Counterparty risk consists of delivery risk for the buyer and credit risk for the seller. These risks have to be managed by those parties who are involved with it.
Next to a master agreement, parties in the OTC markets, may also enter into a so-called credit support annex (CSA) with a counterparty. Such a document describes the terms or rules under which credit support (or collateral) is posted to mitigate the credit risk.
A credit support annex concerns a document which sets out rules to regulate credit support, like collateral or margin, for OTC (derivatives) transactions between two parties. To mitigate credit risk, collateral can be posted on a joint bank account, or an independent bank account.
CSAs contain terms under which collateral is posted or transferred to mitigate credit risk arising from in-the-money derivative positions, including:
- Thresholds
- Minimum transfer amounts
- Eligible securities
- Rules for settlement of disputes arising over valuation
A credit support annex may incorporate or work in conjunction with a credit line. As soon as one party exceeds this limit they need to arrange payment first before they are allowed to enter into new deals. This keeps the exposures within certain boundaries and, therewith, it caps counterparty risk.
A credit support annex is often combined with a master agreement, though it is not mandatory.