Exposure - CSA Provision

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1995 ISDA Credit Support Annex (English Law)
A Jolly Contrarian owner’s manual

Paragraph Exposure in a Nutshell
Use at your own risk, campers!

Exposure” means, for a party on a Valuation Date, any amount payable to it by the other party (if so, a positive number) or by it to the other party (if so, a negative number) under Section 6(e)(ii)(1) were all Transactions (other than the CSA) being terminated at the Valuation Time, assuming that:

(i) it is not the Affected Party and
(ii) the Base Currency is the Termination Currency;

where the Valuation Agent will determine Market Quotations based on its mid-market estimates for Replacement Transactions (as contemplated in “Market Quotation”).
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Paragraph Exposure in full

Exposure” means, with respect to a party on a Valuation Date and subject to Paragraph 4 in the case of a dispute, the amount, if any, that would be payable to that party by the other party (expressed as a positive number) or by that party to the other party (expressed as a negative number) pursuant to Section 6(e)(ii)(1) of this Agreement if all Transactions (other than the Transaction constituted by this Annex) were being terminated as of the relevant Valuation Time, on the basis that (i) that party is not the Affected Party and (ii) the Base Currency is the Termination Currency; provided that Market Quotations will be determined by the Valuation Agent on behalf of that party using its estimates at mid-market of the amounts that would be paid for Replacement Transactions (as that term is defined in the definition of “Market Quotation”).
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Related agreements and comparisons

Related Agreements
Click here for the text of Section Exposure in the 2016 English Law VM CSA
Click here for the text of Section Exposure in the 1994 New York law CSA
Click here for the text of Section Exposure in the 2016 New York law CSA
Comparisons
1995 English Law CSA and 2016 English law VM CSA: click for comparison
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2016 English law VM CSA and 2016 NY Law VM CSA: click for comparison
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Resources and navigation

Resources Full wikitext | Nutshell wikitext
Navigation 1 (Interpretation) | 2 (Credit Support Obligations) | 3 (Transfers, Calculations and Exchanges) | 4 (Dispute Resolution) | 5 (Title Transfer etc) | 6 (Default) | 7 (Representation) | 8 (Expenses) | 9 (Miscellaneous) | 10 (Definitions) | 11 (Elections and Variables)

Index — Click the ᐅ to expand:

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Content and comparisons

A whole extra wodge is added to the 2016 VM CSA to deal with the contingency that you’re on a 2002 ISDA, or a 1992 ISDA and you’ve upgraded to the 2002 close-out methodology.
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Summary

The total mark-to-market exposure under your ISDA Master Agreement on a given day, not counting anything posted by way of credit support. That is, Exposure omits the mark-to-market exposure of the Transaction comprising the CSA itself,[1] because that would entirely bugger things up: the MTM of an ISDA including the CSA is, of course, more or less zero.

Relevance of Section 6 to the peacetime operation of the Credit Support Annex

The calculation of Exposure under the CSA is modelled on the Section 6(e)(ii) termination methodology following a Termination Event where there is one Affected Party, which in turn tracks the Section 6(e)(i) methodology following an Event of Default, only taking mid-market valuations and not those on the Non-Defaulting Party’s side.

This means you calculate the Exposure as:

(a) the Close-out Amounts for each Terminated Transaction plus
(b) Unpaid Amounts due to the Non-defaulting Party; minus
(c) Unpaid Amounts due to the Defaulting Party.

There aren’t really likely, in peacetime, to be Unpaid Amounts loafing about — an amount that you are due to pay today or tomorrow wouldn’t, yet, qualify as “unpaid”, but would be factored into the Close-out Amount calculation.

There is a little bit of a dissonance here, since “Exposure” is a snapshot calculation that treats all future cashflows, whether due in a day, a month or a year from today, the same way: it discounts them back to today, adds them up and sets them off. Your Delivery Amount or Return Amount, as the case may be, is just the difference between that Exposure and whatever the existing Credit Support Balance is. The future is the future: unknowable, unpredictable, but discountable, whether it happens in a day or a thousand years.

All the same, this can seem kind of weird when your CSA you have to pay him an amount today when he owes you an even bigger amount tomorrow. It’s like, “hang on: why am I paying you margin when, tomorrow, you are going to be in the hole to me? Like, by double, if I pay you this margin and you fail to me tomorrow.”

The thing which, I think, causes all the confusion is the dates and amounts of payments under normal Transactions are deterministic, anticipatable, and specified in the Confirmation, whereas whether one is required under a CSA on any day, and how much it will be, depend on things you only usually find out about at the last minute. CSA payments are due “a regular settlement cycle after they are called” — loosey goosey, right? — (or even same day if you are under a VMV CSA and you are on the ball with your calls) whereas normal swap payments are due (say) “on the 15th of March”

So, a scenario to illustrate:

  • Day 1: Party A has an Exposure — is out of the money — to the tune of 100. Its prevailing Credit Support Balance is 90, so (let’s say, for fun, after the Notification Time on the Demand Date) Party B has called it for a Delivery Amount of a further 10, which it must pay, but not until tomorrow.
  • Day 2: Meanwhile, Party A has a Transaction payment of 10 that falls due to Party B, also tomorrow. The arrival of this payment will change Party A’s Exposure to Party B so it is 90. Assuming Party A also pays the Delivery Amount, by knock-off time tomorrow it will have posted a Credit Support Balance of 100, and its Exposure to Party B will only be 90. This means it will be entitled to call Party B for a Return Amount of 10.

This seems rather a waste of operational effort, and will also take years off your credit officer’s life and may even cause his hair to catch fire. Can Party A just not pay the further Delivery Acount in anticipation of what will happen tomorrow?

Fun times in the world of collateral operations.

Market Quotation and the 2002 ISDA

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General discussion

Calculating your Credit Support Amount

Superficially things are quite different between the 1995 English Law CSA and the 2016 English law VM CSA, but this all boils down to the fact that the 2016 English law VM CSA is meant to be a zero-threshold, variation margin-only affair, so the concepts of Independent Amount and Threshold, both of which confuse the 1995 English Law CSA, aren’t there to get in the way. Unless you go and put them in anyway, as we shall see...

1995 English Law CSA

How the IA contributes to the Credit Support Amount — being the amount of credit support in total that one party must have given the other at any time[2] under the 1995 English Law CSA can be mind-boggling.

It pans out for a Transferee like so:

This leaves you with a formula for a Transferee’s Credit Support Amount as follows: Max[0, (ETee + IATor - IATee + Threshold)].

Let’s plug in some numbers. Say:

Your Credit Support Amount is therefore the greater of zero and 10,000,000 + 2,000,000 - 0 + 5,000,000) = 7,000,000.

Now, whether you have to pay anything or receive anything as a result — whether there is a Delivery Amount or a Return Amount, in other words — depends whether your Credit Support Amount is greater or smaller than your prevailing Credit Support Balance, by at least the Minimum Transfer Amount.

2016 English law VM CSA with no IA amendment

Since the 2016 English law VM CSA assumes there is no Independent Amounts and no Thresholds, it is quite a lot easier. It is just the Exposure. So much so, that there isn’t even a concept of the “Credit Support Amount” under the 2016 English law VM CSA, unless you have retrofitted one, and who in their right mind would do that?

Oh.

You have, haven’t you. You’ve gone and co-opted the Credit Support Amount (VM/IA) concept in your Paragraph 11 elections. Yes you did. No, don’t blame your credit department; don’t say you were just following orders. You did it.

2016 English law VM CSA with a customised IA amendment

Never mind. Well, just for you, the formula is a sort of half-way house: Under this unholy bastardisation of a 2016 English law VM CSA, a Transferee’s Credit Support Amount will be: Max[0, (ETee + IATor - IATee)].

Transaction flows and collateral flows

In a fully margined ISDA Master Agreement, all other things being equal, the termination of a Transaction will lead to two equal and opposite effects:

The strict sequence of these payments ought to be that the Transaction termination payment goes first, and the collateral return follows, since it can only really be calculated and called once the termination payment has been made.

I know what you’re thinking. Hang on! that means the termination payer pays knowing this will increase its Exposure for the couple of days it will take for that collateral return to find its way back. That’s stupid!

What with the regulators’ obsession minimise systemic counterparty credit risk, wouldn’t it be better to apply some kind of settlement netting in anticipation, to keep the credit exposure down?

Now, dear reader, have you learned nothing? It might be better, but “better” is not how ISDA documentation rolls. The theory of the ISDA and CSA settlement flows puts the Transaction payment egg before the variation margin chicken so, at the moment, Transaction flows and collateral flows tend to be handled by different operations teams, and their systems don’t talk. Currently, the payer of a terminating transaction has its heart in its mouth for a day or so.

Industry efforts to date have been targeting at shortening the period between the Exposure calculation and the final payment of the collateral transfer.

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See also

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References

  1. Assuming you are on a proper, sensible, English law title transfer CSA, which counts as a Transaction, and not one of those silly American ones, which doesn’t.
  2. As opposed to the amount required to be transferred on that day, considering the “Credit Support Balance” the Transferee already holds — that’s the Delivery Amount or Return Amount, as the case may be.
  3. There’s something faintly absurd both parties exchanging Independent Amounts by title transfer — they net off against each other — but that’s as may be. Stupider things have happened. SFTR disclosure, for example.