Counterparty Risk Management and CSA Terms
Counterparty Risk Management and CSA Terms
Counterparty risk in OTC derivatives arises when the other party may fail to meet its obligations. Credit Support Annexes (CSAs) mitigate this risk by requiring collateral posting, establishing thresholds, and defining credit support terms. Effective counterparty risk management combines documentation, exposure monitoring, and collateral operations.
Definition and Key Concepts
Counterparty Risk Components
| Component | Definition |
|---|---|
| Current exposure | Mark-to-market value if positive |
| Potential future exposure (PFE) | Possible future positive value |
| Expected exposure (EE) | Average exposure over time |
| Expected positive exposure (EPE) | Average of positive exposures |
| Wrongway risk | Exposure increases when counterparty weakens |
Credit Support Annex Overview
CSA: A legal document that governs collateral arrangements between OTC derivatives counterparties.
Key terms:
| Term | Description |
|---|---|
| Threshold | Exposure below which no collateral required |
| Minimum transfer amount (MTA) | Smallest collateral movement |
| Eligible collateral | Acceptable forms of collateral |
| Haircuts | Discounts applied to collateral value |
| Valuation frequency | How often exposures recalculated |
| Dispute resolution | Process for valuation disagreements |
Collateral Types
| Collateral | Typical Haircut | Pros | Cons |
|---|---|---|---|
| Cash | 0% | Most liquid | Financing cost |
| Government bonds | 0.5-5% | Low risk | Price volatility |
| Corporate bonds | 5-15% | Higher yield | Credit risk |
| Equities | 15-25% | Diversification | High volatility |
| Money market funds | 1-5% | Liquid | Manager risk |
How It Works in Practice
CSA Negotiation
Standard CSA terms:
| Parameter | Typical Value |
|---|---|
| Threshold (AA-rated) | $10-50 million |
| Threshold (A-rated) | $5-25 million |
| Threshold (BBB-rated) | $0-10 million |
| Minimum transfer amount | $500,000-$1,000,000 |
| Valuation frequency | Daily |
| Transfer timing | T+1 |
Daily Collateral Process
Step 1: Calculate exposure Sum of all trade MTM values with counterparty.
Step 2: Determine collateral requirement If exposure > threshold, collateral = exposure - threshold
Step 3: Compare to current collateral Required movement = new requirement - current collateral held
Step 4: Issue margin call or return If movement > MTA, call for (or return) collateral.
Exposure Calculation Example
Trade portfolio with Counterparty ABC:
| Trade | Type | Notional | MTM Value |
|---|---|---|---|
| Trade 1 | IRS (pay fixed) | $100M | +$2.5M |
| Trade 2 | IRS (receive fixed) | $75M | -$1.8M |
| Trade 3 | CCS | $50M | +$3.2M |
| Trade 4 | FX forward | $25M | -$0.4M |
| Net exposure | +$3.5M |
CSA terms with ABC:
- Threshold: $2 million
- MTA: $500,000
- Current collateral held: $1.0 million
Calculation: Collateral required = $3.5M - $2.0M = $1.5M Additional needed = $1.5M - $1.0M = $0.5M Since $0.5M = MTA, margin call issued for $500,000.
Worked Example
Portfolio setup:
- Total OTC derivatives with 5 counterparties
- Aggregate notional: $2 billion
- Net positive exposure: $45 million
- Net negative exposure: $30 million
Counterparty Exposure Summary
| Counterparty | Rating | Threshold | Gross Exposure | Net Exposure | Collateral Held | Unsecured |
|---|---|---|---|---|---|---|
| Bank A | AA | $25M | +$35M | +$35M | $8M | $2M |
| Bank B | A | $15M | +$22M | +$22M | $7M | $0M |
| Bank C | A | $15M | -$8M | -$8M | $0 (posted) | N/A |
| Bank D | BBB | $5M | +$18M | +$18M | $13M | $0M |
| Bank E | AA | $25M | -$22M | -$22M | $0 (posted) | N/A |
Total unsecured exposure: $2 million (Bank A only)
Potential Future Exposure
95% PFE calculation (simplified): PFE = Notional × Add-on factor × Confidence multiplier
| Trade Type | Notional | Add-on (1yr) | PFE |
|---|---|---|---|
| Interest rate swaps | $1.0B | 0.5% | $5M |
| Cross-currency swaps | $500M | 5.0% | $25M |
| FX forwards | $300M | 6.0% | $18M |
| Credit derivatives | $200M | 10.0% | $20M |
| Total PFE | $68M |
VaR-Based Exposure
Credit VaR (99%, 1-year): Considers probability of counterparty default.
| Counterparty | Exposure at Default | PD (1-year) | LGD | Expected Loss |
|---|---|---|---|---|
| Bank A (AA) | $35M | 0.03% | 45% | $4,725 |
| Bank B (A) | $22M | 0.07% | 45% | $6,930 |
| Bank D (BBB) | $18M | 0.20% | 45% | $16,200 |
| Total | $27,855 |
Stress Testing
Scenario: Counterparty downgrade + market stress
| Scenario Component | Impact |
|---|---|
| Bank A downgraded to A | Threshold drops to $15M, call $10M |
| Interest rates +200 bps | Swap exposure increases $12M |
| EUR/USD -15% | CCS exposure increases $8M |
| Net impact | +$30M additional collateral needed |
Risks, Limitations, and Tradeoffs
Threshold Risk
| Risk | Description |
|---|---|
| Unsecured exposure | Exposure up to threshold is uncollateralized |
| Downgrade triggers | Rating downgrade may reduce threshold |
| Gap risk | Exposure can jump above threshold between valuations |
Collateral Risks
| Risk | Description | Mitigation |
|---|---|---|
| Liquidity risk | Collateral tied up, unavailable | Maintain liquidity buffer |
| Price risk | Collateral value declines | Apply appropriate haircuts |
| Concentration risk | Too much collateral with one counterparty | Diversify relationships |
| Operational risk | Collateral movements fail | Robust operations team |
Wrongway Risk
Definition: Counterparty exposure increases as counterparty credit deteriorates.
Examples:
- Long CDS protection from a bank on another bank
- FX forward with EM counterparty in their currency
- Commodity swap with commodity producer
Mitigation:
- Lower thresholds for wrongway exposures
- Additional collateral requirements
- Avoid concentrated wrongway risk
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Stale valuations | Using old MTM for margin calls | Daily valuation |
| Threshold arbitrage | Counterparty games threshold | Downgrade triggers |
| MTA exploitation | Counterparty avoids transfer | Lower MTA |
| Eligible collateral drift | Collateral becomes ineligible | Regular monitoring |
CSA Best Practices
Negotiation Priorities
| Priority | Consideration |
|---|---|
| 1 | Zero or low thresholds for lower-rated counterparties |
| 2 | Daily valuation and T+1 settlement |
| 3 | Cash collateral only (reduces haircut disputes) |
| 4 | Two-way CSA (both parties post) |
| 5 | Clear dispute resolution process |
Monitoring Framework
| Metric | Frequency | Alert Threshold |
|---|---|---|
| Current exposure | Daily | 80% of limit |
| PFE | Weekly | 70% of limit |
| Collateral adequacy | Daily | Shortfall > MTA |
| Credit rating | Real-time | Downgrade |
| Dispute aging | Daily | > 5 days unresolved |
Checklist and Next Steps
CSA review checklist:
- Verify threshold appropriate for credit quality
- Confirm MTA is not too high
- Review eligible collateral list
- Check haircut schedule adequacy
- Verify downgrade triggers
- Confirm dispute resolution process
Daily operations checklist:
- Calculate all counterparty exposures
- Determine collateral requirements
- Issue margin calls by deadline
- Track collateral received/posted
- Reconcile collateral positions
- Flag any disputes
Risk monitoring checklist:
- Track exposure vs. limits
- Monitor counterparty credit ratings
- Calculate PFE regularly
- Stress test exposures
- Report to risk committee
- Review CSA terms annually
Related articles:
- For hedging approaches, see Dynamic vs. Static Hedging Approaches
- For liquidity issues, see Liquidity Considerations in Hedging Programs