Credit Support

Credit Support Deed and English and New York Credit Support Annexes

Collateral is commonly provided in respect of parties’ exposures to one another under an ISDA Master Agreement pursuant to the 1994 ISDA Credit Support Annex under New York law (the New York CSA), the 1995 ISDA Credit Support Annex under English law (the English CSA) or the 1995 ISDA Credit Support Deed (the English CSD and, together with the English CSA and the New York CSA, the ISDA Credit Support Documents).

There are a number of similarities between the three ISDA Credit Support Documents and
for this reason they are treated together in a number of places. That said, there are also significant differences… (1)

Security interests created by the English CSD and the New York CSA

Both the New York CSA and the English CSD create a security interest over collateral, though the
specific provisions of the security clauses differ between the two documents as a result of the different governing law in each case.

Subject to the immediately following sentence, collateral is transferred to the Collateral Taker, provided that the Collateral Taker satisfies any eligibility conditions in the applicable document (the pre-printed terms of the New York CSA and the English CSD provide that the Collateral Taker must not be in default but other conditions may be agreed). Alternatively, the Collateral Taker may designate a custodian to whom collateral is to be transferred.

“Transfer” means, in the case of cash, payment and, in the case of securities, appropriate delivery. One point to note is that the English CSD imposes more stringent requirements on the Collateral Taker and any custodian it appoints, including in requiring the Collateral Taker to open (or procure the opening of) segregated accounts in which collateral is to be held and identified, segregated from and not commingled with property of the Collateral Taker.

On a return of collateral by the Collateral Taker, the security interest therein is immediately released. The circumstances in which the Collateral Taker is entitled to exercise the rights available to a secured party under the applicable law, including to liquidate any posted collateral are set out in paragraph 8 of the New York CSA or English CSD, as applicable. In addition to the designation of an Early Termination Date in respect of (i.e. the termination of) transactions under the relevant ISDA Master Agreement, these include broader bases, including the occurrence of an Event of Default in respect of the Collateral Provider.

Although conceptually similar in many ways, there are significant differences between certain aspects of the English CSD and the New York CSA; one example of this is the rights of the Collateral Taker to use posted collateral.

The New York CSA permits the Collateral Taker to sell, pledge, rehypothecate, assign, invest, use, commingle or otherwise dispose of any posted collateral (though these rights can be restricted by the parties’ agreement). By contrast, the English CSD does not allow for the use of collateral; the Collateral Taker is required to exercise reasonable care to assure the safe custody of the posted collateral. Further, the interest of the Collateral Taker is only a partial one – ultimate ownership (in the form of the equity of redemption) remains in the Collateral Provider (i.e. the chargor) and accordingly, it is inconsistent that the Collateral Taker should be able to directly or indirectly dispose of full title in the collateral (under a repurchase or stock lending agreement or a sale, for example).

Parties wishing to deliver support without granting a security interest in such support (for example by means of a letter of credit or financial guaranty insurance policy) may also do so by designating such support as “Other Eligible Support” under the applicable document.

Parties choosing a New York CSA or English CSD must be careful to analyze the choice-of-law rules which apply to security arrangements in respect of specific kinds of collateral. Regardless of the parties’ contractual choice, certain rules may apply to determine the governing law of security arrangements. The applicable law for the creation, perfection and priority of security interests granted under the New York CSA or the English CSD may depend on various factors, including how the collateral is classified under relevant regulation and how the collateral will be held. (2)

Title Transfer under the English CSA

Unlike the New York CSA or the English CSD, the English CSA does not create a security interest in the collateral transferred in favor of the Collateral Taker. Instead, the Collateral Provider retains no proprietary interest in the collateral itself and full legal and beneficial ownership in the collateral passes to the Collateral Taker, subject to an obligation on the Collateral Taker to return “equivalent” property as described below.

There are a number of areas in which the distinction between title transfer and the creation of a security interest is relevant.

The most important provision of the English CSA is Paragraph 6, which provides that, upon the
designation or deemed occurrence of an “Early Termination Date” in respect of (i.e. the termination of) all transactions under the relevant ISDA Master Agreement as a result of an Event of Default, an amount equal to the “Value” (as defined in the Credit Support Documents) of the Credit Support Balance at that time will be included in the close-out netting calculations of the ISDA Master Agreement.

This is not a separate and subsequent contractual set-off of the net exposure under the ISDA Master Agreement against the value of collateral. Instead, the cash value of the Collateral Taker’s conditional contractual obligation to make a payment in relation to cash collateral or to deliver equivalent fungible securities in relation to securities collateral (in other words, the cash value of the Credit Support Balance) forms an integral part of the final close-out of transactions under the single agreement created by the ISDA Master Agreement.

As noted above, Paragraph 6 provides that the “Value” of the Credit Support Balance is included in the close-out calculation. This defined term incorporates any ‘haircut’ the parties have agreed (as described below). The effect of this term in Paragraph 6 is that collateral would be valued at the post-haircut level, rather than including the full value of the collateral posted by the Collateral Provider in the calculation.

Most parties, however, will want the value of securities comprised in the Credit Support Balance to be valued at full market value on default and it is therefore common practice, particularly among sophisticated market participants, to amend Paragraph 6 to provide for this.

It should also be noted that Paragraph 6 only applies following an Event of Default and not a Termination Event. In the event of close-out of all outstanding transactions pursuant to a Termination Event, the exposure of each party would fall to zero and any collateral held by one party would be required to be returned to the other party as a Return Amount. However, this extends the time for which the parties are exposed to the credit risk of each other and parties commonly (but not universally) extend Paragraph 6 so that it also applies upon the designation or deemed occurrence of an Early Termination Date as a result of a Termination Event in relation to all (but not less than all) transactions.

Final returns such as those which occur if Paragraph 6 is not amended in this way might also be subject to the effect of the Minimum Transfer Amount and/or Rounding provisions, leading to the risk of collateral possibly becoming “trapped” , though parties commonly amend the English CSA to address this issue.

The English CSA contemplates only the transfer by the Collateral Provider of cash and securities as permissible forms of collateral (“Eligible Credit Support” ). It does not provide for “Other Eligible Support” as that term is used in the English CSD or New York CSA: although it may be possible to include provisions to allow this, this is relatively uncommon.

The parties specify the types of asset that will constitute Eligible Credit Support for this purpose.
One point to note is that it is important for the effectiveness of the outright transfer contemplated by the English CSA that the securities are capable of being traded. (3)

Other Issues in Structuring the Provision of Collateral pursuant to the Credit Support Documents

Unless amended, the ISDA Credit Support Documents provide for collateral to be posted on a bilateral basis such that either party may be required to provide or entitled to receive collateral depending on the net exposure under the ISDA Master Agreement on a mark-to-market basis (and any other aspects of the Credit Support Amount, as described above). (4)

Resources

Notes

1. Market Review of OTC Derivative Bilateral Collateralization Practices. International Swaps and Derivatives Association – March 1, 2010
2. Id.
3. Id.
4. Id.

See Also

• Collateralization
• Financial Risk
• Collateral Asset
• Collateral
• Risk Retention
• Risk Management
• Support
• Back-To-Back Letter Of Credit
• Currency Risk
• Trade Credit
• Unconfirmed Letter Of Credit