The decision is an attempt by regulators to mitigate currency risk at the point of a counterparty default – which could be significant if a large dealer has collapsed – and clarifies a topic on which dealers claim they had received conflicting answers. The haircut is bad news for the industry's first attempt to draw up a new, standardised credit support annex (SCSA), in which currency mismatches are inherent, but dealers had already decided to revamp the contract.
When finalised, it will transpose into EU regulation the standards drawn up by the Working Group on Margining Requirements (WGMR). The WGMR completed its work in September last year. The idea of an 8 per cent haircut first appeared in the final WGMR standards. The rules allow derivatives users to calculate initial margin using an internal model or via a standardised table drawn up by the group. The latter sets an additional 8 per cent whenever there is a difference between the currency of the collateral and the currency of the underlying trade. European regulators confirm the requirement will apply to both variation and initial margins.
The original standard CSA was developed to eliminate the optionality within multi-currency CSAs that had led to huge numbers of valuation disputes. It does so by requiring counterparties to allocate trades to one of 17 currency silos, based on the currency of the underlying transaction. Parties can only post cash variation margin in that currency, and the trades in each silo are discounted using the relevant overnight indexed swap (OIS) rate.
However, dealers had been worried about Herstatt risk – essentially, the risk created by each bank having up to 17 separate currency settlements each day. As a result, an industry group developed the so-called implied swap adjustment (ISA). Put simply, this allows users to convert the various collateral amounts into one of seven ‘transport' currencies, using a set of daily OIS, foreign exchange spot and tom/next forex swap rate fixings.
The new version will ditch the ISA methodology and require counterparties to physically exchange collateral in each of 17 different currencies, which means settlement risk will be added back in.
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