What is the difference between a cleared interest rate swap and a OTC interest rate swap with collateral in theory

Question

I understand the aspect that central clearing reduced counterparty risks. From the valuation side, am I right that cash flows for both trades will be discounted at the OIS rate?

The party that holds the collateral will need to pass back the interest, but if you pay into the margin account, the money is "gone" and you gets no interest. If this is right, why a cleared swap cash flows are discounted using OIS rate?

Thanks,

Answer 1

For both cleared and OTC swaps you need to post margin. If you are delivering cash then you will receive OIS in generally in either case. As OTC trades are bespoke you might have a different agreement with your particular counterparty - but that would be unusual.

The main advantage of a central clearer is the recycling of margin. If I receive 5y from party A and pay 4.5 year to party B then, if we centrally clear, I will only post net enough margin to satisfy the net of the two. There are some exceptions - but most central clearers today have some form of span netting.

Answer 2

A cleared swap faces the clearing house. As a centralised trade depository the clearing house imposes margin requirements, as a kind of insurance for their perceived lower credit risk. Margin is nowadays remunerated at local currency OIS I believe. The collateral is posted in local currency (or USD depending upon product) and remunerated at local OIS. Margin is often calculated based upon net risk.

An OTC swap has a collateral and remuneration stipulated by the terms of the credit support annex (CSA) which is a part of the ISDA Master Agreement drawn up between the two specific counterparts. It can vary significantly to the terms with the clearing house (currencies, remuneration, allowable securities, timing of exchange, etc) although typically there is no margin on OTC swaps, and some may even be unfunded or uncollateralised.

If all the terms are the same as the clearing house then there will be minimal difference except for the clearing house margin. However, the (Basel III) capital requirements/ratios and credit risk concerns for the OTC swap are likely more onerous.