How Uncollateralized OTC Derivatives Create Bank Funding Costs
Summary
The document explains why an uncollateralized OTC derivative can still impose funding costs on a bank, even though the trade itself requires no initial cash. One source is the hedge: the bank may hedge through collateralized interbank trades, and adverse movements in the hedge can require collateral payments while the uncollateralized customer trade provides no offsetting cash. Coupon payments can also require funding when they are cash outflows, because uncollateralized trades do not automatically return those payments as collateral.
The answer separately identifies regulatory capital as another cost. Uncollateralized trades may attract greater capital requirements, including risk-based and leverage constraints, and banks account for the cost of financing that capital. The explanation is qualitative: it gives two cash-flow mechanisms and a capital channel, but no formulas, pricing model, or quantitative comparison. Actual funding impact depends on the hedge, payment direction, collateral terms, and applicable capital rules.
Key ideas
- A bank may need to post cash on a collateralized hedge even when its uncollateralized customer trade produces no cash payment.
- Coupon outflows on uncollateralized trades can require treasury funding.
- Collateralized coupon flows may be offset by collateral adjustments, reducing the need for a separate cash injection.
- Regulatory capital requirements can add funding costs, and may be higher for uncollateralized trades.
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Full text
# uncollateralised otc derivatives and bank funding costs # uncollateralised otc derivatives and bank funding costs I've read multiple references that imply that the valuation of OTC derivatives being related to bank funding cost. Given that an uncollateralised OTC derivative needs no funding from the bank's treasury - no cash is required to maintain the position - I am struggling to see the connection. Is there a simple relation between the two that I've missed? Is there a relationship between the value of the derivative and what the bank posts onto their balance sheet? ## Answer by Attack68 (score 5) https://quant.stackexchange.com/a/40574 Here are two scenarios where physical cash is immediately required from the treasury to fund the position; #### Collateralised hedges, and market movements. A bank will typically hedge its exposure using the interbank market which have collateralised trades. If the uncollateralised trade moves positively and becomes an asset the hedge, natyrally, moves adversely and becomes a liability. The bank will be required to post collateral on the liability and it will receive nothing fron the uncollateralised trade, meaning a cash injection. #### Paying coupons, without a market movement. On a collateralised trade when a coupon payment is made the NPV of the remaining trade is adjusted and the side with liability who receives the coupon posts it back to the asset holder as collateral, so although there is a transfer of ownership of cash there is no practical movement of cash. Not so with uncollateralised trades. The coupon payment is a physical movement of cash and needs to be funded if it is an outflow. edit.. #### Regulatory Capital Capital charges for banks, as specified by Basel III, form a different kind of funding charge. The minimum capital that a bank is required to hold against the trade, in terms of risk capital charge, leverage ratio, and/or risk-weighted-asset (RWA) charge are more stringent in general for uncollateralised trades. Bank capital costs are measured against the cost of funding.
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