Template:M summ 2018 CSD 13(h)

What an omnishambles. ISDA’s crack drafting squad™ may usually be tiresome, leaden in its literary style, and pernickety to the point of distraction, but one thing you can say for it is that it does, usually, do things properly. It is thorough. It leaves no stone unturned, even when you wish it rather had.

With this provision it looks like the ’squad got to the point of maximum disarray, with all rocks upturned and slaters, bugs and cockroaches scuttling everywhere, and it just had a tantrum and stormed off. These provisions don’t even make sense. They are not even grammatical.

The basic problem

The problem to be solved is this: initial margin is designed to cover mark-to-market exposure between (usually daily) variation margin calls. It is usually calculated to cover the likely possible drop in portfolio value over that “liquidity period”.

However, when a counterparty goes titten hoch, the process of closing it out and determining who is owed what is a long process. For a big complex financial institution, can be months or years. One day’s market move starts to look a little bit meagre. Seeing as the initial margin is, by regulation, in the shape of non-cash assets, it too is subject to the vagaries of the market and can move up or down. So it might not quite cover what you thought it was going to cover.

to a great extent, that is just the non-linear unpredictable risk of the market. The answer is to take more collateral, of better quality, but that has its limits. So the alternative is to at least allow people in to convert the collateral into cash, to stop half of the portfolio moving around.

But fundamentally, this is just one of those risks it would be lovely to banish, but you can’t. Sorry, regulators!

What were they trying to achieve? go figure.

God only knows what they thought they were trying to achieve. Whatever remote objective they had as a goal, and whatever contingencies were dogging the ’squad’s fevered subconscious as they trudged, in formation, through the moist, dengue-infested swamps of of this drafting exercise — and there is some talk that there may have been skirmishes with pockets of rogue buy-side advisors to distract them as they went waded through the hip-high sludge — what is left to posterity is a confused, gibbering disaster.

What did they need to achieve? Straightforward

All this provision does is describe when a Secured Party can actually take the initial margin the Custodian (IM) is holding for it.

You should not be surprised to hear this should be, more or less, when the Chargor has actually defaulted and been closed out — and, really, the control of secured collateral held under Control Agreement would ordinarily be most suitably dealt by that Control Agreement. The clue, surely, is in the name?

Until the ISDA Master Agreement has been fully closed out and the Early Termination Amount — that is, the total amount due following termination and valuation of all Transactions following the default — determined, you don’t definitively know what you are owed — even if you are owed anything: only one party to an ISDA Master Agreement can be owed something, remember — so until then, what business have you got appropriating the Initial Margin? Nor do you have any credit risk over it: it is held at a third party and secured in your favour. Cool your jets.

But that event — by our read, a “Failure to Pay Early Termination Amount” — isn’t even the default value for a Secured Party Rights Event: rather, it is one of a tangled menu of alternatives.

The alternatives

As-standard: a “designated Early Termination Date”

The as-standard Secured Party Rights Event in the 2018 English law IM CSD is the designation of an Early Termination Date in respect of all Transactions following an Event of Default but — unless designated as an “Access Condition” — not a normal Termination Event or an Additional Termination Event. For what it is worth, “Access Conditions” are a list of Termination Events and Additional Termination Events set out in Paragraph 13(e)(ii) for each of which one can opt — severally for each party — in your elections. What on earth ISDA’s crack drafting squad™ managed to achieve with such pointless, fine-grained optionality (other than a sumptuous lifestyle for the hoardes of legal eagles who will feast on client negotiations as a result) it is hard to say.

In any case, just as a piece of design this is cruddy: any event leading to the early termination of all outstanding Transactions, should count as a Secured Party Rights Event, since at that point you are off risk, right? And before you complain that this is too wide, since there may still be amounts undetermined, or not as yet due under those Transactions, well, yes: that is exactly why the Early Termination Date is the wrong trigger point in the first place.

Why do you need to appropriate Initial Margin before you know if you are actually owed anything?

Failing that: “Failure to Pay Early Termination Amount”

(Quick drafting point: this means that a party fails to pay its Early Termination Amount once it has been determined, not that there is an Early Termination Amount determined following only a Failure to Pay or Deliver Event of Default.) That being the case, this is — well, if it covered all Termination Events, would be — the obvious best choice: it means, beyond any doubt the counterparty really has failed, it really did owe something, and it really did fail to pay it.

Now you have all the justification you need to wade in and repossess your counterparty’s initial margin. Only, oddly — infuriatingly — it doesn’t capture finally determined Early Termination Amounts that were caused by non-Events of Default (the so-called “Access Conditions”). Why, since at this point you have failed to pay the amount, and? Search me, readers.

Failing that: “Control Agreement Secured Party Rights Events”

If you have chosen to designate in your Control Agreement what the Secured Party’s rights to possess collateral are, then that applies, and overrides any of the disastrous trainwreck we have just picked through above.

Cutting through the nonsense

For those who don’t trust Control Agreements to do what they say on the tin, consider this kind of wording:

“Secured Party Rights Event” means that, following the occurrence or designation of an Early Termination Date with respect to all outstanding Transactions, an Early Termination Amount payable by the Chargor has been determined and notified to the Chargor under Section 6(d), and the Chargor has not paid it in full when due under Section 6(d)(ii).