Transaction terminations and VM
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2016 VM CSA Anatomy™
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Now the timings of the various payments under the ISDA architecture lead to one rather odd effect:
If you have an existing Transaction with a large MTM exposure, that is currently collateralised, as it almost certainly will be, with variation margin, and then the in-the-money party decides to close out that exposure (or — I dunno — the swap just gets to its Schedulted Termination Date, then you have a coupole of opposite things that have to happen.
- The out-of-the-money counterparty has to pay the termination value of the Transaction; and
- The in-the-money counterparty has to repay a corresponding portion of the variation margin it has already posted on the Transaction
These two amounts should be — intra-day market moves permitting — the same. Stands to reason: the point at which I finally pay you your winnings on the swap casino, you must pay me back the cashI gave you as collateral for the value of your trade.
Now you would like to think these things would seamlessly net off against each other: you keep the variation margin cash value, maybe there’s a small true up payment to cater for the market movement since the last collateral exchjange, and we’re all square.
But that’s not how ISDA’s crack drafting squad™ played it.[1] Instead the OTM counterparty must pay out the whole value of the swap mark to market — like, again — then wait for a new opportunity to value the master agreement, tomorrow, and then call for the equivalent credit support back then.
This leads to enormous overnight exposure, but this is the way the market seems to have operated since credit support annexes were a thing.
- ↑ In fairness, the mechanics were first designed in an innocent, primordial era where variation margin was barely even an idea let alone the regulatory mandatory behemoth it is today. So they weren’t really to know.