Title Transfer etc - VM CSA Provision

ISDA 2016 English Law VM Credit Support Annex A Jolly Contrarian owner’s manual™ Go premium Overview — Summary — Premium — See also — Wikitext Crosscheck: →NY OG →Eng OG →NY VM →Eng VM →Eng IM Transfer of Title in a Nutshell™ The JC’s Nutshell™ summary of this term has moved uptown to the subscription-only ninja tier. For the cost of ½ a weekly 🍺 you can get it here. Sign up at Substack. You can even ask questions! Ask about it here. Original text Paragraph 5 Transfer of Title, No Security Interest, Distributions and Interest Amount 5(a) Transfer of Title. Each party agrees that all right, title and interest in and to any Eligible Credit Support (VM), Equivalent Credit Support (VM), Equivalent Distributions or Interest Payment (VM) which it transfers to the other party under the terms of this Annex will vest in the recipient free and clear of any liens, claims, charges or encumbrances or any other interest of the transferring party or of any third person (other than a lien routinely imposed on all securities in a relevant clearance system). 5(b) No Security Interest. Nothing in this Annex is intended to create or does create in favour of either party any mortgage, charge, lien, pledge, encumbrance or other security interest in any cash or other property transferred by one party to the other party under the terms of this Annex. 5(c) Distributions and Interest Amount. 5(c)(i) Distributions. The Transferee will transfer to the Transferor not later than the Settlement Day following each Distributions Date cash, securities or other property of the same type, nominal value, description and amount as the relevant Distributions (“Equivalent Distributions”) to the extent that a Delivery Amount (VM) would not be created or increased by the transfer, as calculated by the Valuation Agent (and the date of calculation will be deemed a Valuation Date for this purpose). 5(c)(ii) Interest Payment (VM). Unless otherwise specified in Paragraph 11(g)(iv): 5(c)(ii)(A) if “Interest Transfer” is specified as applicable in Paragraph 11(g)(ii), the Interest Payer (VM) will transfer to the Interest Payee (VM), at the times specified in Paragraph 11(g)(ii) and on any Early Termination Date referred to in Paragraph 6, the relevant Interest Payment (VM), provided that if “Interest Payment Netting” is specified as applicable in Paragraph 11(g)(ii): (I) if the Interest Payer (VM) is entitled to demand a Delivery Amount (VM) or Return Amount (VM) in respect of the date such Interest Payment (VM) is required to be transferred: (a) such Delivery Amount (VM) or Return Amount (VM) will be reduced (but not below zero) by the Interest Payment (VM), provided that, in case of such Return Amount (VM), if the amount in the Credit Support Balance (VM) which is comprised of cash in the Base Currency is less than such Interest Payment (VM), such reduction will only be to the extent of the amount of such cash comprised in the Credit Support Balance (VM) (the “Eligible Return Amount (VM)”); and (b) the Interest Payer (VM) will transfer to the Interest Payee (VM) the amount of the excess, if any, of such Interest Payment (VM) over such Delivery Amount (VM) or Eligible Return Amount (VM), as applicable; (II) if under Paragraph 5(c)(ii)(A)(I)(a) a Delivery Amount (VM) is reduced (the amount of such reduction, the “Delivery Amount Reduction (VM)”) or a Return Amount (VM) is reduced (the amount of such reduction, the “Return Amount Reduction (VM)”), then for purposes of calculating the Credit Support Balance (VM) only, the Transferee will be deemed to have received an amount in cash in the Base Currency equal to any Delivery Amount Reduction (VM) and will be deemed to have transferred an amount in cash in the Base Currency equal to any Return Amount Reduction (VM), as applicable, in each case on the day on which the relevant Interest Payment (VM) was due to be transferred; and 5(c)(ii)(B) if “Interest Adjustment” is specified as applicable in Paragraph 11(g)(ii), the Credit Support Balance (VM) will be adjusted by the Transferee, at the times specified in Paragraph 11(g)(ii) and on any Early Termination Date referred to in Paragraph 6 as follows: (I) if the Interest Amount (VM) for an Interest Period is a positive number, the Interest Amount (VM) will constitute an addition of an amount of cash in the Base Currency comprised in the Credit Support Balance (VM); and (II) if the Interest Amount (VM) for an Interest Period is a negative number, the Interest Amount (VM) will constitute a reduction to the amount of cash in the Base Currency comprised in the Credit Support Balance (VM) in an amount (such amount, the “Interest Adjustment Reduction Amount (VM)”) equal to the absolute value of the Interest Amount (VM); provided that if the amount in the Credit Support Balance (VM) which is comprised of cash in the Base Currency is less than the Interest Adjustment Reduction Amount (VM), such reduction will only be to the extent of the amount of such cash comprised in the Credit Support Balance (VM) and the Transferor will be obliged to transfer the remainder of the Interest Adjustment Reduction Amount (VM) to the Transferee on the day that such reduction occurred. The varieties of ISDA CSA Subject 1994 NY 1995 Eng 2016 VM NY 2016 VM Eng 2018 IM Eng Preamble Pre Pre Pre Pre Pre Interpretation 1 1 1 1 1 Security Interest 2 - 2 - 2 Credit Support Obligations 3 2 3 2 3 Transfers, Calculations and Exchanges - 3 - 3 - Conditions Precedent, Transfer Timing, Calculations and Substitutions 4 - 4 - 4 Dispute Resolution 5 4 5 4 5 Holding and Using Posted Collateral 6 - 6 - 6 Transfer of Title, No Security Interest - 5 - 5 - Events of Default 7 6 7 6 7 Rights and Remedies 8 - 8 - 8 Representations 9 7 9 7 9 Expenses 10 8 10 8 10 Miscellaneous 11 9 11 9 11 Definitions 12 10 12 10 12 Elections and Variables 13 11 13 11 13 Resources and Navigation Index: Click ᐅ to expand: CSA

Comparisons

Paragraphs 5(a) and 5(b) and 5(c)(i) is identical in the 1995 CSA and the 2016 VM CSA. It is only in Paragraph 5(c)(ii) that things start getting a bit funky, as this comparison illustrates.

Paragraph 5(c)(i) is self-contained. It does not need adjustment in Paragraph 11: the reference to “Distributions” in the heading of Paragraph 11(f) simply reflects the heading of Paragraph 5(c), and does not imply you need to add anything.

Paragraph 5(c)(ii) and beyond in the 2016 VM CSA is an utter horror show and is broadly the same as the equivalent provision in the New York law VM CSA. There is a comparison of that to look at too. Here ISDA’s crack drafting squad™, bless them, contrived in Para 5(c)(ii) to design an option no-one in their right mind would have wanted, namely to choose between Interest Transfer — in which you can have interest that accrues on your Credit Support Balance periodically paid to you — or Interest Amount, in which interest accruals are just capitalised and added to the Credit Support Balance, effectively folding all that into the weft and warp of daily transfers that you will be making anyway.

Basics

Clearing system liens

In these modern, dematerialised but not yet entirely decentralised times, the securities in a clearing system — that is, pretty much all securities — exist only as entries in a ledger maintained by the clearing system. The individual securities are no longer and have not been for a half-century or more, security-printed, physical things. It may be we are moving “on-chain” but it has not happened yet, and if the speed at which lawyers have given up the legal vestiges of definitive physical securities is anything to go by, it will not happen for some time yet. Sorry, hodlers: I don’t make the rules. ANYWAY.

In any case, like all good intermediaries, the clearing system gets fees from participants for being a clearing system. As a kind of surety against non-payment of these fees, it keeps a lien on all global securities it holds. All this means is, if you haven’t paid your fees, you can’t have your securities back — conceptually a weird prospect, since you can’t have your securities back, can you — there are no physical securities — but in practice, you can’t deal with them without paying your fees, and even more realistic practice, if you do, the clearing systems will just deduct their fees from your sale proceeds. all of this is entirely unobjectionable, entirely normal, should not ever offend or adversely affect anyone, but it is, by the lights of the law, a “security interest” and therefore is regarded as a necessary exception, to be mentioned for the avoidance of doubt and carved out in polite circles whenever one makes sweeping statements as to the lack of any encumbrances on one’s assets.

Now all this sits a long way down the stack of turtles that makes up the modern metaphysical financial system — almost so deep as to be beyond the paranoid articulations of an ISDA ninja — but, as you can see, not quite.

The twain between NY law and English law CSAs: pledge v title transfer

This feels as good a time as any to raise the great subject of title transfer and pledge.

Under a 1994 NY CSA one transfers Credit Support by means of pledge.

Under a English law CSA one transfers Credit Support by title transfer.

What is the difference?

Title transfer

Under a “title transfer collateral arrangement” one party transfers collateral to the other outright and absolutely: it gives it, free of all reversionary interests, to the Transferee.

Securities delivered to Transferee become the Transferee’s property absolutely. There is no custody involved: the Transferee owns them outright, and not to Transferor’s order. The Transferee has only an obligation to redeliver an “equivalent” security — ie one that is fungible with the Credit Support originally posted.

There are no custody/client asset regulatory issues, and nor does it make sense to talk about the Transferee’s right to “reuse” or “rehypothecate” the asset. It owns the asset outright: by definition, it can do what it wants with it.

Pledge

The NY law CSAs and English law CSDs are “security financial collateral arrangements” in that there is a Pledgor who creates a security interest in favour of the Secured Party, but retains beneficial ownership of the assets.

The Pledgor delivers the assets to the Secured Party to hold in custody, subject to the security interest, for the Pledgor. Secured Party holds the assets subject to a security interest securing its payment obligation under the related transaction.

There is a custody arrangement but only while Secured Party holds the security: Under the NY law CSAs, the Secured Party (by default) is entitled to sell the pledged asset absolutely, under a process known as “rehypothecation”. This, we believe, converts the security financial collateral arrangement into a title transfer collateral arrangement — at least from the point of rehypothecation. If so, it makes you wonder why, you know, all the fuss with security interests.

“Transaction” or “Credit Support Document”?

English law Credit Support Annexes are Transactions under the Master Agreement. Therefore they are not Credit Support Documents.

New York law Credit Support Annexes are not Transactions. Explicitly, they are Credit Support Documents, though you should not (according to the ISDA User’s Guide) describe the parties to one as “Credit Support Providers”.

English law Credit Support Deeds (including the 2018 English law IM CSD) — rare birds in the Forest of Bretton — are not Transactions and, explicitly, are Credit Support Documents.

This means that a failure to perform under an English law CSA Transaction is a Failure to Pay or Deliver under Section 5(a)(i). by contrast, a failure to perform under a New York law CSA or an English law CSD is a Credit Support Default under Section 5(a)(iii).

Does this mean anything substantive? Or is the difference only formal?

Enforcement

Because ownership transfers absolutely, a Transferee under an English law CSA doesn’t have to do anything to enforce its collateral. It already owns it outright. Indeed, to the contrary, should the Exposure that the collateral supports disappear, the Transferor will be the creditor of the Transferee. It is as if it were a Transaction under the ISDA where the mark-to-market exposure had flipped around.

As New York law CSAs are not Transactions, they are old-fashioned security arrangements. Therefore they 'are Credit Support Documents in the labyrinthine logic of ISDA’s crack drafting squad™ and must be enforced.

Distributions and Interest Amount

It used to be so simple, until the 2016 VM CSA came along and started confusing everything with all this talk of Interest Adjustments versus Interest Payments.

This part simply requires the holder of credit support to manufacture income back to the poster of credit support — as long as doing so wouldn’t create in itself trigger a further Delivery Amount by the Transferor — thus precipitating a (short) game of operational ping-pong between the two parties’ back office teams.

How would that happen? All other things staying equal, it couldn’t: if the Transferee’s Exposure and the Value of the Transferor’s Credit Support Balance stayed the same as it was when variation margin was last called, the arrival of income on any part of that Credit Support Balance ought to be spirited back to the Transferor: as long as the Transferee was still holding it, the Transferee otherwise would become indebted for the value of that income to the Transferor.

But as we know, Exposures don’t just quietly sit there. If they did, there wouldn’t be any need for initial margin, and collecting even variation margin would be less fraught. So if the Transferee’s Exposure has increased, the arrival of that income might serve to fill a hole in the existing coverage, in which case, why pay it away only to ask for it back again? Similarly, the value of a pending but as-yet-unpaid income payment will be priced into the value of the securities generating it. So even if the Exposure hasn’t changed in the mean time, the arrival of a coupon or dividend will reduce the Value of those securities on which it was paid, so — all other things being equal — the Transferee might expect to hang onto the Distribution.
To be fair to them, the OG only contemplated transfer of accrued interest, which in the context of a modern, daily margined swap business, is barking mad, so at least having the option to just capitalise interest is better than not having it.

But better still would be just straight out capitalising interest, with no option to transfer it. Perhaps this is just me.

Interest Amounts under the 1995 CSA

It really ought to be quite simple, and in the 1995 CSA it is: if a Transferor has posted cash — probably less likely back in the day, but in the world of regulatory margin, de rigueur nowadays — then you get interest on it — as long as paying interest wouldn’t, in itself, trigger a call for a further Delivery Amount by the Transferor — thus precipitating a (short) game of operational ping-pong between the two parties’ back office teams.

How would that happen? All other things staying equal, it couldn’t: if the Transferee’s Exposure and the Value of the Transferor’s Credit Support Balance stayed the same as it was when variation margin was last called, the arrival of interest on any part of that Credit Support Balance increases its value and, since it was calibrated to equal an exposure exactly, ought to be spirited back to the Transferor: the Transferee otherwise would become indebted for the value of that interest to the Transferor, which for variation margin is not the idea.

But as we know, Exposures don’t just quietly sit there. If they did, there wouldn’t be any need for initial margin, and collecting even variation margin would be less fraught. So if the Transferee’s Exposure has increased, the arrival of that interest might serve to fill a hole in the existing coverage, in which case, why pay it away only to ask for it back again?

Interest Amounts under the 2016 VM CSA

But in the 2016 VM CSA things get a little more complex. There follows an excruciating torture session for innocent and well-loved members of Her Majesty’s vocabulary, and all to get across a simple point. In the premium content nutshell JC has tried to simplify the drafting but I am a bit jet-lagged and it is testing even my patience. But know this: Interest Payment is a fiddly, time-and resource-consuming pain which will inevitably lead to error, confusion and name-calling. Interest Adjustment — just adding accrued interest to your Credit Support Balance — is far simpler and more elegant: none of this Kafkaesque complexity for netting and offsetting individual payments. It all comes out in the wash.

When you might want Interest Payment

Now there is a “use-case” for the Interest Payment method — it’s pretty niche, though — which we will talk about over at the premium JC.

Interest Amounts under the 1995 CSA

It really ought to be quite simple, and in the 1995 CSA it is: if a Transferor has posted cash — probably less likely back in the day, but in the world of regulatory margin, de rigueur nowadays — then you get interest on it — as long as paying interest wouldn’t, in itself, trigger a call for a further Delivery Amount by the Transferor — thus precipitating a (short) game of operational ping-pong between the two parties’ back office teams.

How would that happen? All other things staying equal, it couldn’t: if the Transferee’s Exposure and the Value of the Transferor’s Credit Support Balance stayed the same as it was when variation margin was last called, the arrival of interest on any part of that Credit Support Balance increases its value and, since it was calibrated to equal an exposure exactly, ought to be spirited back to the Transferor: the Transferee otherwise would become indebted for the value of that interest to the Transferor, which for variation margin is not the idea.

But as we know, Exposures don’t just quietly sit there. If they did, there wouldn’t be any need for initial margin, and collecting even variation margin would be less fraught. So if the Transferee’s Exposure has increased, the arrival of that interest might serve to fill a hole in the existing coverage, in which case, why pay it away only to ask for it back again?

Interest Amounts under the 2016 VM CSA

But in the 2016 VM CSA things get a little more complex. There follows an excruciating torture session for innocent and well-loved members of her majesty’s vocabulary, and all to get across a simple point. In the nutshell to the right I have tried to simplify the drafting but I am a bit jet-lagged and it is testing even my patience. But know this: Interest Payment is a fiddly, time-and resource-consuming pain which will inevitably lead to error, confusion and name-calling. Interest Adjustment — just adding accrued interest to your Credit Support Balance — is far simpler and more elegant: none of this Kafkaesque complexities for netting and offsetting individual payments. It all comes out in the wash.

First, you have the choice between “Interest Transfer” and “Interest Adjustment”.

Interest Transfer

Here there is the choice of whether “Interest Payment Netting” applies. As far as the JC can tell, most market participants have switched this off, we surmise simply to avoid the torture of figuring out what you have to pay if it is switched on.

If Interest Payment Netting does not apply, then the Interest Payer must pay interest per the agreement in the elections (at Paragraph 11(g)(ii)), and note there is no proviso allowing you to cry off if paying this amount would create a new Delivery Amount.

If Interest Payment Netting does apply then descend we must into the labyrinthine mind of ISDA’s crack drafting squad™. The short point is that you must work out if, on the same date, the Interest Payer is due a cash payment under the 2016 VM CSA, and if so, net the two off and pay the balance. Again, no proviso for what happens if this payment would lead to a margin call from the Interest Payer.

Interest Adjustment

Interest Adjustment is a far simpler method: incoming interest is just added to the Credit Support Balance. If, on your next margin call, net, the Credit Support Balance exceeds your counterparty’s Exposure to you, you get your interest back through the normal mechanism of calling for a Return Amount. All the netting and offsetting happens automatically. The only contingency — and well spotted, ISDA’s crack drafting squad™, for this one is truly for details freaks — is if you receive negative interest on your Credit Support Balance such that it wipes out the Credit Support Balance entirely and is still unsatisfied, then the Interest Payer — and in the case of negative interest, this is the person Transferor, not the Transferee — has to pay the balance. But if you are accruing interest and calling for margin daily, the likelihood of that happening is extremely low, and it is hard to see why you couldn’t just add this to the usual margin call process as well (since it is likely to be a daily process).

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