. Moreover, it would appear that only those currencies with the most liquid OIS curves (being USD, EUR, GBP, CHF and JPY) will be eligible under the SCSA. It also seems likely that we will see zero Thresholds and zero Minimum Transfer Amounts as the default position going forward.
The SCSA will require parties to individually calculate one collateral requirement per currency per day (each called a currency “silo” by ISDA). Each currency must then be delivered to the party holding the exposure. With agreement it will be possible to convert each “silo” amount into a single amount payable in a single currency, with an accompanying interest adjustment (known as the “Implied Swap Adjustment Mechanism” or “ISA Method”). These trades would then be discounted at the OIS rate.
What problems will that create?
The continual movement of cash in multiple currencies between counterparties gives rise to settlement risk. The initial approach to addressing this issue will be via netting as part of the ISA Method. As the SCSA project develops beyond the initial pilot phase, involving a select number of volunteer firms, ISDA intends to introduce a more robust system based on “payment-versus-payment” or escrow arrangements. Participants will remain free to use their preferred method.
What next?
A small number of volunteer firms are due to trial the SCSA in the first half of 2012. However, counterparties will not simply be able to enter into SCSAs on a bilateral basis and so wider market adoption can only take place once the necessary market infrastructure has been developed. This will entail such things as the creation of:
• a set of common rates;
• a common ISA Method calculation; and
• interoperable electronic communication methods for margin calls and other data.
Current indications are that this is envisaged to take place in the latter part of 2012.
The Impact
As already mentioned, the SCSA project is not a mandatory initiative for counterparties to derivative transactions. However, those intending to take advantage of the SCSA should be aware of the process changes envisaged by ISDA, including the requirements that:
• All SCSAs should be created electronically, stored in digital form and electronically executed;
• All margin calls and data transfers under an SCSA should be made electronically;
• The SCSA and dispute resolution procedures should be fully conformed and compatible; and
• Legal Entity Identifier (“LEI”) support should be designed in and employed once LEIs are available.
As such firms should begin planning their approach to the SCSA and particularly its impact on existing document storage, data capture and collateral systems as soon as possible.
