BlackRock tries to renegotiate 'dirty CSAs'

Asset manager seeking to remove collateral optionality - and pricing divergence - from thousands of CSAs

BlackRock, the world's largest asset manager, is renegotiating thousands of credit support annexes (CSAs) governing collateral posting on its derivatives transactions in an attempt to make it easier to compare prices between dealers – but some banks are trying to charge for the privilege, says BlackRock's New York-based global head of trading, Richard Prager.

"The interpretation of CSAs has evolved significantly and a lot of previous market conventions have come unstuck. It is becoming difficult for buy-side clients to navigate the market given the variability of each respective CSA and each bank's posture toward the issue," he says.

The problems arise because of changes in derivatives pricing practices. Dealers now discount cash-collateralised trades using the overnight indexed swap (OIS) rate associated with the currency of the collateral being posted. But many CSAs include the option to switch from one type of collateral to another, and the market has no standard way of taking this into account. Prager refers to agreements with collateral posting optionality as "dirty CSAs".

One shortcut is to assume the counterparty will always deliver the cheapest collateral available to it at any point in time, but that requires a dealer to forecast and blend multiple discount rates over the life of a trade. As a result, dealers have developed different pricing and valuation approaches, making it difficult for clients to compare quotes from one dealer to the next, or to exit a trade via novation, says Prager.

"It started with the move to OIS discounting and then the emergence of cheapest-to-deliver collateral across currencies, as well as the moving around of each bank's funding rates because of respective credit ratings. This has created a lot of noise that has made it almost impossible for us to think that, if we have a trade, we can just pick up the phone and novate to another firm and move on," he says.

It is becoming very difficult for buyside clients to navigate the market given the variability of each respective CSA and each bank's posture toward the issue

"It also changes the liquidity of a bilateral contract, making it more expensive to trade. Whenever you have a multi-currency option embedded, you have a wide variability of pricing from bank to bank. I don't want to impair our liquidity because of too much nuance in the marketplace or non-standardisation of prices. We need to take the nuance out of the equation," Prager adds. BlackRock is trying to do this by replacing dirty CSAs with clean ones, in which both counterparties agree to post a single type of collateral, and therefore value the trade using one discount rate. Centrally clearing trades would have a similar effect because clearing houses insist on collateral denominated in the same currency as the trade.

Variation in swap prices is due to a lack of consensus over how to reflect CSA optionality. If a swap is collateralised with US dollar cash, the present value of the trade should be discounted using the federal funds rate. If euro cash is being posted, the rate should be Eonia – the euro overnight index average. If a counterparty has the option to post either, the appropriate discount rate could switch as well.

Some banks claim the discount rate should be computed as a blended curve based on projections of the collateral that would be cheapest for the counterparty to deliver at given points during the life of the trade. Others advocate sticking to the discount rate applicable to the collateral delivered at the outset of the trade. As a result, even plain vanilla swaps can produce big pricing differences from one dealer to the next.

The issue is complicated further if securities are accepted as collateral. In that case, the trade should theoretically be discounted using the rate at which the assets could be funded – the repo rate – but repo markets do not extend to the maturities seen in longer-dated swaps. Some banks will extrapolate from observed rates, while others revert to using Libor as the discount rate – the practice that prevailed prior to the acceptance of collateral-based discounting.

While BlackRock has opted to move away from dirty CSAs, not all of its sub-funds have enough collateral to limit themselves to a single currency, and will not switch as a result. "Our ideal is to move all swaps to clearing, which would solve all the pricing variability issues. However, that is not possible at the moment, so the next best thing we can do is try to move to single-currency clean CSAs. It will be a strong preference of ours. But there will be exceptions for some funds that are not asset-rich and don't have the eligible collateral," says Prager.

Meanwhile, Prager is also wary about the potential costs associated with making the move to single-currency CSAs and says some dealers are seeking to take advantage by taxing the move. "The conversion from the dirty CSA to the single-currency CSA effectively means terminating one set of transactions and entering a new set of transactions. However, my concern is dealers might want to extract a transaction cost for the elimination of the optionality in the dirty CSA. We are worried about this possible added tax, and so far not all our conversations have gone as smoothly as we would have wanted," he says.

Dealers are trying to draw up an industry-wide standard CSA that would also eliminate collateral optionality. The process has proved more complex than some market participants envisaged – in part because of arguments about how to resolve the resulting increase in settlement risk - but is now drawing to a conclusion.