The point where, with the greatest of respect, the 2018 English law IM CSD gets totally over the front of its skis. Had it just reined in its enthusiasm, and limited itself to dealing with *just* regulatory IM, that actually has to be posted, compulsorily, to a third party custodian, this document would have been shorter, less controversial, and way easier to understand. But no: ISDA’s crack drafting squad™ went into bafflement overdrive.
A casual reader might also wonder whether someone is having a laugh, at our expense, about how these undoubtedly overcomplicated provisions are expressed. ISDA’s crack drafting squad™ could scarcely have made this more convoluted, as our nutshell summary to the right should indicate.
A common confusion in the 1995 CSA used to be its use of “Independent Amount” to describe what everyone else in the market colloquially calls initial margin. Were they the same? Were they different? it was quite difficult on a cold read to say, especially as an Independent Amountlooks, in the 1995 CSA, like it is meant to function as a distinct amount of standalone credit protection, held without reference to a given Transaction, but in practice it does not, and is called Transaction-by-Transaction.[1]
The problem ISDA’s crack drafting squad™ was trying to “solve for” was the swap counterparty who is already taking initial margin and wants to keep doing that, its own way, somehow, even now the technocrats have railroaded their way into the room and mandated by regulation their own version initial margin, which you must do their way.
These counterparties include, for example, those in a prime brokerage relationship, who might have their swap positions “cross-margined” with a wider range of physical and futures positions that their prime brokers will want to margin — and rehypothecate — as a single pool of assets and liabilities.
But it might be as simple as a dealer who has set its Independent Amounts higher than those mandated by the regulators, and wants to keep the higher value.
Let’s call your existing, pre-regulatory initial margin arrangement your “IA”, and the regulatory requirement “IM”. IA could be more than IM, less than IM, or (unlikely, but let’s say) the same.
The other difference is that usually you paid your IA directly, and by title transfer, to your counterparty. Since generally dealers would require IM, but customers would not, this had the curious effect of increasing the customer’s credit exposure to the dealer, at the same time it reduced the dealer’s market exposure against the customer. But — and for that very reason, Reg IM you must pay not to your dealer, but to a third-party custodian, subject to a security arrangement and an account control agreement, to avoid exacerbating counterparty credit risk the other way. The regulatory regime is therefore economically not the same as the previous non-regulatory IA regime, as the recipient cannot monetise the regulatory initial margin it receives, or use it elsewhere in its business. This reuse right is important for those involved in margin lending.
So once the Reg IM comes in, the question becomes (a) do you still want your old IA delivered to you so you can reuse it — in total, or just any of it in excess of the new IM requirement?
Allocated Margin Flow Approach: you pay the Reg IM portion of the IA under the 2018 English law IM CSD, and pay any excess over that in the IA to the counterparty under the Other CSA. To the JC’s way of thinking, this is the only one that makes any sense;
Greater of Margin Flow Approach: You pay the whole of the IA (or the IM, if it is greater) under the 2018 English law IM CSD and nothing under the Other CSA. We don’t think the broker will ever give up the right to reuse excess IA by steering that to a third party custodian, and nor, really should the client, since their implied financing rates will surely rise.
We think that almost all punters will go for the Allocated Margin Flow approach as this best deals with the regulatory obligation without unduly penalising either side or changing the basic economics — though where the Secured Party would otherwise be in the rehypothecation game, it does change the economics a bit — thus, render unto CESR what is required by CESR;[2] pay any excess over that to your counterparty.
It leaves one rather arid and academical dispute that one may quickly tire of having, as to whether the excess should be over one’s Credit Support Amount (IM) — being the amount one is obliged to post to the Custodian (IM) by way of regulatory margin — or one’s Posted Credit Support (IM) — being the amount one actually has posted to the Custodian (IM) — these may be different if you are in the habit of operational laxity in providing Reg IM or reclaiming it when it is no longer required, or you have just blown up and missed a call — and we consider this further below.
↑This was ALMOST an awesome pun. It doesn’t quite work, seeing as (a) the Committee of European Securities Regulators was formally disestablished in 2011 and replaced by ESMA; and (b) you render your Reg IM unto a custodian, not to ESMA (or CESR) anyway. But still, it was close enough to roll the dice on it anyway Hope you like it. Here all week, folks!This gag comes to you direct from our “here all week, folks!” store of corking one-liners.
