Ali Curi: [00:00:00] Hi everyone, and welcome to ION Markets Quick Takes. I'm Ali Curi, and every week, along with my guests, Amir Khwaja and Chris Barnes, we take a quick dive into the headlines on the Clarus blog.

Let's get started. Hi Amir. Hi Chris.

Amir Khwaja: Hi Ali. 

Chris Barnes: Hey Ali, how you doing? 

Ali Curi: I'm doing great. It's great to have you back to Quick Takes.

Chris, let's start with you. What's your Quick Take for this week? Which headline from the ClarusFT blog would you like to discuss? 

Chris Barnes: All right, this week, I'm going to try and talk about CSAs, which is the credit support annex of an ISDA agreement. Two reasons sparked me to write this. One is that somebody that I've spoken to for like three, four, five years in the market, suddenly out of the blue asked me, "So what exactly is a CSA when you're talking about these things?"

And sometimes when you're in the weeds and you're talking about these things day in, day out, sometimes, I do need to take a step back and remind people that three letter acronyms do actually have something real. So a structure of a blog was forming in my head [00:01:00] after that conversation. And then secondly, one of my old colleagues famously described a CSA as the most complex derivative ever created by man.

And it's really hard to gel those two things together. When everybody hears about a CSA who are trades in the markets, the implementation of the unclear margin rules meant that you have to have a CSA with all of your counterparties now. So in essence, in 2024, if you don't have a CSA, you're probably not trading OTC derivatives anyway.

And yet, it has the propensity to be the single most complex derivative in your entire portfolio. And so I thought I would try and lay out a blog that really explained it. And I started from the perspective that, banks just like to charge, right? Everyone moans about bank charges and that doesn't really change if you're a retail client [00:02:00] or if you're a trading client, you're always looking at, "What are these charges? Where is the bid offer coming from?", et cetera. And certainly with the evolution of bilateral markets over the past 10 years, a lot of the focus has been on increasing, "charges" that banks are finding from an XVA perspective. And what the blog really does is pulls together what a CSA actually is and relates it to what these XVA charges are.

I wanted to really start from first principles and show you how the interest that is paid or received on the collateral that you post defines the discounting of your portfolio. So I throw up a very simple spreadsheet, which I think is a great exercise for people who are first starting in the industry to actually complete.

If you earn interest on one day, prove that the time value of that changes the MPV of your portfolio by [00:03:00] exactly the same amount by shifting the date of the portfolio a day forward. And so that is the basis, the kind of mathematical reasoning behind it, but that's all well and good when you're talking about a single currency portfolio, when you're posting collateral in the same currency, and then take it a step forward, and show that if you've got Euro rates, underlying the move in value of your portfolio, but you're posting dollars, what you're effectively ending up with is a loan in euros and a deposit in dollars for the life of your portfolio. And that will inherently carry a funding costs that will define the discounting of your portfolio that will define the value of it over and above that you then have the possibility of course, that funding position changes.

And so that funding position is related to the volatility of those two things, your discount curve and your predicted valuation. And then the final layer, and this is why it can be [00:04:00] so complex is you've got a multi currency portfolio, but you're not actually posting cash. You start posting a security or you start posting the example I give is "guilts."

And historically, we wouldn't have ended up in this position if we'd started with a blank piece of paper and recognized all of these risks on day one. But historically, what happened was that a CSA was seen as a back office function. You were just collateralizing the approximate value of a portfolio.

And so people would just post what they had loads of without any consideration of what it would do to the valuation of the portfolio. That sounds like a really crazy thing to state up front, but that is literally how our markets have evolved. And so there's a lot of different threads here. I tried to make CSAs as interesting as possible, because I think it's very easy just to think of them as these dull agreements, but actually they are intrinsic to how you [00:05:00] trade your whole portfolio. 

Amir, any specific questions on the blog? 

Amir Khwaja: Yeah, sure Chris. So I guess first I'd say, that's a great blog. So mostly as you say, when we hear the word CSA and read about CSAs, much of what we read is back office orientated; collateral, what do you provide, what's legible, what's the haircuts are.

Very back office process driven, and I've always found it, counterintuitive that, in software, what it means now is that if your CSA is dollars and you have exposure in euros, you're discounting for that, your interest rate swap requires a cross country basis curve between dollars and euros, add it to the discounting curve, I think you explained it very well, in terms of why that happens, and fundamentally, I think that understanding, has really changed the valuation of loss attributives. 

Chris Barnes: I would say it's probably not a coincidence that I'm stood here as an ex cross currency swaps trader talking about CSA discounting, because I distinctly remember back in 2008 when we were looking at [00:06:00] discounting across the market.

And most of our Euro swaps traders, most of our dollar swaps traders had never heard of cross currency swaps really trading, they were rates trading. And so like the idea that their portfolios would suddenly start creating these cross currency basis positions and they would have to start trading both of them was really kind of anathema.

That was a funding product. It was a second order risk. You're not going to make or lose your year's P&L based on the discounting, right? And we know over time that has proven to be wrong. And in essence, you can't trade uncleared derivatives markets without having an element of cross currency risk on your book.

Amir Khwaja: Yeah, because I remember equally, on the IT side, when maybe after '08, we started to change our software to also be aware of a different currency discounting spread. From a synchronicity trade, that was a big change in that software. And so again, so I guess it had many manifestations.

And I guess your other point, which I really is that, clients need to [00:07:00] understand the charges that they see from their banks, where whether I'm a retail client and I'm being charged some fee for doing an FX trade, whatever the bid is, I think similarly on, on this sort of stuff, it becomes important to know that why there's a cost depending on what currency you're providing as your exposure.

Chris Barnes: Yeah, and it's very hard for dealers to be transparent on that, to be fair, because a lot of it is model driven. It's not observable. There isn't a cross currency swaption market, and so there isn't a volatility for 10 year Eurodollar that's quoted on Bloomberg. And so there's a model input that feeds into where your expected marked market of a portfolio will be.

It is inherently difficult for dealers to be transparent about it. I think the thing that we can do is help educate clients as to these are the drivers behind it. 

Amir Khwaja: Exactly. And I think, that's what your blog does, showing that it's a loan in a different currency, clients will understand that rationale in terms of why that's [00:08:00] happening.

They may not be able to quantify the charge that they're being posed, but that they have a good sense of why it's there, what the quantum is. Great. Thanks, Chris. 

Chris Barnes: Ali, that was a blog called Mechanics and Definitions of the ISDA Credit Support Annex, in brackets, CSA. 

Ali Curi: Thank you, Chris, and thanks for sharing the title of your blog post.

Chris Barnes, Amir Khwaja, thank you both for sharing your Quick Takes. 

Let's do it again next week. 

Amir Khwaja: Thanks, Ali. 

Chris Barnes: Thanks, Ali. 

Ali Curi: And that's our episode for today. You can read more about these topics on the Clarus blog, and you can follow ION Markets on X and on LinkedIn. Thank you for joining us.