How does a company pledge collateral?
November 11, 2008 11:30 PM   Subscribe

What actually happens when a company (e.g. AIG) posts additional collateral for a credit default swap (or other financial instrument)?

From, September 15, 2008

But none of those downgrades appeared to be trigger events requiring A.I.G. to post billions of dollars of collateral to its swap counterparties.

Would AIG maintain cash on their books that is pledged to the counterparty? Or do they actually transfer money to the counterparty, and that party holds the cash? Or is there some sort of independent escrow service that holds the collateral?

Furthermore, what can they use as collateral? Is that spelled out in each particular CDS, for example?
posted by csw to Work & Money (3 answers total) 1 user marked this as a favorite
Best answer: Generally speaking derivative contracts are documented under ISDA Master Agreements, which mostly include a Credit Support Annex. The CSA regulates the posting of collateral across all the derivative positions between two firms. AIG be a different case though and may not have had CSAs in place with its counterparties and they will have relied on bespoke collateral transfer provisions in each confirmation.

Very roughly, how a normal CSA works is that all open interest rate, currency, credit etc derivative positions between two counterparties are netted out and a single number is produced. This number is (more or less) the net amount that one party would have to pay the other if all the contracts were terminated at that time. This amount is the "Exposure". If the value of collateral that has previously been transferred by one party to the other is less than this amount, they will have to transfer more. If the value is greater, they will be due some back. As the value of the derivatives and the collateral already transferred moves, amounts will be due back and forth. There are limits and thresholds to prevent constant transfers of small amounts. The valuation generally happen daily or weekly.

The terms of the CSA will specify what collateral is allowed. Cash is always allowed though the CSA will specify which currencies. Government securities are also generally ok, but their value is discounted by a certain percentage to reflect the credit and liquidity risk - i.e. the chance that $100 of bonds won't be worth $100 in cash when the time comes to call on them. The percentage reduction is a "haircut". So, for example, you might see US Treasuries with a maturity of less than one year at 98%, which means transferring $100 face amount of treasuries will only count as $98 of collateral. The eligible securities would be pre-agreed, normally with a proviso that the parties can agree anything they like, as long as the haircut is agreed.

There are a number of different standard form CSAs depending on choice of governing law, but the two main ones are New York Law and English Law - Transfer. Both of them require the party posting collateral to actually make a real transfer to the other party. The New York law version also sets up a pledge once the transfer has been completed.

In some case insurance companies that wrote CDS, especially so-called "super-senior" tranches, didn't use CSAs. As they were lightly capitalised (in AIG's case its structured finance arm) they didn't want to have to transfer cash if the market value of the swaps moved away from them. Instead they got their counterparties happy with downgrade triggers instead. Traditional CSAs don't look at the likelihood of a counterparty going bust, just the value of the exposure if it were to happen. The insurance companies essentially said "we're so safe, you only need to start worrying if we're rated less than A+". Each CDS will have the exact trigger and what the required collateral transfer is on a downgrade. Generally, the collateral isn't linked to the exposure as in a normal CSA but is an arbitrary number, most likely the entire notional of the CDS (often many billions of dollars). As such, when the downgrades hit, the insurers had huge amounts of cash to transfer.
posted by patricio at 2:22 AM on November 12, 2008 [2 favorites]

See also this explanation by Felix Salmon at
posted by patricio at 12:05 PM on December 4, 2008

And there's an update too
posted by patricio at 4:14 AM on December 9, 2008

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