When It Comes to Sovereign CDS, Collateral is King

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

We have talked a lot about sovereign CDS exposures being largely collateralized. What exactly do we mean by that? And why is it so important to understand how collateral works?

Exposures between two counterparties under an ISDA Master Agreement are typically subject to one of ISDA’s credit support annexes. Our margin survey indicates that over 70% of derivatives exposure is subject to these arrangements. But some of the entities that are users of other types of derivatives ? sovereigns, supranationals and corporates ? are not active in CDS. As a result, well over 90% of CDS are subject to collateral arrangements, and these arrangements are virtually all two-way (i.e., either party could post collateral to the other based on the mark-to-market value of trades between them).

With the standardization of CDS contracts resulting from the 2009 Big Bang Protocol, there are now two standard coupons on CDS, 100 basis points for investment grade credits and 500 basis points for high yield names. An upfront payment is made by one party to the other to reflect the present value of the difference between the market rate for buying protection and the standard coupon. Where the reference entity is distressed, a significant amount is paid by the buyer of protection upfront because the market rate for buying protection greatly exceeds the coupon.

This upfront payment feature of the CDS market is distinct from other derivatives markets. But once the upfront payment is made, the collateral practice is the same. The trade is marked to market and collateral is posted. For a distressed reference entity, the protection seller would have to post collateral, but the amount of that collateral would, at least initially, be more or less equivalent to the upfront payment. In effect, the upfront payment from the buyer to the seller becomes the collateral that the seller posts with the buyer. Subsequent, incremental fluctuations in market value will lead to more collateral being posted or some collateral being returned.

To understand the implications of collateral arrangements, let’s take a simple example involving Greek CDS. Let’s assume that Bank A is a net seller of five-year protection and that all of its Greek CDS trades are with one other bank, Bank B.  In this case, Bank A would have posted collateral, primarily cash, to Bank B in an amount equal to the mark-to-market value of the CDS trades. 

As the likelihood of default increases, the value of the contract will increase as well and more collateral will need to be posted, a process that happens daily. So based upon current prices for five-year Greek CDS, Bank A will be posting 62% or so of notional against the Greek protection it has sold. Each day, assuming conditions get worse, the amount of collateral increases. The risk for Bank B is that either Bank A defaults on one of the daily incremental collateral calls or a Greek default occurs and the price of the CDS increases greatly. However, this latter event would hardly constitute an extreme “jump to default” situation, such as where an otherwise creditworthy entity defaults out of the blue, generating a collateral call of 50% or more. So Bank A’s daily collateral requirement will be relatively modest and the replacement cost to Bank B will be modest if, indeed, Bank A should default for whatever reason.

Counterparty risk management for CDS involves assessing the exposure that could arise between one counterparty and another due to a jump to default by a reference entity or a counterparty default on the CDS. How much does it cost to replace the defaulted positions as well as the shortfall in collateral? There is no unsecured exposure before the default. In Bank A’s case, it already has posted 62% against its sold Greek protection.

Collateral management between two dealers is more complex, of course, because all their OTC derivatives contracts are covered by one collateral arrangement. But the principle is the same: how much collateral was not delivered and how much will it cost to replace the positions? Collateral arrangements between dealers are also very efficient due to netting arrangements that enable in the money positions to offset out of the money positions across asset classes.

One final note: Consider what happens when, as is far more likely than not, Bank A performs its obligations under the Greek CDS. When Bank A performs its obligations on the Greek CDS the balance on its collateral arrangements with Bank B will be altered. After payment on the Greek CDS, the net mark-to-market position shifts. Because the Greek CDS trades are settled, Bank A will be able to demand collateral to be returned to it by Bank B.

Collateral is an incredibly powerful and dynamic tool and understanding how it works should, we believe, provide a great deal of comfort to both experienced and casual observers of the sovereign CDS product.

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