The time has come to amend your CSA

The time has come to amend your CSAThe time has come to amend your CSA

The London Clearing House (LCH) recently announced that it would move to SOFR discounting by the second half of 20201. Noting that the CME had already switched to SOFR discounting as of July of 2018, this signifies a convergence discounting indexes for exchange cleared derivatives on both exchanges.

This convergence, however, will not eliminate the notoriously famous “CME-LCH” basis spread though. This basis existed even when both exchanges were using Fed-Fund/OIS discounting. Within the Quant community, the spread is believed to be explained by an imbalance of trade flows on each exchange, imposing an effect on margin requirements. Switching to SOFR discounting will not change this.

On the other hand, it would be inconvenient to have collateralized derivatives with a customer that has a Credit Support Annex (CSA) with an agreed collateral return rate still given in terms of OIS (Overnight Index Swap), which is currently the standard. This makes life complicated: this derivative is to be valued using OIS discounting, while your hedge will be valued using SOFR discounting. If this derivative is a LIBOR trade, you will need to manage LIBOR, OIS, and SOFR all at the same time.

In theory, there isn’t really a choice when it comes to a discounting index. From the Quant point of view, it is the bi-directional collateral return interest rate you have agreed to with the customer. This rate is typically not negotiated trade by trade. Rather, it is agreed to in the CSA with your customer. Therefore, to minimize the mismatch and to reduce risk for a customer, a plan should be prepared as soon as practicable to renegotiate the CSA collateral return rate to be SOFR based.

It is also important to note that a changing discount index will have valuation impacts. Since it is unlikely you can process the CSA change for all your customers on the same day, this means there will be a period where, for example, 20% of your customers already moved to SOFR discounting while the other 80% are still using OIS discounting. Some weeks later this may change to 30-70 split, and so on. During this transition period you need to be very cautious about discount curve assignment. One approach is to group customers according to whether the CSA update is in effect and assign discount curve to the group. This reduces operational risk for valuation and risk management.

Banks should reach out to their counterparties to start planning to amend the CSA, the sooner the better.

1.    Bartholomew, Helen. ‘LCH plans 2020 switch to SOFR discounting,’ Risk.net, February 12, 2019. https://www.risk.net/derivatives/6385026/lch-plans-2020-switch-to-sofr-discounting.