The current financial crisis has exacerbated counterparty risk and raised to unprecedented heights the importance of collateral arrangements in over-the-counter derivatives. More than 85% of such arrangements are documented by a version of the International Swaps and Derivatives Association (ISDA) Credit Support Annex (CSA)1, and in most cases the negotiation of an ISDA Master Agreement is done simultaneously with the preparation of the related CSA2.
The CSA provides an elaborate framework for calculating exposure under derivatives transactions, posting and returning collateral, resolving disputes and various other issues.
This article will focus on the New York law CSA, which is the most common version of the agreement because of the widespread use of U.S. government securities as collateral.3 Paragraphs 1 through 12 of the CSA contain standard provisions, and any modifications to such provisions appear in Paragraph 13. In Paragraph 13, the parties also describe collateral eligible for posting and specify operational mechanics for several CSA provisions. Under the standard provisions of the CSA, either of the two parties can be the one required to post collateral ("Pledgor") or the one entitled to the benefits of collateralization ("Secured Party"), depending on the parties' relative exposure in their derivatives transactions.
The recent deterioration in the creditworthiness of many counterparties throughout the derivatives industry has triggered the renegotiation of numerous existing collateral arrangements and the creation of new ones. The number of collateral agreements in OTC derivatives is expected to have grown 20% by the end of 2008, in comparison to 2007.4 This article intends to provide a framework for understanding and negotiating some of the key issues under the CSA: the calculations for posting and returning collateral; the CSA's dispute resolution mechanism; the designation of the Valuation Agent and the transparency of its calculations; and the bilateral or unilateral nature of the CSA.5
Calculations for Posting and Returning Collateral
Credit Support Amount is the defined term for the necessary amount of collateral. The Pledgor is required to post collateral if Credit Support Amount is more than the Value of Posted Collateral, and the Secured Party is required to return collateral if the opposite is true. The parties have to specify in Paragraph 13 the frequency with which these amounts will be verified, with daily valuation being the most common arrangement. Collateral has to be Transferred within one or two days after demand, depending on the time of the day at which demand is made. The three elements for calculation of Credit Support Amount are Secured Party Exposure, Independent Amount and Pledgor's Threshold, as Chart 1 describes.
Secured Party's Exposure is the net positive amount (if any) that the Secured Party would be entitled to receive from the Pledgor if the ISDA Master Agreement and its underlying derivatives were terminated on a non-fault basis. This amount is the direct measure of counterparty risk, since it refers to the losses of the Secured Party if all transactions were closed out and the Pledgor were to default on the entirety of the amounts it owes. It is the only element in the calculation of Credit Support Amount that is not specified in Paragraph 13 of the CSA. The Valuation Agent has to determine Exposure on a mark-to-market basis, using estimates of mid-market quotations for derivatives that would replace the transactions between the parties in case of termination.
Independent Amounts increase the amount of required collateral when specified for the Pledgor, and decrease such amount when specified for the Secured Party. Parties use Independent Amounts to tailor collateralization obligations to the relative credit risk of each party and to the volatility of the underlying market. This is an important feature when collateralizing derivatives in emerging markets currencies, credit products and equities: in these markets, abrupt increases in Exposure may create a collateral shortfall, and the Pledgor's Independent Amount will provide partial security for the increased Exposure until additional collateral is posted, which does not happen immediately.6 The Pledgor's Independent Amount is a fixed amount and is not subject to periodic reassessment unless renegotiated by the parties, and therefore can lead to posting of collateral even when there is no Exposure at all, a result often overlooked by the parties.
Pledgor's Threshold is the extent to which the Pledgor can be out-of-the-money in the derivatives without being required to post any collateral for the Secured Party. In other words, it is the amount of unsecured counterparty risk the Secured Party agrees to tolerate under the CSA.7
A numerical example may be helpful in understanding these three concepts. If we assume that Exposure is $100, Pledgor's Threshold is $70, and Independent Amount is $10 for Pledgor and $5 for Secured Party, then we can just apply the formula of Chart 1 to find that Credit Support Amount is $35. If the amount of Posted Collateral is $20, Pledgor is required to post the difference, which is $15.
How should these concepts be negotiated? The definition of Exposure encompasses all derivatives under the ISDA Master Agreement, but the parties could tailor it to their actual collateralization needs. For example, they could narrow the concept to certain types of derivatives or even expand it to include spot foreign exchange transactions.8 As for the other two elements, it is always in a party's interest to have Paragraph 13 of the CSA specify for itself a low Independent Amount and a high Threshold. The other party, of course, will have the same expectations for itself. Reciprocity and the relative creditworthiness of each party are key factors to take in consideration in the negotiation of these provisions.
Dispute Resolution and Valuation Agent
The two main amounts to be calculated under the CSA are the Value of collateral (for purposes of Posted Collateral and Eligible Collateral) and Exposure. Both of these calculations are performed by the Valuation Agent designated by the parties in Paragraph 13. These calculations are the causes of all disputes under the dispute resolution mechanism of Paragraph 5 of the CSA, with Exposure being the most common.9 Chart 2 outlines the standard CSA dispute resolution process. Paragraph 5 is the primary mechanism for disputing CSA calculations. A recent judicial decision found that under New York law a party cannot challenge CSA calculations in court if it did not first attempt to resolve the dispute under Paragraph 5.10 The amounts recalculated by the Valuation Agent under this process are binding on the parties.
The dispute resolution mechanism raises a host of issues negotiated by the parties in Paragraph 13. The Valuation Agent is very often the CSA party that is the derivatives dealer, and in such cases the other party may request that Paragraph 13 provide for designation of a third-party Valuation Agent if (i) the dealer is subject to an Event of Default or Termination Event, or (ii) recalculation is required under the dispute resolution process. As to the recalculation method itself, Paragraph 5(i)(B) requires that Exposure be recalculated using actual mid-market quotations from leading dealers of the highest credit standing. A similar provision could be negotiated by the parties for the other principal cause of CSA disputes, the Value of collateral securities. The CSA is silent on how such Value is to be determined, and the Valuation Agent can solve this type of dispute only if the parties specify a valuation procedure in Paragraph 13. When the collateral consists of debt securities, the amount of accrued and unpaid interest should be included in its valuation in order to reflect properly its market value.
Another important issue relates to the transparency of calculations. The CSA requires that the Valuation Agent give notice to the parties of its "calculations", which must be commercially reasonable and made in good faith. The CSA provides no further guidance on how detailed such calculations should be. The parties may modify the CSA to require that the Valuation Agent explain upon demand the sources and inputs used in its calculations, although dealers should be expected to resist any disclosure of proprietary calculation models.
Unilateral and Bilateral Arrangements
Parties may negotiate many additional provisions in Paragraph 13, but few of them change the CSA structure more radically than the provision that makes the agreement unilateral, so that only the bank's counterparty (and never the bank) is required to post collateral. Recently, there is a clear trend towards bilateral arrangements, which now account for a clear majority of all CSAs.11 This trend is likely to continue, as a result of the current credit crisis and the perception of higher credit risk in transactions with derivatives dealers.12 A common compromise when the dealer resists a bilateral CSA is to provide a downgrade trigger, so that the dealer is required to post collateral only in the event of a significant downgrade in its credit ratings.
Certain market surveys indicate that losses in past financial crises were successfully mitigated through effective collateral arrangements13, and the CSA is likely to be equally valuable in the current market. Adequate time should be reserved for understanding the key issues discussed in this article and tailoring the CSA to the particular risk management needs of the parties. If worse comes to worst, collateral could be all you end up with.
Acknowledgment: I would like to thank David L. Williams, partner at Simpson Thacher & Bartlett LLP, for his insightful comments to this article.
1 ISDA, ISDA Margin Survey 2008 (2008), p. 7.
2 ISDA, ISDA Master Agreement Negotiation Survey (November 2006), p. 5.
3 Nina Hval, Credit Risk Reduction in the International Over-the-Counter Derivatives Market: Collateralizing the Net Exposure with Support Agreements, 31 International Lawyer 801 (1997), Part III(A).
4 ISDA, supra note 1, p. 2.
5 Terms with capital initials in this article are defined in the New York law CSA or the 1992 ISDA Master Agreement.
6 ISDA, User's Guide to the 1994 ISDA Credit Support Annex (1994), p. 5.
7 Id., pp. 5, 7.
8 Paul C. Harding & Christian A. Johnson, Mastering Collateral Management and Documentation (2002), pp. 185-188.
9 Id., p. 95.
10 VCG Special Opportunities Master Fund Limited v. Citibank, N.A., 2008 WL 4809078 (S.D.N.Y.), p. 6.
11 ISDA, supra note 1, p. 7.
12 Lawyers Drafted to Shore Up Collateral Arrangements, Derivatives Week (March 24, 2008), pp. 1, 12.
13 Dietmar Franzen, Design of Master Agreements for OTC Derivatives (2001), p. 28.
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