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Liability Driven Investment

4. Mitigating credit risk within swap contracts using collateralisation

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4.1          Normally the pension scheme would want the swap counterparty to collateralise the swap contract. The aim is to reduce the exposure that the pension fund has to the risk of default of the bank involved.  The aim is to have moved some suitable form of collateral from the bank to the pension fund whenever such a default might be costly to the pension fund. This involves marking to market the swap (by definition this is the estimated cost of effecting a similar sort of swap with another counterparty), and whenever this builds up to be materially positive as far as the pension fund is concerned, for additional collateral to be ‘posted’ by the bank to the fund. If the mark to market then declines, some of the collateral would be released and returned back to the counterparty.

 

4.2          The counterparty might of course also require the swap to be collateralised for the same reason but in reverse. Over the last few years, many life insurers entering into over-the-counter derivative transactions have discovered that they may be deemed less credit-worthy than their counterparties, although this may have become less true of late. Underfunded pension funds may face the same learning curve!

 

4.3          For most transactions of any size, it is now common for collateral flows to occur quite frequently, even daily (although there will typically be minimum thresholds and a minimum build-up of exposure, typically dependent on credit rating, before any flow occurs). It may be possible to pledge securities held within the underlying portfolio. Or, it may be necessary to hold some cash buffer within the swap portfolio itself to meet such calls. If instead the bank is posting collateral to the scheme then it too needs looking after, since it may need to be returned at some stage.

 

4.4          Typically, the asset manager would negotiate collateralisation arrangements on behalf of its client via a Credit Support Annexe within its wider negotiation of the master International Swap Dealers Association (ISDA) legal documentation governing the overall relationship between the client and its bank counterparty. Normally the client would legally be one of the two parties to swap, with the asset manager merely acting as its agent. The pension fund might therefore want its own lawyers to review or negotiate these contracts. But in practice, the investment manager is likely to have greater negotiating clout with the bank, given other relationships it may have. The investment manager may therefore adopt umbrella documentation relating to all of its clients that wish to transact with the relevant counterparty. Where the client has multiple swap transactions with the same counterparty it is normal to have them all netted off within the relevant ISDA and Credit Support Annexe. Otherwise one party can find that in the event of the other party defaulting it owes money to the defaulted party on one transaction but cannot recover what it is owed on another.

 


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