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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