Understanding the ISDA Credit Support Annex · PDF file · 2013-02-19Understanding...
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Transcript of Understanding the ISDA Credit Support Annex · PDF file · 2013-02-19Understanding...
IECA Spring Conference March 11, 2012
Newport Beach, California
GuyLaine CharlesGuyLaine Charles TeiglandTeigland--Hunt LLPHunt LLP
New YorkNew York
Understanding the ISDA Credit Support Annex
Outline of Presentation
Overview of the CSA
Key Provisions of the CSA and modifications made in Paragraph 13:
Secured Party and Pledgor
Security Interest
Credit Support Obligations
Conditions Precedent
Transfer Timing
Calculations of Value and Exposure
Dispute Resolution
2
Outline of Presentation
Key Provisions of the CSA and modifications made in Paragraph 13 (continued):
Substitutions of Collateral
Events of Default
Rights and Remedies of Pledgor and Secured Party
Representations
Miscellaneous
3
Outline of Presentation
Credit Implications of Dodd-Frank
Clearing Requirement and End-User Exception
Margin Requirements
Segregation of Collateral Securing Uncleared Swaps
4
Overview of the Credit Support Annex
Annex to the ISDA Master Agreement
Can be customized (in Paragraph 13) to accommodate the individual needs of the parties while providing a basic contractual framework under New York law to:
State the parties’ obligations to deliver and release credit support.
Identify the types of credit support that will be acceptable to the parties.
Include a grant of a security interest on collateral.
Set out the rights, remedies and duties of the parties with respect to the credit support provided.
5
Overview of the Credit Support Annex
Benefits:
Protects against mark-to-market exposure.
Costs:
Requires constant monitoring and back-office systems.
6
CSA Paragraph 1(a): Definitions and Inconsistencies
Definitions
As provided in Paragraph 12 and modified in Paragraph 13.
Inconsistencies
Annex prevails over Schedule and Paragraph 13 prevails over Annex.
7
CSA Paragraph 1(b): Secured Party/Pledgor
Secured Party and Pledgor
Each of the parties have the dual role of Secured Party and Pledgor under the CSA (assuming CSA is bilateral).
8
CSA Paragraph 2: Security Interest
Security Interest in Posted Collateral
Provides for grant of security interest in Posted Collateral under the CSA.
Covers parties’ Obligations under the ISDA, including certain expenses under CSA.
Scope of “Obligations” can be extended beyond Transactions under ISDA.
9
Paragraph 13: Elections & Variables
13(b)(ii): Eligible Collateral:
Paragraph 13 permits the parties to specify “Eligible Collateral” under the Annex, as well as the applicable Valuation Percentage used in determining the Value of such collateral.
Paragraph 13 provides for Cash, Treasury Bills, Notes or Bonds as potential Eligible Collateral. Typically energy commodity counterparties elect Cash.
10
Paragraph 13: Elections & Variables
13(b)(iii): Other Eligible Support:
Paragraph 13 permits the parties to specify what collateral may constitute “Other Eligible Support” apart from any Eligible Collateral.
Many energy commodity counterparties elect for Letters of Credit to constitute “Other Eligible Support”.
11
Security Interest in Posted Collateral
Eligible Credit Support
“Posted Collateral” vs. “Posted Credit Support”
“Eligible Collateral” posted with a Secured Party is “Posted Collateral”, e.g., Cash .
Other Collateral is “Posted Credit Support”. E.g., Letter of Credit.
12
CSA Paragraph 3: Credit Support Obligations
The provision requiring the Transfer (i.e. delivery or return) of Eligible Credit Support.
Obligation to transfer credit support arises if the Secured Party is entitled to a Transfer and makes a demand on or promptly after a Valuation Date.
Obligation to return credit support arises if the Pledgor is entitled to a Transfer and makes a demand on or promptly after a Valuation Date.
13
CSA Paragraph 3(c): Credit Support Amount
Credit Support Amount = for any Valuation Date
(i) the Secured Party’s Exposure for that Valuation Date plus
(ii) the aggregate of all Independent Amounts applicable to the Pledgor, if any, minus
(iii) all Independent Amounts applicable to the Secured Party, if any, minus
(iv) the Pledgor’s Threshold;
provided, however, that the Credit Support Amount will be deemed to be zero whenever the calculation of Credit Support Amount yields a number less than zero.
14
CSA Paragraph 12: Definition of “Exposure”
Exposure:
Defined in Paragraph 12 of CSA.
The amount payable under Section 6(e)(ii)(2)(A) [6(e)(ii)(1) w/r/t 2002 ISDA] of the ISDA Master Agreement as if all Transactions were terminated as of the Valuation Date.
15
Paragraph 13: Elections & Variables
13(b)(iv)(A): Independent Amount
Typically established in confirmation.
Overcollateralization required to be maintained by Pledgor in addition to collateralization for mark-to-market exposure.
minimum collateral amount that a party must maintain at all times under the Transaction/Agreement.
13(b)(iv)(B): Threshold
Unsecured credit granted by one party to another.
Can be:Fixed amountCredit ratings matrix that varies by counterpartyBased on amount of guarantee
16
CSA Paragraph 3(a): Delivery Amount
Delivery Amount:
(i) the amount by which the Credit Support Amount exceeds
(ii) the Value as of that Valuation Date of all Posted Credit Support held by the Secured Party.
17
CSA Paragraph 3(b): Return Amount
Return Amount:
(i) the amount by which the Value as of the Valuation Date of all Posted Credit Support held by the Secured Party exceeds
(ii) the Credit Support Amount.
18
Paragraph 13: Elections & Variables
13(b)(iv)(C): Minimum Transfer Amount:
Unsecured Exposure
Will vary by counterparty and the anticipated volume of Transactions under the ISDA.
13(b)(iv)(D): Rounding: The parties may specify the dollar amount by which calculated values will be rounded up or down.
MTA and Rounding Amounts can be amended to make collateral obligations more or less onerous.
Round Amounts to $1 if there are no transactions outstanding.
19
CSA Paragraph 3(a): Delivery Amount
Upon a demand by the Secured Party:
If on any Valuation Date the Delivery Amount equals or exceeds the Pledgor’s Minimum Transfer Amount, then
The Pledgor must Transfer Eligible Credit Support with a Value at least equal to the Delivery Amount.
20
CSA Paragraph 3(b): Return Amount
Upon a demand by the Pledgor:
If on any Valuation Date the Return Amount equals or exceeds the Pledgor’s Minimum Transfer Amount, then
The Secured Party must transfer Eligible Credit Support with a Value at least equal to the Return Amount.
21
EXAMPLEExposure: $1000Pledgor’s Threshold: $100Pledgor IA: $0Secured Party IA: $0Credit Support Amount: $1000- $100= $900
1
EXAMPLECredit Support Amount: $1000- $100= $900Posted Collateral:$200MTA: $250Rounding $100
Delivery Amount: $900-$200=$700
1
CSA Paragraph 4(a): Conditions Precedent
Conditions Precedent: Each Transfer obligation of Pledgor and Secured Party is subject to the following conditions:
no Event of Default, Potential Event of Default or Specified Condition has occurred and is continuing with respect to the other party; and
no Early Termination Date for which any unsatisfied payment obligations exist has occurred or been designated as the result of an Event of Default or Specified Condition with respect to the other party.
24
Paragraph 13: Elections & Variables
13(d): Conditions Precedent and Secured Party’s Rights and Remedies.
The parties will specify Termination Events which shall qualify as “Specified Conditions” with respect to either party under the CSA.
Specified Conditions arise when parties desire to exercise remedies under Paragraphs 8(a) and 8(b).
Parties need to consider what Termination Events should be “Specified Conditions”.
E.g., Credit Event Upon Merger
25
CSA Paragraph 4(b): Transfer Timing
If a demand is made by the Notification Time, then Transfers are required no later than close of business on the next Local Business Day.
If a demand is made after the Notification Time, Transfers are required no later than the second Local Business Day.
26
Paragraph 13: Elections & Variables
Paragraph 13 modifications:
Same day transfer
Notification Time elected by the parties in Paragraph 13 (e.g., 10:00 a.m. EST on any Local Business Day).
When designating the Notification Time, parties must consider how quickly they can transfer collateral.
No distinction between various types of Eligible Credit Support elected in Paragraph 13, including Letters of Credit.
Operational Concerns:
How quickly can your LoC Issuer issue a new LoC?
Does your company need to increase Transfer timing to avoid breach?
27
CSA Paragraph 4(c): Calculations of Value and Exposure
Calculations of Value and Exposure:
Made by the Valuation Agent as of the Valuation Time for purposes of
(1) Credit Support Obligations
(2) Distributions
All calculations of Value and Exposure will be made by the Valuation Agent as of the Valuation Time.
Notice given to each party of the calculations by the Notification Time on the Local Business Day following the Valuation Date
Valuation Agent and Valuation Time will be specified in Paragraph 13.
Valuation Time will be same time of day.
28
Paragraph 13: Elections & Variables
13(c): Valuation and Timing:
13(c)(i): Valuation Agent:
Generally, the Valuation Agent is the party making a demand under Paragraph 3, but the parties may amend this requirement.
The Valuation Agent is the party calculating the Delivery or Return Amount under Paragraph 3 of the Annex.
29
Paragraph 13: Elections & Variables
13(c): Valuation and Timing:
13(c)(ii): Valuation Date:
The parties specify in Paragraph 13 what date shall constitute a “Valuation Date” for purposes of determining whether a Delivery Amount or Return Amount is due.
Parties often elect that the Valuation Date shall be each Local Business Day, requiring the parties to monitor daily whether a Delivery Amount or Return Amount is due.
30
Paragraph 13: Elections & Variables
13(c): Valuation and Timing:
13(c)(iii): Valuation Time:
The parties may select the time when the Delivery Amount or Return Amount shall be calculated, either:
By close of business on the Valuation Date, or
By close of business on the Local Business Day before the Valuation Date.
31
CSA Paragraph 4(d): Substitutions
Paragraph 4(d): Substitutions:
Generally, Pledgor may Transfer substitute Eligible Credit Support (“Substitute Credit Support”) to the Secured Party on any Local Business Day by providing notice.
The Secured Party then Transfers the Posted Credit Support being replaced back to the Pledgor no later than the Local Business Day following the date it receives the Substitute Credit Support (the “Substitution Date”).
32
Paragraph 13: Elections & Variables
Substitution terms often amended in the Paragraph 13 elections:
Secured Party’s consent for any substitution?
The parties specify in Paragraph 13 whether the “Substitution Date” has the meaning specified in the CSA or whether the parties wish to amend such definition.
“Substitution Date” generally means the Local Business Day following the date on which the Secured Party receives the Substitute Credit Support from the Pledgor.
33
Paragraph 13: Elections & Variables
Used by Pledgor to access liquidity or mitigate counterparty credit risk by substituting a less liquid form of Eligible Credit Support (e.g., Letter of Credit) for previously-posted Cash.
The substituted collateral must be Eligible Credit Support agreed upon by the parties in the Paragraph 13 elections.
34
CSA Paragraph 5: Dispute Resolution
Dispute of Valuations Agent’s calculation of Delivery/Return Amount by a “Disputing Party”
What amount of collateral is a party required to deliver or return?
Dispute of Value of any Transfer of Eligible Credit Support or Posted Credit Support
What is the Value of the collateral being posted or held?
May arise when dealing with fluctuating collateral, e.g. securities.
35
CSA Paragraph 5: Dispute Resolution
Procedure for resolving disputes:
Disputing Party gives notice by close of business on the Local Business Day following the date of the demand or Transfer (as applicable);
The appropriate party will Transfer the undisputed amount no later than the close of business on the Local Business Day following the date of the demand or Transfer (as applicable); and
The parties will attempt to resolve the dispute informally.
36
CSA Paragraph 5: Dispute Resolution
If the parties fail to resolve the dispute by the Resolution Time (elected in Paragraph 13), then:
For disputes on Delivery/Return Amount: The Valuation Agent will recalculate using undisputed calculations or by seeking four actual quotations at mid-market from Reference Market-makers to calculate Market Quotation (note alternatives if less than four or no quotes available).
For disputes on the Value of collateral: The Valuation Agent will recalculate the Value as of the date of the Transfer by following the procedures specified in Paragraph 13 for calculating Value.
37
Current Issues with the Dispute Resolution ProcedureParagraph 5. Dispute Resolution
If a party (a Disputing Party” )disputes (I) the Valuation Agent’s calculation of a Delivery Amount or a Return Amount or (II) the Value of any Transfer of Eligible Credit Support or Posted Credit Support, then :
1) the Disputing Party will notify the other party and the Valuation Agent (if the Valuation Agent is not the other party) not later than the close of business on the Local Business Day following (X) the date that the demand is made under Paragraph 3 in the case of (I) above or (Y) the date of Transfer
2.) in the case of (II) above, (2) subject to Paragraph 4(a),
3.) the appropriate party will Transfer the undisputed amount to the other party not later than the close of business on the Local Business Day following (X) the date that the demand is made under Paragraph 3 in the case of (I) above or (Y) the date of Transfer in the case of (II) above, (3) the parties will consult with each other in an attempt to resolve the dispute and (4) if they fail to resolve the dispute by the Resolution Time, then:
(i) In the case of a dispute involving a Delivery Amount or Return Amount, unless otherwise specified in Paragraph 13, the Valuation Agent will recalculate the Exposure and the Value as of the Recalculation Date by:
(A) utilizing any calculations of Exposure for the Transactions (or Swap Transactions) that the parties have agreed are not in dispute;
(B) calculating the Exposure for the Transactions (or Swap Transactions) in dispute by seeking four actual quotations at mid-market from Reference Market-makers for purposes of calculating Market Quotation, and taking the arithmetic average of those obtained; provided that if four quotations are not available for a particular Transaction (or Swap Transaction), then fewer than four quotations may be used for that Transaction (or Swap Transaction); and if no quotations are available for a particular Transaction (or Swap Transaction), then the Valuation Agent’s original calculations will be used for that Transaction (or Swap Transaction); and
(C) utilizing the procedures specified in Paragraph 13 for calculating the Value, if disputed, of Posted Credit Support.
(ii) In the case of a dispute involving the Value of any Transfer of Eligible Credit Support or Posted Credit Support, the Valuation Agent will recalculate the Value as of the date of Transfer pursuant to Paragraph 13.
Following a recalculation pursuant to this Paragraph, the Valuation Agent will notify each party (or the other party, if the Valuation Agent is a party) not later than the Notification Time on the Local Business Day following the Resolution Time. The appropriate party will, upon demand following that notice by the Valuation Agent or a resolution pursuant to (3) above and subject to Paragraphs 4(a) and 4(b), make the appropriate Transfer.
Allows too long an elapse of time before a dispute becomes apparent – increased risk
Often parties decline to transfer undisputed amount or there is no undisputed amount – e.g. both parties calling each other
Undefined what “consult with each other” means
Dealer poll is often impossible to perform as the number of dealers willing to participate is zero – especially for complex structured products where market expertise to price may be thin. Also, no compulsion or compensation for dealers to participate. If zero quotes, the Valuation Agent opinion dominates
Entire process needs to be repeated for every disputed margin call (potentially). Dispute resolution outcomes do not have any longevity
38
ISDA Collateral Dispute Resolution Procedure: Summary of Changes
39
The new DR Procedure provides a clear structure for the dispute resolution process, including:
Defined timelines An obligation to investigate portfolio differences, including via portfolio reconciliation
An obligation and specific structure to permit consultation between the parties to resolve apparent differences Provides guidelines for ring-fencing trades contributing to margin dispute
Enforces a Preliminary Collateralization phase to ensure quick settlement of as much collateral as can be agreed between the parties, providing a measure of credit protection while the parties proceed through the resolution process.
Provides a range of alternative methods the parties may adopt for resolution of trade differences not resolved through consultation.
Establishes a definitive fallback method in case the parties cannot mutually agree which method to use.
Introduces the term Reference Independent Price source which defines the institutions qualified to play the role of a Market Making Party (as a party of the dispute) and institutions eligible to provide Reference Quotes (for purposes of a Market Poll).
39
CSA Paragraph 6: Holding and Using Posted Collateral
Care of Posted Collateral
Use of reasonable care to assure safe custody.
No duty to collect any Distributions or enforce or preserve any rights pertaining to Posted Collateral.
Eligibility to Hold Posted Collateral; Custodians
General
Failure to Satisfy Conditions
Liability
40
CSA Paragraph 6(b): Eligibility to Hold Posted Collateral
Why Use a Custodian?
Usually when a party doesn’t meet the conditions for holding of Posted Collateral.
Counterparties who have to post Independent Amounts may want to use a Custodian.
Paragraph 13 generally requires that a Custodian be a “Qualified Institution” by meeting some form of credit rating and asset tests.
Tri-party custodial agreements take time to establish and are expensive.
41
Paragraph 13: Elections & Variables
13(g): Holding and Using Posted Collateral
13(g)(i): Eligibility to Hold Posted Collateral; Custodians.
Paragraph 13 generally provides that a party or its Custodian may hold Posted Collateral provided that:
Such party is not a Defaulting Party;
Posted Collateral only may be held in a jurisdiction specified by the parties (generally, the U.S.);
Any other terms or conditions the parties may require in holding collateral, such as minimum credit ratings or other creditworthiness standards.
42
CSA Paragraph 6(c): Use of Posted Collateral
If the Secured Party is not a Defaulting Party or an Affected Party and no Early Termination Date has occurred, then the Secured Party has the right to sell, invest, assign, commingle or otherwise dispose of any Posted Collateral.
However, the Secured Party shall be deemed to be holding such Posted Collateral for purposes of calculating Delivery/Return Amounts and Disputed Amounts.
43
Paragraph 13: Elections & Variables
13(g): Holding and Using Posted Collateral
13(g)(ii): Use of Posted Collateral.
The parties may specify whether or not Paragraph 6(c) applies to either party such that Posted Collateral may be sold, assigned, commingled or otherwise disposed of by the Secured Party.
44
CSA Paragraph 6(c): Distributions
Paragraph 6(c): Distributions
The Secured Party shall Transfer to the Pledgor a Distributions that it receives (or is deemed to receive) with respect to Posted Collateral no later than the following Local Business Day, so long as a Delivery Amount would not be created or increased by such Transfer.
45
CSA Paragraph 6 (d): Interest Amounts
Paragraph 6(d): Interest Amounts.
The Secured Party shall Transfer to the Pledgor the Interest Amount with respect to Posted Collateral at the time designated in Paragraph 13, so long as a Delivery Amount would not be created or increased by such Transfer.
Any Interest Amount not Transferred will constitute Posted Collateral.
46
Paragraph 13: Elections & Variables
13(h): Distributions and Interest Amount. The parties specify in Paragraph 13 the “Interest Rate” to be used under the Annex, the timing of Transfers of the Interest Amount (generally on a specific Local Business Day of each calendar month), and whether Transfers of the Interest Amount by the Secured Party shall apply under the Annex pursuant to Paragraph 6(d)(ii).
47
CSA Paragraph 7: Events of Default
An Event of Default occurs under Section 5(a)(iii)(1) (“Credit Support Default”) of the Agreement if:
A party (or its Custodian) fails to make any Transfer of Eligible Collateral, Posted Collateral or Interest Amount when required if not cured within two (2) Local Business Days after receiving notice of same.
48
CSA Paragraph 7: Events of Default
An Event of Default occurs under Section 5(a)(iii)(1) (“Credit Support Default”) of the Agreement if:
A party fails to comply with Paragraph 6(c) (“Use of Posted Collateral”) if not cured within five (5) Local Business Days after receiving notice of same.
A party fails to comply with any other obligation under the Annex (not otherwise a separate Event of Default) if not cured within thirty (30) days after receiving notice of such failure.
49
CSA Paragraph 7: Events of Default
Any default under Paragraph 7 of the CSA is an Event of Default under Section 5(a)(iii) of the Master Agreement:
Right to suspend payments and performance under Section 2(a)(iii) of the Master Agreement.
Right to suspend Transfers of Eligible Credit Support under Paragraph 4(a) of the CSA.
Right to designate an Early Termination Date and liquidate all Transactions under the ISDA.
50
CSA Paragraph 8(a): Secured Party’s Rights and Remedies
When do Secured Party’s rights arise?
Event of Default as to Pledgor
Specified Condition as to Pledgor, or
The occurrence or designation of an Early Termination Date with respect to the Pledgor.
51
CSA Paragraph 8(a): Secured Party’s Rights and Remedies
Secured Party’s rights
Unless Pledgor has paid all Obligations then due, Secured Party may exercise any of the following remedies:
All remedies available under applicable law;
Any rights and remedies under the terms of Other Posted Support
E.g., Drawing on outstanding Letters of Credit
Setoff of amounts payable by Pledgor against Posted Collateral held by Secured Party; or
Liquidate Posted Collateral and apply proceeds to any Obligations owed by Pledgor.
52
CSA Paragraph 8(b): Pledgor’s Rights and Remedies
When do Pledgor’s rights arise?
The occurrence or designation of an Early Termination Date arising from:
an Event of Default or
Specified Condition with respect to the Secured Party.
53
CSA Paragraph 8(b): Pledgor’s Rights and Remedies
Pledgor’s rights
Unless Secured Party has paid all Obligations then due, the following shall apply:
Pledgor can exercise all remedies available under applicable law.
Pledgor can exercise any rights and remedies under Other Posted Support.
E.g., Drawing on outstanding Letters of Credit
Secured Party is obligated to immediately Transfer all Posted Collateral back to the Pledgor.
54
CSA Paragraph 8(b): Pledgor’s Rights and Remedies
If Secured Party does not Transfer back all Posted Collateral to Pledgor, then Pledgor may:
Set-Off amounts payable by Pledgor against any Posted Collateral held by the Secured Party; and
If amounts are not Set-Off, withhold payment of amounts due up to the Value of Posted Collateral until such Posted Collateral is returned.
55
CSA Paragraph 8(c): Deficiencies and Proceeds and 8(d): Final Return
Paragraph 8(c): Deficiencies and Proceeds.
Secured Party must Transfer to Pledgor any proceeds and Posted Credit Support remaining after liquidation, Set-Off and/or application of funds after all amounts payable are satisfied in full.
Pledgor remains liable for any unpaid amounts.
Paragraph 8(d): Final Returns.
When no amounts may become payable by Pledgor with respect to Obligations under the ISDA, Secured Party will Transfer all Posted Credit Support and Interest Amounts back to the Pledgor.
56
CSA Paragraph 9: Representations
Each Party represents the following on the date the CSA is executed and each date the Pledgor transfers Eligible Collateral:
It has the power to grant a security interest and lien on the Eligible Collateral and has taken all necessary actions to effect same;
It is the sole owner of the Eligible Collateral it Transfers, and it Transfers such Eligible Collateral free and clear of liens or other encumbrances;
57
CSA Paragraph 9: Representations
Upon a Transfer, the Secured Party will have a valid and perfected first priority security interest and lien on the Eligible Collateral; and
The performance of its obligations under the CSA will not result in any other security interest, lien or encumbrance other than provided to the Secured Party.
58
Paragraph 13: Elections & Variables
13(i): Additional Representations.
The parties may incorporate any additional representations into the CSA in addition to those in Paragraph 9.
59
CSA Paragraph (10): Expenses
Paragraph 10(a): General.
Each Party generally pays for its own expenses in
performing its obligations under the CSA.
Paragraph 13.
Parties typically state that all costs with respect to Letters of Credit will be borne by Pledgor.
60
CSA Paragraph (10): Expenses
Paragraph 10(b): Posted Credit Support.
The Pledgor shall promptly pay all taxes or charges imposed with respect to Posted Credit Support held by the Secured Party upon becoming aware of same (except taxes with respect to the Secured Party’s use of Posted Collateral).
61
CSA Paragraph (10): Expenses
Paragraph 10(c): Liquidation/Application of Posted Credit Support.
All reasonable costs and expenses incurred in connection with the liquidation and/or application of Posted Credit Support shall be payable either by the Defaulting Party, or if there is no Defaulting Party, equally shared by the parties.
62
CSA Paragraph 11(a): Default Interest.
If Secured Party fails to make any Transfer of Posted Collateral or Interest Amount, such amount shall accrue interest at the Default Rate from the date such amount was required to be Transferred until the date actually paid.
63
CSA Paragraph 11(b): Further Assurances.
Paragraph 11(b): Further Assurances.
Upon demand by a party, the other party shall execute or deliver any financing statement, specific assignment or other document that may be necessary or desirable with respect to creating, perfecting, enforcing and/or releasing any security interest or lien granted under the Annex.
64
CSA Paragraph 11(c): Further Protection
Pledgor will give notice to the Secured Party of, and defend against, any suits, actions or proceedings relating to Posted Credit Support Transferred by the Pledgor or that could adversely affect the security interest and lien granted under the CSA (unless such suit or action results from Secured Party’s exercising its rights to use Posted Collateral).
65
Paragraph 13: Elections & Variables
13(j): Other Eligible Support and Other Posted Support.
Paragraph 13 permits the parties to define how to calculate the “Value” of Other Eligible Support and Other Posted Support, as well as what constitutes a “Transfer” of same.
E.g., LoC Value will be 100% unless (i) an Event of Default occurs and is continuing, or (ii) fewer than 20 days remain before expiry of the Letter of Credit, in which case the Valuation Percentage will be zero (0).
66
Paragraph 13: Elections & Variables
Letters of CreditTerms or conditions with respect to a Letter of Credit would be
included in Paragraph 13.
A “Transfer” of amounts with respect to a Letter of Credit does not necessarily mean a drawing of funds. Instead, a “Transfer” means increasing or decreasing the stated value of the Letter of Credit depending on the applicable Delivery Amount or Return Amount to be Transferred.
Drawdown on the Letter of Credit.
67
Dodd-Frank Wall Street Reform and Consumer Protection Act
68
Dodd-Frank Wall Street Reform and Consumer Protection Act
Clearing Requirements
Swaps are to be cleared through a Derivatives Clearing Organization if they are the types that the CFTC determines must be cleared unless an exception to clearing applies.
69
Dodd Frank: End User Exception
The End User Exception: Commodity Exchange Act (CEA), new Section 2(h)(7)
End User Exception may be used if party to a swap:
(i) is not a financial entity;
(ii) is using the swap to hedge or mitigate commercial risk; and
(iii) satisfies notification requirements to the CFTC.
70
CFTC Collateralization Requirements
Major Swap Participants and Swap Dealers that are not governed by a prudential regulator are governed by CFTC regulations (“Covered Swap Entities”).
On April 12, 2011, the CFTC proposed regulations to require initial and variation margin in connection with uncleared swaps. The proposed regulations apply to Covered Swap Entities.
71
72
Collateralization of Uncleared Swaps under Dodd-Frank (Proposed)
Proposed Rule on Protection of Collateral of Counterparties to Uncleared Swaps
Right to Segregation
Section 724(c) of the Dodd-Frank Act amends the Commodity Exchange Act (CEA) by inserting a new section 4s(1), which requires that SDs and MSPs notify their counterparties that such counterparties have a right to require that any initial margin which they post to guarantee uncleared swaps be segregated at a third party custodian. The right to segregation does not The right to segregation does not apply to variation margin.apply to variation margin.
73
Dodd Frank Regulation re: Collateral Protection for Uncleared Swaps
17 CFR Parts 23 and 190: Protection of Collateral of Counterparties to Uncleared Swaps
The counterparty’s chief risk officer, chief executive officer or the high- level decision maker must be advised of the right to segregate before the terms of the swap are confirmed.
Such notification need only be made to a particular counterparty once in any calendar year.
Before the terms of a swap transaction are confirmed, the SD or MSP must obtain confirmation of receipt of the notification along with the counterparty’s election whether or not to segregate the initial margin.
A counterparty can change its election at any time by the delivery of a written notice.
74
Proposed Rule on Protection of Collateral of Counterparties to Uncleared SwapsRequirements of a Segregated Account: If a counterparty elects segregation for its
initial margin, the account must be held at a custodian that is independent* of both the counterparty and the SD or MSP. There must be a written custody agreement between the counterparty posting the initial margin, the SD or MSP, and the custodian, which meets certain minimum standards of clarity.
The segregated account may also hold variation margin. Investment of Segregated Margin: Segregated margin may only be invested pursuant
to the Commission’s Rule 1.25, which governs investment of customer property of futures customers. The proposed regulations do not, however, limit the types of margin collateral that a customer may post. Nor do they limit any commercial arrangements between the parties concerning allocation of gains and losses resulting from such investments.
Withdrawal of Segregated Margin: Other than when there is a turnover of control of margin, any withdrawal of margin shall be made pursuant to an agreement between the counterparty and the SD or MSP. Immediate notification of withdrawal must be made to the non-withdrawing party.*Proposed § 23.602(a)(1) does not require that the initial margin be held in an account that is
independent of any affiliate of the SD or MSP or the counterparty, in order to permit parties to engage in swaps transactions with affiliates of their usual depositories.
75
Investment of Segregated Margin
Segregated initial margin may only be invested in a manner consistent with CFTC Rule 1.25.
Rule 1.25
Amendments effective February 17, 2012 further limit the permissible investments of such funds. The following investments are no longer permitted:
Corporate obligations not guaranteed by the U.S.
Investments in obligations by Fannie Mae and Freddie Mac are permissible so long as those entities operate under the Federal Housing Finance Agency with capital support from the U.S.
Investments in foreign sovereign debt securities.
In-house transactions between a SD or MSP and a counterparty.
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Requirements for Non-Segregated Collateral
If the counterparty does not choose segregation, the SD or MSP shall report to the counterparty, on a quarterly basis, ‘‘that the back office procedures of the swap dealer or major swap participant relating to margin and collateral requirements are in compliance with the agreement of the counterparties.”
Such reports must be made no later than the fifteenth (15th) business day of each calendar quarter for the preceding calendar quarter.
This obligation shall apply no earlier than the 90th calendar day after the first swap is transacted between the counterparties.
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Compliance Schedule
Category 1 Entity – 90 days
Category 2 Entities – 180 days
Category 3 and 4 Entities - 270 days
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Understanding the ISDA Credit Support Annex
Judicious use of the ISDA CSA will help parties mitigate counterparty credit risk.
Negotiation of terms must take into consideration situations of market stress.
Under Dodd Frank the CSA will remain an important and mandatory risk mitigation tool with respect to uncleared swaps.
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GuyLaine Charles
Teigland-Hunt LLP
127 West 24th Street, 4th Floor
New York, NY 10011
Tel: 1-212-269-10160
Direct Email: [email protected]
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