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Distinguish CSAs that run one way from those that run both ways, and describe how collateral parameters can depend on credit quality.

FRM® Part II · Credit Risk Measurement and Management · Margin (Collateral) and Settlement · FRM2.CR.17.h

The idea

A one-way CSA requires only one party to post collateral, and the other posts nothing. It is typical when one side has much weaker credit, or when a strong party such as a highly rated corporate or supranational will not post. A two-way (bilateral) CSA requires both sides to post, depending on whose exposure is positive. Collateral parameters often depend on credit quality. Thresholds are set by rating, falling toward zero as a rating drops. Minimum transfer amounts and haircuts can tighten, and a downgrade can trigger an additional call or a termination event. A downgrade therefore increases collateral demand precisely when the poster is under stress, a cliff effect. The exam point: one-way versus two-way is about who posts, while rating dependence changes the size of what is required.

A practice question

From the question bank, with the reason each wrong option is wrong.

A one-way CSA is one in which:

  1. Both parties post collateral but only one of them may rehypothecate itWhy not: Confuses the right to reuse collateral with the obligation to post.
  2. Collateral may be posted in one currency onlyWhy not: This describes an eligibility restriction, not the direction of posting.
  3. Only one party must post collateral, whatever the sign of the exposure - correct
  4. Only one trade in the portfolio is collateralisedWhy not: One-way refers to who posts, not to how many trades are covered.

Under a one-way CSA, collateral flows in one direction only; the other party posts nothing even when its exposure to the first is negative.

A harder one

A CSA sets thresholds by rating: USD 10 million at A, USD 3 million at BBB and zero below BBB. Exposure to the counterparty is USD 15 million, and it has already posted USD 5 million at its A rating. It is downgraded to BBB. What additional collateral is called? There is no minimum transfer amount.

  1. USD 12 millionWhy not: Reports the total requirement rather than the additional amount.
  2. USD 7 million - correct
  3. USD 5 millionWhy not: Repeats the collateral already posted at the old threshold.
  4. USD 3 millionWhy not: Reads the new threshold as the call.

At BBB the requirement is 15 - 3 = 12. Already posted 5, so the additional call is USD 7 million.

The hardest tier

Why do rating-contingent thresholds create a cliff effect?

  1. They lower the exposure of the downgraded party's counterparties, so it gains liquidity from themWhy not: Reverses the effect; a downgrade leads to more collateral demanded, not less.
  2. They remove the need for margining of weaker partiesWhy not: Weaker parties are margined more tightly.
  3. A downgrade raises required collateral just when the party's funding is most stressed - correct
  4. They apply only to the stronger party, which then faces calls it cannot forecastWhy not: Rating triggers bind the party whose rating falls, not the stronger party.

Collateral demand rises when the poster is weakest, so a trigger can force asset sales or cash raising at the worst moment.

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