Why ISDA Agreements are One-sided
It should come as no surprise that the International Swap Dealer Agreements (ISDA) today’s multinational corporations sign with banks tend to be one-sided. If the bank defaults on a corporate customer, there’s no opportunity to collect on collateral. All of this may work well for the banks, but not so well for your company. This paper looks at some of the problems associated with over-the-counter (OTC) trading, and specifically how it relates to counterparty risk mitigation.
A critical component to any OTC trading relationship is your ISDA agreement, specifically the schedule to your master agreement and your credit support annex (CSA). As many corporate financial professionals know, an ISDA agreement is the cornerstone of any transactional relationship between two parties engaged in OTC financial transactions.
An ISDA agreement is composed of three major components:
Figure 1: Example of Commercial Counterparty Distress 
Source: Atlas Risk
Figure 1 illustrates how a CSA might work. The company in the upper left has just been downgraded to a BB+ rating from investment grade, and the banking counterparty notifies them that: a) they’ve violated the terms of their CSA; and b) they need to post additional collateral because the trade – or the net of all their trades they have outstanding with this counterparty – is out of the money. The key thing to notice in Figure 1 is that the bank has ISDA agreements with all the participants, whereas individual companies typically only have an ISDA agreement with the bank, or potentially multiple banking counterparties. Individual companies don’t have nearly as many ISDA agreements as the banking counterparty has with other commercial clients.
Figure 2: Example of Financial Counterparty Distress 
Source: Atlas Risk
Figure 2 illustrates what we’ve seen happen over the last couple of years. Our banking counterparty example in the middle is Lehman Brothers, which moved from a mid A credit rating to basically going bankrupt over a weekend. There was no opportunity for the commercial counterparties to demand collateral from them, and they probably wouldn’t have received it. In fact, when Lehman went under, they had over 8,000 master ISDA agreements signed and over 67,000 open trades. This is the state of ISDA agreements as they exist today. A typical CSA may call for the exchange of collateral at a level of BBB or lower. This results in a one-sided benefit for the bank, with no practical benefit for the commercial counterparty. A commercial counterparty may be able to operate just fine with a BBB rating, or even in an environment below investment-grade for quite some time, giving the bank ample opportunity to receive collateral under a typical existing CSA. Conversely, a change in a major bank’s credit rating to the same level would be a proverbial nail in their coffin. Sufficient capital would have already left the bank, and the bank’s cost of funds would have already increased to a level that would make operating as a bank impossible. So as they exist today, CSA’s only provide a false sense of security to the commercial counterparty.
What your company can do to help protect itself Companies have largely taken two different approaches to correct for what they see as one-sided CSAs that favour the financial counterparty: using third-party collateral managers and trading on a listed futures exchange.
Many companies arrange for third-party collateral managers to accept and remit collateral – based on the market-to-market status of the outstanding trades – to each financial counterparty. While the daily posting of collateral tends to be the most effective way to ensure the credit worthiness of your OTC counterparty, it tends to be very cumbersome for both the commercial and the banking counterparty.
Beyond the operational complications of posting collateral on a daily basis, arrangements with the third-party collateral manager can become further complicated due to a practice known as ‘re-hypothecation’, which is illustrated in Figure 3.
Figure 3: Re-hypothecation 
Source: Atlas Risk
In this example, Party A is out of the money on a trade, or a series of trades, to Party B, and is therefore required at the end of the day to post the collateral. In this example, Party B is the commercial counterparty, which actually has no net position in this particular transaction due to the fact that it has an equal and offsetting trade to counterparty C. So while Party A is out of the money to Party B, Party B is also out of the money to Party C. Party B therefore passes on the collateral that it received from Party A to Party C, i.e. Party B has ‘re-hypothecated’ Party A’s collateral. Where this situation gets even more interesting is when Party C goes bankrupt, and Party B is left to deliver a termination notice to Party C. Party B is essentially forced to re-issue the equal and offsetting trade that it had to counterparty A. Most re-hypothecation risk is due to operational issues. It could take a long time for you to discover that Party C has gone out of business, deliver your termination notice, and then to go ahead and put on new trades with another counterparty to replace the trades that you just terminated. During this time, you’re completely exposed, as the value of those trades could be moving rapidly in what is likely a very volatile market. This explains why there’s currently a lot of discussion in the Financial Reform Bill over the subject of central clearing for OTC transactions.
While nothing has been firmly decided, it certainly appears that market participants will be encouraged to clear their transaction centrally as it is a far more effective solution. In the scenario above, there wouldn’t be any remaining credit exposure for the commercial entity, which would have offsetting trades with the clearing firm. You would no longer have a position in that currency or interest rate at all, as opposed to having two equal and opposite transactions with two different counterparties.
The good news is that there is a solution available today: trading your currency and potentially some of your interest rate volumes on the Chicago Mercantile Exchange (CME) Chicago Mercantile Exchange using a generic futures contract. The futures market is incredibly deep, with over US$100b in daily liquidity, and handles all the collateral arrangements for you. In addition to more efficient handling of the collateral, trading on a listed futures exchange offers much more transparent pricing: you have the ability to join the bid or join the offer depending on which side of the transaction you wish to participate. There are plenty financial institutions complaining in the press right now about the possibility of moving the central clearing, and moving to exchange listed contracts. They don’t mention the CME in particular, but these shifts would have a huge negative impact on profits in the banking sector. Atlas Risk has found that commercial counterparties generally lack the knowledge, and therefore the motivation, to prevent the financial counterparties from taking advantage of them in these OTC transactions.
Figure 4: Listed Futures Market 
Source: Atlas Risk
Figure 4 illustrates the advantages and disadvantages of trading on a listed exchange for your currency or interest rate volumes. Again, futures markets are sufficiently deep. You only have a single name as counterparty with an established record for addressing collateral arrangements. You also have anonymity in dealing, which equates to better pricing. The main disadvantage to using futures contracts is that they only mature four times a year and must be traded in notional amounts that are compliant to the exchange. FASB 133, or income statement hedging activity, requires cash flows to occur in the same month as the hedge. So unfortunately, as the current future markets exist, FASB 133 hedging won’t necessarily work. As a general rule, it would work only if you had the underlying exposure occur in the same month that the futures contract matured. At lot of risk management professionals – particularly currency risk management professionals – are thinking about cash flow transactions and how problematic those would be with hedging using futures contract. But Atlas Risk feels that to the extent you’re doing balance sheet hedging correctly, one shouldn’t be conducting any spot transactions in the middle of the month, anyway.
So, to the extent you’re in need of a cash transaction, you’d really facilitate that using a swap, where you’d be buying and selling a particular currency. Using futures contracts, there is a way to book what they call a block transaction, where one can essentially call up an OTC counterparty and book a swap where you maintain the near leg as a cash transaction – which, due to its near-term maturity, carries little credit risk. The far leg would be booked to a futures-compliant date in a futures-compliant amount. You would then simply call up the CME and convert that OTC contract into a number of futures contracts, and now it would be booked to the futures exchange. In the current environment, Atlas Risk feels it’s just a matter of time before central clearing and exchange listed transactions become a reality.