For those that know what PAI is, the first part of this post can be skipped, the rest of the post is my understanding of why PAI is applied to OTC portfolios, and not Futures. This arose from a question at a training course I delivered, and was interesting to understand.
What is PAI?
Imagine two banks, with an Interest Rate Swap, cleared through a CCP such as SwapClear. At the beginning of the life of the swap the PV is close to zero, so worth little to either party. Over the life of the trade the value of the floating leg will vary leading to an NPV to one of the parties. The change in this NPV from day to day is what Variation Margin is, calculated and moved by a CCP on a daily basis.
Imagine you are the unlucky party where the NPV is against you (out of the money), the CCP will require you to pay the NPV into the CCP, which they will transfer onwards to the other party.
- You: -NPV (and suffer a funding cost)
- Counterparty: +NPV (and invest to earn interest)
In this case the other party enjoys the benefit of depositing the NPV and earning interest on it, very nice. You on the other hand, have to fund the NPV payment which costs you money.
PAI is used to level this uneven playing field by transferring the benefit of receiving the NPV back to the payer of NPV (VM) like this:
- You: -NPV (and suffer a funding cost) : Receive PAI
- Counterparty: +NPV (and invest to earn interest) : Pays PAI
PAI is the overnight cost of funding the VM, debited from the receiver and transferred to the payer. The rate at which PAI is calculated is chosen by the CCP so may not match your own cost of funds.
So the net effect is this:
- You: Fund the VM/NPV but receive an amount of PAI to compensate
- Counterparty: Receive VM/NPV but are debited PAI which offsets the interest you might earn.
Why is PAI included in the CCP model for OTC products, and not for futures?
Legal aspects of Futures
A clue can be found in this blog post by Noah Melnick at Linklaters, which describes how trades such as futures are treated at an exchange / CCP.
For a Futures trade, the rules of the CCP define that each day the closing price of the contract is used to calculate VM, and the profit or loss is debited from your margin account daily. The exchange regards this payment as full and final settlement of the contract, as should your counterparty default, you will receive no further payment on this contract. This means a Futures trade is regarded as “final” or “matured” on each and every day, until the expiry date of the contract, in which case the VM payment is a settled amount, and not a margin asset.
In this case you are free to re-use any VM payment, as in the example above, without the PAI adjustment.
OTC PAI treatment
For an OTC trade, the VM payment represents the value of future cash flows, which remain unsettled until each coupon date, and final maturity, so you regard VM as an amount of margin which you would receive back should the value of the contract move in your favour. The difference in default, is that in some CCPs for OTC products, the portfolio of trades owned by the defaulting party (for direct members) are auctioned, such that eventually a new party takes ownership, and the contract continues unchanged until maturity.
This means the VM payment for an OTC trade is characterised as a margin asset, which you would expect not to lose should your counterparty default, hence the application of PAI, equivalent to receiving interest on your margin asset, is applied.
A further aspect is equivalence of an OTC IRS in the cleared and bilateral world. Should PAI be ignored by a CCP, the payer of VM would feel the penalty of clearing, which they wouldn’t outside a CCP. PAI evens this out to some degree.
More work is being done by ISDA to promote the use of the Standard CSA to align the costs of VM with the currency and accrual basis of the Swaps, using OIS rates instead of the LIBOR curve.
Read the blog post from Noah who covers an unresolved question on why or how VM should be segregated under US law, but of course it isn’t held by a CCP but passed through between parties.
Update May 16th 2013 from Jon Skinner
- PAI also causes the convexity factor to be added to swap curve building / pricing methologies.
- Banks treat cleared VM as collateral not settlement in the futures model. However, CME treats VM as settlement even for swaps.
- Deliverable Swap Futures are another variant and the VM in that case is supposed to be settlement i.e. realized P & L. They do have PAI but the VM is clearly not collateral.