Secured Party Rights Event - IM CSD Provision
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2018 ISDA Credit Support Deed (IM) (English law)
Paragraph 13(h) in a Nutshell™ Use at your own risk, campers!
Full text of Paragraph 13(h)
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This is a 2018 innovation, not before seen, apparently the sweat of a brow also nursing a bottomless, spiteful hatred of derivatives negotiators, the capital markets, and the English language.
Happily — at any rate, if you are the kind of sadist who revels in the knowledge that your American friends will have to push the same rocks up the same hill you do — the same provision more or less exactly the same in the 2018 NY law IM CSA.
Summary
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, part I
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 change in portfolio value over that “liquidity period”, given the potential drop in collateral value over the same period. That is, one day.
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!
The basic problem part II
Now remember: unlike variation margin, where only the in-the-money counterparty holds it, there are necessarily two buckets of Regulatory IM at all times: the stuff you posted as security for mark-to-market moves against you, and the stuff the other guy posted as mark-to-market movements against her.
Now: if a catastrophic event affects one party that precipitates a close-out, you stop exchanging variation margin. There’s no point: one side can’t pay it, Q.E.D.; the other side would be mad to pay it (and thanks to Section 2(a)(iii), doesn’t have to in any case).
At the last point that the parties exchanged VM, the net mark-to-market of the whole portfolio was (more or less) nil. After that point, until all Transactions are terminated, the MTM value of the portfolio will swing around. It could go either way. It does not follow that the Unaffected Party will be owed any money. By the time it has determined the Early Termination Amount, it may owe the defaulting party money. Until then it doesn’t need its own initial margin back, it should not get its initial margin back, and nor should it get to take the Affected Party’s initial margin.
This is just my opinion.
What was ISDA’s crack drafting squad™ trying to achieve?
So this brings us to the abomination we find on the page before us. God only knows what ISDA’s crack drafting squad™ 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 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 — the return of its own initial margin, and the stuff the other guy has posted, assuming the other guy is the one who, at the end of the day, owes the money.
You should not be surprised to hear this should be, more or less, when the Chargor has actually defaulted and been closed out, the Early Termination Amount calculated, been found to be owed by the Chargor, and the Chargor having failed to pay it — and, really, the control of secured collateral held subject to a “Control Agreement” would ordinarily be most suitably dealt by that Control Agreement. The clue, surely, is in the name? Well, the 2018 English law IM CSD does its own job or determining when this would be — it does a horrible job of it, truth be told, but it is a job — so (anecdotally) the market-standard Control Agreements all tend to defer to the Secured Party Rights Event as determined under the 2018 English law IM CSD. So here we are.
What did they achieve?
An unholy mess. The starting point — crafted by sell-side-influenced squad™, endeavours to match the regulatory margin regime as closely as possible to the broker-imposed contractual initial margin regime. But — and say what you like about the wisdom of regulation-enforced bilateral initial margin — bilateral, regulation enforced initial margin is a different prospect altogether. We suppose the squad may have been in some denial about this, and the worldwide community of regulators may have been in some denial that the sell-side would be in denial about it, too. But for the record, here are the differences:
- It is bilateral: Contractual margin tends not to be: the brokers require their customers to provide it. The customers don’t ask for it from brokers.
- It is title transfer:[1] Therefore, whoever holds initial margin generally has it, to use as it sees fit, at all times. Where initial margin is posted away to a third party custodian with expressly no right of reuse, things are different.
- It is held in safekeeping by a third party: Again, if you don’t hold the margin, you can’t reuse it, are not meant to be able raise funds against it, it does not secure present indebtedness,[2] it is there purely as a credit default mitigant.
That starting point, therefore — “an Early Termination Date in respect of all Transactions has occurred or been designated as the result of an Event of Default or Access Condition with respect to the Chargor” — is one buy-side counsel are unlikely to like, as it allow a Secured Party to spring Posted Credit Support (IM) out of the Custodian’s possession at an arbitrary date at which time you do not know whether you are even owed anything. You don’t even know whether you are owed anything on the Early Termination Date for that matter (and since it is bilateral, nor, really should sell-side legal eagles like it, either).
Or you can elect to let your Control Agreement govern.
What would the JC suggest?
If you can resist the urge to fire them at ISDA’s headquarters, you can damn the torpedoes and take the JC’s recommendation, as discussed below.
General discussion
The logic
There is some debate even as to the logical structure of the clause. We discovered this because we read it one way, whereas a correspondent who saw action in ISDA’s crack drafting squad™ during its gestation read it another way.
Initially, we read the logic as follows:
SPRE means (i) unless FPETA applies, in which case it means (ii), unless CACSPRE applies, in which case it means CASPRE.
The alternative reading is:
SPRE means (for EODs and ACs) (i), and (for ETAs that came about for any other reason) (ii) unless CACSPRE applies, in which case it means CASPRE.
With profound regret, we find ourselves agreeing with the latter logic, notwithstanding the absurd outcome it generates, and despite the desperate drafting in which it is wrought.
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 — separately for each party — in your elections. What on earth ISDA’s crack drafting squad™ thought it was achieving 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, now we have a subset of termination rights that allow an Innocent Party to immediately seize the other party’s Posted Credit Support (IM) at the moment of notifying close-out, and days, weeks or months before it knows whether it is actually owed anything.
This leaves those means of terminating of one or more Transactions that are not Events of Default or “Access Conditions”. For these you must wait until you have determined and demanded an Early Termination Amount, and the client has failed to pay it when due, that failure itself representing a further Event of Default (putting you somewhat back in the position of (i), but okay let’s gloss over that.
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, at the same time, since at that point you are off risk, right? ISDA’s crack drafting squad™, obsessed as ever with counterparty credit default, uses this as the distinction point for early access to the collateral, when in fact this is not what initial margin is about. For initial margin to be in play it is a given that there has been a credit failure. Initial margin is about market losses between that failure and when you finally go off risk. Until that point yuou don’t have a claim, and you don’t have credit risk, since the initial margin is held with a third party. As long as amounts are undetermined, or not as yet due under those Transactions, there is nothing to appropriate the collateral for.
Why do you need to appropriate initial margin before you know if you are actually owed anything?
The sensible point for an SPRE: “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.
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, or Secured Party Rights Events, 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).