Banks tout break clauses as capital mitigant

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Working it out

Once a trade has been broken, it has to be settled through payment of a close-out amount from one counterparty to the other – but some dealers say the process for calculating that sum, laid out in the 2006 product definitions published by the International Swaps and Derivatives Association, produces close-out values that are inaccurate.

After a break clause has been exercised, the Isda definitions say either one or both parties to the swap are required to get third-party market quotes, with quoting banks assuming they are facing a counterparty of the highest credit standing on an uncollateralised trade. That can produce a wide range of quotes, dealers say, in part because post-crisis swap pricing orthodoxy requires uncollateralised trades to be discounted using a bank’s own cost of funding.

“There is a massive propensity for noise around the close-out price. If five banks quote on the swap, every dealer is going to use a different discount rate because the theory says you should discount trades at your own cost of funding. But in some cases, they won’t even do that – we have seen a case where one bank priced using its own cost of funding, another at Libor flat and the third at the overnight indexed swap (OIS) rate. In addition, there is just no pressure on the quoting banks to be accurate. This needs to be changed to reflect the fact that most trades are collateralised,” says a head of interest rate swaps trading at one European bank.

The vast majority of dealers now agree that cash collateralised trades should be discounted at the relevant OIS rate, while uncollateralised transactions should be discounted at the rate at which each bank can borrow. LCH.Clearnet’s SwapClear service, which switched to the new pricing methodology in 2010, requires the currency of the swap to determine the currency of the collateral, and the discount rate to be based on the rate associated with that currency – so a euro swap is collateralised with euro cash and discounted at the euro overnight index average. The European bank’s interest rate swap trading head suggests the Isda definitions should adopt the same approach.

Subtracting credit risk from the quotes – by assuming a counterparty of the highest credit standing – removes one other source of divergence between quoting banks, but it can produce a significant gap between the close-out level and the value at which the trade had been carried by its original counterparties, dealers say. The original trade is likely to have been priced and valued taking the counterparty’s creditworthiness into account.

There appears to be little chance of a swift revision – Isda says it is not working on the topic at the moment – but not all dealers are unhappy with the current close-out method. “We see break clauses as the best way to end a dispute over the valuation of a trade. There are frequent disputes over how to value trades with optionality in the credit support annexes, where people started to play with the discount rates. If we are unable to resolve that dispute, we know this method means our counterparty has no ability to fudge discount rates. So we see it as a useful tool,” says a rates trader at another European bank.

When the break clause is exercised, at least three third-party quotes are required – which are then averaged – to calculate the close-out price. If no market quotes are received, the onus falls on the calculation agent – identified in documentation covering trades between the two counterparties – to work out the close-out value.

“The valuation process has to assume that the parties are of the ‘highest credit standing’. So, regardless of whether you use market quotations or fallback to a calculation agent calculation, the process is still going to give you a value that does not reflect actual credit risk of the counterparties, and will therefore generate a cashflow that does not properly reflect for either side the consequences of the early termination. This may be a ‘zero fault’ termination, but it is unlikely to be a ‘zero cost’ one. It is also a result that is markedly different from the value that would be determined on a default, or where an early termination under the master agreement had occurred,” says Paul Cluley, partner at law firm Allen & Overy in London.