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Derivatives

Collateralization Of OTC Derivatives

Over the past decade, collateral has become an increasingly significant tool in the over-the-counter derivatives market, with the International Swaps and Derivatives Association estimating there is some USD1.017 trillion in use and expectations that volumes will continue to increase.

Over the past decade, collateral has become an increasingly significant tool in the over-the-counter derivatives market, with the International Swaps and Derivatives Association estimating there is some USD1.017 trillion in use and expectations that volumes will continue to increase.  

Why Is Collateral So Widely Used?

ISDA's margin survey reveals that the most significant use of collateral is as a tool to reduce credit exposure on a counterparty's default. In addition, institutions often set themselves internal credit limits for each counterparty. By having their transactions collateralised, these institutions are able to increase their trading capacity with counterparties whose credit limits would otherwise be reached.

Another significant benefit of taking collateral, particularly for larger financial institutions, is that it can result in regulatory capital savings. Provided that the relevant conditions are satisfied, institutions can report exposure on a collateralized basis and therefore reduce the amount of regulatory capital that is required.

Other advantages of using collateral include the ability to price derivatives more competitively by reducing the charge for credit factored into derivative spreads and also the ability to access more complex or higher risk trades.

 

Documenting Collateral Arrangements

Under ISDA Documentation

The sharp increase in the collateralization of OTC derivatives is to a large extent attributable to ISDA's publication of market standard collateral documentation, which has simplified the time and cost of putting collateral arrangements in place. The most commonly used ISDA documents are:

* the New York law 1994 Credit Support Annex, under which a New York law pledge is taken over collateral; and

* the English law 1995 Credit Support Annex, which involves the transfer under English law of full legal and beneficial interest in collateral to the collateral taker.

Other collateral agreements published by ISDA are an English law 1995 Credit Support Deed (under which a security interest is created over collateral), a 1995 Japanese law Credit Support Annex and the 2001 ISDA Margin Provisions (which consolidate the approaches contained in the New York, English and Japanese law Credit Support Annexes).

Of the ISDA collateral documents, the New York law Credit Support Annex is the most popular with an estimated 59% of collateral agreements being documented under it, according to ISDA's recent margin survey. Whilst I do not intend to discuss the New York law Credit Support Annex in any significant detail, it is worth noting that it allows the collateral taker to use and dispose of the pledged collateral.

Looking at the English law governed ISDA documentation (i.e. the English law Credit Support Annex and the Credit Support Deed), historically there have been two major advantages in collateralizing transactions under a Credit Support Annex rather than under a Credit Support Deed: first, an outright transfer of collateral to the collateral taker means that the collateral taker is free to use and dispose of the collateral it has received, something which was not possible under the Credit Support Deed. The second advantage was that by not creating a security interest, no additional formalities on creation (such as a prescribed legal form of agreement), perfection (such as registration or public filing) or on enforcement (such as moratoria on creditors' enforcement or court applications) were required. These two factors have resulted in the English law Credit Support Annex being extremely widely used.

 

Features Of ISDA Documentation

There are several features that are common to all of the ISDA collateral agreements. These include:

* mechanisms enabling supplemental collateral to be provided or excess collateral to be returned in order to correspond with fluctuations in the mark-to-market value of the collateralized transactions and in the value of the collateral provided;

* the ability for the collateral provider to substitute new collateral for collateral already provided to the collateral taker;

* amounts corresponding to distributions in respect of securities provided as collateral and to interest on cash collateral to be paid by the collateral taker to the collateral provider; and

* a prescribed dispute resolution procedure.

E.U. Directive On Financial Collateral Arrangements

The E.U. Directive on Financial Collateral Arrangements was adopted by the European Parliament in June 2002 with the aim of simplifying the process of taking and providing financial collateral within the European Union. This would be achieved by establishing uniform base requirements for national legislation relating to financial collateral across the member states.

In particular the two disadvantages of using the English law security interest approach described above no longer apply as the Directive, amongst other things, requires each member state to, where necessary, modify its national law so that:

* a party with a security interest over financial collateral can be free to use and dispose of that collateral if such a right is provided for in the contract; and

* the only formalities applicable to the security interest are that the collateral relationship be evidenced in writing and the collateral be in the possession or control of the collateral taker. Importantly, this means that there must be no formal requirements for the creation, perfection or enforceability of security.

The directive does not have direct effect and is only effective when implemented by a member state. In the U.K. the directive was implemented by The Financial Collateral Arrangements (No. 2) Regulations 2003, which came into force on Dec. 26. In order for a collateral arrangement to fall within the scope of the U.K. regulations:

* the collateral must be "financial collateral", which comprises:

(i) cash

(ii) financial instruments, which consists of shares, securities equivalent to shares, bonds and other instruments for indebtedness if they are tradeable on the capital market;

* the financial collateral must be provided pursuant to a "financial collateral arrangement", which is either:

(i) a "title transfer financial collateral arrangement," that is to say an arrangement under which the collateral provider transfers legal and beneficial ownership in financial collateral with an obligation on the collateral taker to re-transfer equivalent financial collateral once the underlying obligations are discharged. These mechanics are embodied in the English law Credit Support Annex; or

(ii) a "security financial collateral arrangement," that is to say an arrangement under which the collateral provider creates a security interest in financial collateral and the financial collateral is in the possession or control of the collateral taker. These mechanics are embodied in the English law Credit Support Deed.

In each case, the arrangement cannot be with an individual.

 

Focusing again on the English law governed ISDA collateral agreements, the implementation of the directive means that the two major advantages of using the Credit Support Annex over the Credit Support Deed are removed. In fact there is now perhaps a small advantage in using the Credit Support Deed. This advantage arises in circumstances where (1) the collateral taker is over collateralized, that is to say has taken collateral with an aggregate value higher than that of the outstanding obligations, (2) a right of use is expressly provided for in the Credit Support Deed, (3) the collateral taker has not exercised its right to use or dispose of the collateral and (4) the collateral taker becomes insolvent. In this scenario, the collateral provider would have a proprietary claim against the excess collateral rather than, as would be the case under the Credit Support Annex, an unsecured claim against the collateral taker for an amount corresponding to the excess collateral provided.

This is unlikely to be a significant advantage, however, as it is unlikely that the collateral taker will be greatly over collateralized (due to commonly used mechanics such as daily marking to market and thresholds which mean that a certain portion of the collateral taker's exposure is not required to be collateralized). In light of this and since the market is accustomed to using the Credit Support Annex rather than the Credit Support Deed, the implementation of the directive seems unlikely to prompt a significant move towards using the Credit Support Deed.

 

Common Forms & Uses of Collateral

ISDA's margin survey showed cash, particularly dollars and euros, is the most commonly used type of collateral, followed by government securities, again, particularly dollar and euro denominated. These types of government securities are so commonly used because:

* they are liquid, which means that they are easily valued and easily converted into cash, which is particularly important in a default scenario;

* they have a low price volatility; and

* for the purposes of assessing a bank's regulatory capital charge they attract a reduced risk weighting.

As noted above, collateral received under a New York law or English law Credit Support Annex can be re-used. Although this is done in a variety of ways, such as under repurchase or stock lending agreements, the most common use of collateral is to meet other collateral calls.

 

This week's Learning Curve was written by Deepak Sitlani, associate in the derivatives and structured products group at Linklatersin London.

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