A Short Introduction to the Standard Credit Support

A Short Introduction to the Standard Credit Support Annex Michael Clarke Managing Director Goldman, Sachs & Co. © 2011 -2012 International Swaps and Derivatives Association, Inc. ISDA® is a registered trademark of the International Swaps and Derivatives Association, Inc.

15 Collateral in circulation • $2. 9 trillion collateral in circulation for derivatives • >150, 000 agreements • Many examples of effective loss mitigation during credit events since 1996 Volume of Collateral in US$ billions (Bars) Collateral Agreements (Line) 2 Source : ISDA Margin Survey 2011 and earlier years

20 Issue 1 - Embedded optionality • The CSA permits: § Delivering Party choice of collateral asset from the list of Eligible Collateral § Delivering Party ability to substitute collateral § Receiving Party consent for substitutions under English Law CSAs (to reduce re-characterization risk) • These are options and have economic value. § How can we project their future value? § How can they be priced? § Extreme pricing complexity § Impossible to hedge § “The CSA is the most exotic of exotic derivatives” 3

21 Issue 2 - Embedded funding mismatch • The CSA takes the mark-to-market exposure of many transactions in different currencies, nets them, and requires collateral to cover that amount (ignoring Thresholds, MTAs and IA). • In most cases, the collateral is delivered in a single currency, often USD or EUR. • Interest accrues at the overnight index rate for the relevant currency of the collateral actually delivered, e. g. Fed Funds or EONIA. • This creates a mismatch in funding currency and interest accrual between the underlying derivative cashflows and the collateral. 4

22 Aligning collateral and swap cashflows • Consider a swap with a single cashflow of $10 in one year. . . PV = FV Discount rate i = OIS FV = $10 PV = $9 (1+i)n Today + 1 Year Time • Under the SCSA collateral is required to cover the mark-to-market value of the swap, so $9 of collateral is delivered today. • Under the SCSA collateral must be cash in the currency of the swap, and cash collateral earns interest at the OIS rate. • Therefore $9 of collateral delivered today earns interest of $1 over the next year. When it is returned at the end of the swap, the collateral plus interest will precisely cover the $10 cashflow due with no currency risk and no basis risk. • If properly aligned, the collateral funds the future swap cashflow. 5

23 Example: Economics of mis-alignment 1. Accruals by Currency Silo Undisputed Amount (in currency) Spot FX Rate Net Undisputed Amount Collateral Actually Delivered under CSA Implied Funding Rate Index (in Transport Currency) USD 8, 000 1. 00000 8, 000 n/a Fed Funds H-15 EUR 100, 000 1. 44102 144, 102, 400 n/a EONIA JPY (5, 000) 0. 01000 (50, 000) n/a GBP (6, 000) 1. 61000 (9, 660, 000) CHF (2, 000) 1. 16000 (2, 320, 000) Total: USD Equivalent for Comparison 6, 400 USD 6, 400 1. 0710% EUR 1, 071, 000 USD 1, 543, 337 Mutan Call 0. 5601% JPY (28, 005) USD (280) n/a SONIA 0. 0950% GBP (5, 700) USD (9, 177) n/a TOIS 0. 0210% CHF (420) USD (487) 0. 0800% 140, 072, 400 Net Undisputed Amount 140, 072, 400 Total: USD (in Transport Currency) Portfolio Implied Annual Funding Cost USD 2. Accrual for Transport Currency If Held Unconverted Implied Funding Rate Actual Funding Collateral Actually Actual Funding Rate Index if Held in Delivered under CSA Rate Transport Currency 140, 072, 400 Fed Funds H-15 0. 08% Actual Annual Funding Cost USD 112, 058 1, 549, 737 USD Equivalent for Comparison USD × 112, 058 6

24 Issue 3 - Impediments to risk transfer • There is an active market in derivative novation and assignment. In addition, regulators and market participants are encouraging the transfer of bilateral risk to CCPs where possible. • The LIBOR-OIS discounting issue discussed earlier makes these risk transfers more difficult, because of the differences in choice of underlying curve. • The collateral-related effects render these risk transfers even more difficult, since CSA terms are not consistent across the market, and the two parties to a given CSA may factor the collateral terms into pricing differently (if at all). 7

25 Issue 4 - Lack of standardization • The inherent flexibility of the CSA is a major positive in that the vast majority of the exceedingly wide universe of derivatives executed with the entire spectrum of credit quality counterparties can be collateralized under a CSA. • However, regulatory perception is that not all variations under the CSA are warranted; or put another way, standardizing some terms to reduce the number of variations would not harm the market. • Focus on eligible collateral, Thresholds, MTAs and IA. • Operational procedures and market standards are in fact very consistent across market participants. 8

28 How the SCSA works: Context Portfolio of executed transactions between two counterparties PARTY X Transactions clearable when executed Clearing House 1 Clearing House 2 Clearing House 3 Clearing House 4 Clearing House 5 Clearing House …n… Each clearing house has its own unique margin rules PARTY Y Transactions not clearable when executed CSA (Legacy Trades) One net collateral requirement each day, delivered in eligible collateral of choice SCSA (New trades) See over for detailed mechanics One collateral requirement per currency each day, delivered in each currency or converted to a single currency with an interest adjustment overlay. Netting Set maintained across full Master Agreement scope and all collateral. Trades may be moved from the CSA to the SCSA (but not vice versa). 9

29 How the SCSA works: Mechanics PARTY X PARTY Y PARTY X PERSPECTIVE: PARTY X USD INCLUDED TRANSACTIONS EUR Transactions GBP CHF GBP Transactions CHF Transactions Pro Forma Current CSA for Comparison JPY Transactions All Transactions (See next page for cross-currency transactions and non-G 5 single currency transactions) ∑MTM COLLATERAL ∑CASH USD ∑CASH ∑MTM USD ∑MTM EUR ∑CASH ∑MTM EUR ∑MTM GBP ∑CASH ∑MTM GBP ∑MTM CHF ∑CASH ∑MTM CHF ∑MTM JPY ∑CASH ∑MTM ∑CASH + ∑SECURITIES ∑MTM ALL JPY ∑CASH ∑MTM JPY ALL ALL THRESHOLD OR Herstatt Risk Elimination EUR USD Transactions EXPOSURE REQUIRED SETTLEMENT Threshold = 0 MTA = 0 Designated Collateral Currency (DCC) Silos OR OR SAFE SETTLEMENT (PVP OR ESCROW) PLATFORM OR COMMON ARBITRAGE-FREE IMPLIED SWAP ADJUSTMENT MODEL OR OR MIRROR IMAGE PARTY Y PERSPECTIVE OR OR PARTY Y 10

49 Silo (DCC) and Transport (CSC) Currencies 1 Required by the SCSA + ISA USD Designated Collateral Currencies (“Silos”) EUR 2 JPY GBP Determined by firmspecific ALM considerations, not the SCSA Required by the SCSA + ISA 4 5 EUR . . etc. . G 17 Convert to a Collateral Settlement Currency (“Transport Currency”) and Net 3 USD CHF Settle the Net Transport Currency Amount Re-convert to Silo currencies JPY GBP CHF . . etc. . G 17 Compute and pay interest at OIS on Silo balances of collateral 11

51 Receiving party has a choice • There is no SCSA requirement for the party receiving the net amount of Transport currency to do anything in particular with it…. • BUT… it is fully rehypothecable and each party has the obligation to pay interest at OIS for each silo Undisputed Amount Collateral Amount Physically Moved PARTY X USD 140, 072, 400 PARTY Y Interest Obligations PARTY X EUR 1, 071, 000 USD 6, 400 JPY (28, 005) CHF (420) GBP (5, 700) PARTY Y • Which implies two important actions for the parties… 12

52 Balances must be manufactured • The actual physical movement was USD 140, 072, 400. • The implied DCC silo balances were however… Implied Silo Balances PARTY X EUR 100 mm USD 8 mm JPY 5 mm CHF 2 mm GBP 6 mm PARTY Y • So Party X has to establish balances of EUR 100 mm and USD 8 mm on which to accrue interest it will pay. § This is more than the physical movement received. • Party Y has to do the same for JPY 5 mm, CHF 2 mm and GBP 6 mm. § This is more than the physical movement received (which was nothing, because Y delivered to X of course). 13

53 Integration into treasury management • Balance sheet obligations for the individual DCC balances need to be established, so that correct accruals can occur. • The actual physical movement of USD 140, 072, 400 also needs to be addressed. It needs to be funded by Party Y and invested by Party X. • It must therefore be integrated into the treasury management processes at the two firms. • The receiver of the physical movement will need to consider: § Converting the received transport currency amount into the relevant DCC silo balances - a direct hedge of the funding risk. § Factor the received transport currency amount into the general treasury funding flows for the day - a portfolio hedge of the funding risk. § Leave the collateral in the transport currency and do not hedge. • We do not recommend the last option. 14

54 Baseline funding and collateral flows PARTY X EUR 100 mm 7 4 EUR 100 mm 3 EONIA 8 EUR 100 mm Net Interest 5 Zero PARTY Y EUR 100 mm 2 EONIA 6 Net Interest 1 EONIA 9 EUR 100 mm Party Y Funding Trade Party X Funding Trade Collateral Flows EUR 100 mm Zero 15

55 Netted settlement collateral flows (EUR silo only) Collateral Flows USD 144, 102, 400 4 EUR 100, 000, 000 8 USD 144, 102, 400 3 12 PARTY Y USD 144, 102, 400 2 EONIA Basis Difference USD 144, 100, 000 Cash Difference 13 Party Y Funding Trade Tom/Next Swap PARTY X 1 Fed Funds 7 9 USD 144, 100, 000 10 USD 144, 102, 400 5 EUR 100, 000, 000 EONIA 11 6 Party X Funding Trade 16

56 Economics PARTY X PARTY Y Receive EONIA 3, 635 Pay EONIA (3, 635) Receive EONIA 3, 635 Pay Fed Funds (1, 001) Cash Difference (2, 400) Net Zero 234 (Cross-currency basis) 17

57 Cross Currency Basis • Cross-currency basis refers to the spread adjustment required on one leg of a Libor vs. floating cross-currency swap in order to make the swap price at par. • This basis is observable in the market (see Bloomberg or Reuters swap rate screens). • There is a no-arbitrage relation between FX forwards, interest rate swap levels, and crosscurrency basis. • Two streams of par cashflows in different currencies may have a zero present value when considered each in isolation, but when linked via a transaction the net value is non-zero; the difference is the cross-currency basis and reflects the differences in perceived credit risk and market access between the parties funding in the two currencies. • Cross-currency basis may be positive or negative. • The ISA methodology implicitly includes the cross-currency bases for all silos. • One can consider the $234 cross-currency basis as the “cost” of using net settlement (the ISA methodology) to eliminate Herstatt risk and compare it to the cost of constructing alternative methods of managing this risk (eg building a PVP platform). 18

60 SCSA program plan Q 4 2011 Q 1 2012 As of February 28, 2012 - subject to change Q 2 2012 Q 3 2012 Q 4 2012 Q 1 2013 Phase 1 - Pathfinder Implementation for Volunteer Firms JAN 1. Commercial Design Stream FEB MAR APR Commercial Design MAY JUN JUL AUG SEP OCT NOV DEC Arrows illustrate certain key dependencies Continued Business Technical Input 2. Legal Stream 3. FPML Stream Counsel Review Legal Doc Drafting Program critical path is outlined in blue FPML Design Infra Spec 5. ISDA SCSAFIX Stream ISA Details Market Infra Development Design 4. Infrastructure Stream Internal IT Change Design ISDAFix SCSA Build Test Prep 6. Execution Stream 7. Education and Regulatory Outreach Stream Local Counsel Opinion Updates Market Testing Adoption Design Market Education Execution Phase 1 Live Date August 10 Bilateral pairs of firms may execute the SCSA at any time after August 10 Market Education Regulatory Outreach Phase 2 - Wider Market Adoption (Timings are highly uncertain) Timing for PVP delivery is highly uncertain at this time and dependent on third party construction. Historical examples of linked-settlement infrastructure have shown that construction can take many years. PVP Requirement Definition PVP Infra Construction and Testing NOW 19

61 Advantages of the SCSA • Removes collateral “switch options” • Restricts variation margin to cash only, so that collateral interest accruals will approximate the funding cost of the underlying cashflows. § Further limits this to cash for which a liquid OIS market exists. § Will be extensible as other OIS markets develop liquidity, promoting the growth of liquid OIS markets. • Simplifies calculations by standardizing terms. • Eliminates structural CSA differences, thus: § Trade valuation more consistent and transparent. § Making novation, assignment and risk transfer to CCPs easier. § Reducing one cause of margin disputes. 20