The Collateral Call That Became a Liquidity Crisis
A hedge fund runs a $2 billion portfolio of interest rate swaps with a single dealer under a bilateral CSA with a $5 million threshold and daily variation margin in cash. The fund also has a $400 million repo book with the same dealer, secured by Treasuries. In a rate shock, the swaps move $85 million against the fund. The dealer issues a margin call for $80 million (the amount above threshold). Simultaneously, the dealer declines to roll $150 million of maturing repo, citing 'counterparty concentration limits.' The fund's prime broker is a different entity and offers no relief. The fund has $60 million of unencumbered cash. The CFO asks whether the fund can 'net' the swap exposure against the repo exposure to reduce the call, and whether the dealer's actions are permissible.
1. Explain whether the fund can net the swap variation margin against the repo exposure, and why the margin call is what it is.
Read the worked answer
The fund generally cannot net the swap variation margin against the repo exposure unless the master agreement and CSA explicitly provide for cross-product netting and the dealer agrees. Several reasons:
- Separate legal relationships. The ISDA/CSA governs the swaps; the repo is typically under a GMRA or separate master. Netting across them requires a cross-product netting provision, which is uncommon and must be documented.
- Different collateral mechanics. Variation margin on swaps is a settlement of mark-to-market; repo is a secured financing where the collateral (Treasuries) is pledged, not netted against a derivative MTM.
- The margin call math. With a $5M threshold, the call is the exposure above threshold: $85M − $5M = $80M. That is correct under the CSA as written. The threshold is a credit line, not a netting right.
So the CFO's 'net it' idea is not available. The fund must meet the $80M call in cash (it has $60M, so it is $20M short) and separately address the repo roll-off.
2. Evaluate the dealer's decision to decline the repo roll and recommend the fund's response.
Read the worked answer
The dealer's decision is generally permissible if the repo documentation gives it discretion not to roll at maturity - a repo is a short-term financing that matures; there is no obligation to renew unless contractually committed. Declining to roll is a credit/risk decision, not a default, provided the dealer returns any excess collateral and honors the existing terms. 'Counterparty concentration limits' is a legitimate internal risk rationale.
However, the combination - a large margin call plus a refusal to roll - is a classic liquidity squeeze and may trigger contractual rights:
- Check the CSA for collateral thresholds, minimum transfer amounts, and any rating triggers that could alter the call.
- Check the repo master for set-off, cross-default, or cross-product netting provisions that might allow the fund to apply repo collateral or net exposures.
- Assess whether the dealer's actions breach any implied duty of good faith or the specific notice provisions.
Recommended response:
- Meet the $80M call by sourcing the $20M shortfall (draw on committed facilities, sell liquid assets) to avoid a swap default, which would be far more costly.
- Do not unilaterally withhold or net - that risks a default and cross-default across both books.
- Diversify counterparties going forward; the concentration with one dealer is the root cause.
- Document the event and escalate to legal; consider whether the dealer's conduct supports a complaint or renegotiation of the CSA threshold.