3(c)(iii) - IM CSD Provision

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2018 ISDA Credit Support Deed (IM) (English law)
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Paragraph 3(c)(iii) in a Nutshell

Use at your own risk, campers!
3(c)(iii) Margin Approach. Based on the “Margin Approach” specified in Paragraph 13 to govern the relationship between “Margin Amount (IM)” and “Margin Amount (IA)”, a Chargor’s “Credit Support Amount (IM)” on any Calculation Date (IM) will be:
(A) If “Distinct Margin Flow (IM) Approach” applies: Max [Margin Amount (IM) - Threshold (IM), 0], and the Chargor’s Margin Amount (IA) posting obligation under any Other CSA will not be affected in any way.
(B) If “Allocated Margin Flow (IM/IA) Approach” applies: Max [Margin Amount (IM) - Threshold (IM), 0] and its posting obligation for Margin Amount (IA) under any Other CSA will be reduced by that Credit Support Amount (IM) (subject to a minimum of zero).
(C) If “Greater of Margin Flow (IM/IA) Approach” applies: Max [Max [Margin Amount (IM) -Threshold (IM), Margin Amount (IA)], 0], and its posting obligation for Margin Amount (IA) under any Other CSA will be reduced to zero.

Full text of Paragraph 3(c)(iii)

3(c)(iii) Margin Approach. The parties have agreed, in Paragraph 13, to implement one of the following approaches (each a “Margin Approach”) with respect to the relationship between “Margin Amount (IM)” and “Margin Amount (IA)”.
(A) If the “Distinct Margin Flow (IM) Approach” is specified as applicable in Paragraph 13, the following provisions will apply:
(1) “Credit Support Amount (IM)” means, with respect to a party as the Chargor, for any Calculation Date (IM), (i) the Margin Amount (IM) applicable to the Chargor, if any, minus (ii) the Chargor’s Threshold (IM); provided, however, that the Credit Support Amount (IM) will be deemed to be zero whenever the calculation of the Credit Support Amount (IM) yields a number less than zero.
(2) No Amendment to Obligations in respect of Margin Amount (IA). The posting obligation of a Chargor in respect of any amount that constitutes a Margin Amount (IA) under any Other CSA shall not be affected or amended in any way by the provisions of this Deed.
(B) If the “Allocated Margin Flow (IM/IA) Approach” is specified as applicable in Paragraph 13, the following provisions will apply:
(1) “Credit Support Amount (IM)” means, with respect to a party as the Chargor, for any Calculation Date (IM), (i) the Margin Amount (IM) applicable to the Chargor, if any, minus (ii) the Chargor’s Threshold (IM); provided, however, that the Credit Support Amount (IM) will be deemed to be zero whenever the calculation of the Credit Support Amount (IM) yields a number less than zero.
(2) Amendment to Obligations in respect of Margin Amount (IA). The posting obligation of a Chargor in respect of any amount that constitutes a Margin Amount (IA) under any Other CSA shall be reduced on an aggregate basis by the amount of the Chargor’s Credit Support Amount (IM); provided, however, that if, after such reduction, any such Margin Amount (IA) would be a negative amount, such Margin Amount (IA) will be deemed to be zero.
(C) If the “Greater of Margin Flow (IM/IA) Approach” is specified as applicable in Paragraph 13, the following provisions will apply:
(1) “Credit Support Amount (IM)” means, with respect to a party as the Chargor, for any Calculation Date (IM), the greater of (i)(A) the Margin Amount (IM) applicable to the Chargor, if any, minus (B) the Chargor’s Threshold (IM) and (ii) the Margin Amount (IA); provided, however, that the Credit Support Amount (IM) will be deemed to be zero whenever the calculation of the Credit Support Amount (IM) yields a number less than zero.
(2) Amendment to Obligations in respect of Margin Amount (IA). The posting obligation of a Chargor in respect of any amount that constitutes a Margin Amount (IA) under any Other CSA, other than such obligations of a Chargor under this Deed, shall be reduced to zero.

Related agreements and comparisons

Related Agreements
Click here for the text of Section 3(c)(iii) in the 2016 ISDA VM CSA
Comparisons
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Content and comparisons

This is all-new, state-of-the-art, oven-fresh, 21st century ninjery by ISDA’s crack drafting squad™. We have not seen its like before and, we hope, we’ll never see it again.

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Summary

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.

Initial margin and independent amounts

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 Amount looks, 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]

Anyway, opportunistically ISDA’s crack drafting squad™ has solved that problem by introducing two kinds of “Margin Amount” in the 2018 English law IM CSD, and giving them ugly parenthetic suffixes: the Margin Amount (IM) and the Margin Amount (IA). Maybe someone thought this was a neat trick, I don’t know. It seems a dumb one to me: once everyone knew Independent Amount and initial margin were, for all intents and purposes, the same; now they are subtly different.

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.

So the 2018 English law IM CSD contemplates, on one hand, regulatory initial margin, which it calls “Margin Amount (IM)”, and non-regulatory initial margin, which it labels with fond redolence to the old days of Independent Amounts, as “Margin Amount (IA)”.

The theory of the Margin Approach

Let’s call your existing, pre-regulatory, contractual 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. Now everyone must post at least IM, so the only realistic scenarios are (i) those who who want extra IA over the regulatory-prescribed IM, and (ii) those who don’t.

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?

The 2018 English law IM CSD proposes three ways of solving this:

Allocated Margin Flow is the best bet

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.

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General discussion

Credit Support Amount (IM) rather than Posted Credit Support (IM)

Reduction of Margin Amount (IA) posting obligation

An interesting comparison between Credit Support Amount (IM) and Posted Credit Support (IM). The first is the amount you are obliged at any point to have posted to the Custodian (IM); the latter is the amount you actually have posted at any time. The two might be different, without any suggestion of a default: There might be a pending but not yet due margin call; you might be owed some Margin Amount (IM) back, but not yet received it.

Right. Now, should you be using the Allocated Margin Flow (IM/IA) Approach is their interaction with the obligation due for for Margin Amount (IA) under the Other CSA. Note the definition, which in its Nutshell form I present as follows:

(B) If “Allocated Margin Flow (IM/IA) Approach” applies: Max [Margin Amount (IM) - Threshold (IM), 0] and its posting obligation for Margin Amount (IA) under any Other CSA will be reduced by that Credit Support Amount (IM) (subject to a minimum of zero).

“...will be reduced by that Credit Support Amount (IM)”. Now that amount is the amount you are required to have posted to the Custodian (IM) as regulatory initial margin, not what you actually have posted — the Posted Credit Support (IM). It’s all square, between friends, I guess — but it seems to me to miss a trick. The Other CSA is likely to be the controlling one — a prime brokerage agreement, referencing a total margin requirement, of which the Margin Amount (IM) is just a part. If the actual Posted Credit Support (IM) at a given time is not equal to the required Credit Support Amount (IM), this should not reduce (or for that matter increase) the total margin the prime broker requires.

The practical effect is likely to be transitory, since Margin Amount (IM) is recalculated and called every day, and should a Chargor default entirely in meeting a Margin Amount (IM) obligation, it will bring the ISDA Master Agreement down, and will cross-accelerate the Other CSA arrangement, whatever it is, also, but all the same this doesn’t seem, instinctively, like the right approach.

Why this might matter

Let’s just say your Other CSA is a cross-margining arrangement under a prime brokerage agreement, which, until the advent of regulatory initial margin, covered all margin for all PB products, including derivatives. Let’s take the example:

  • Client has $100m of long custody assets with the PB, over which the prime broker has a security interest.
  • Client puts on a $100m swap, which is fully variation margined, so the net mark-to-market value of the ISDA and VM CSA = zero.
  • Just to make the example straightforward, the client has no other indebtedness to the PB and a zero cash balance.
  • Under the PBA — being an “Other CSA”, the prime broker calls initial margin of $35m, all of which is attributable to the swap.
  • Under the appropriate Method, the client’s Margin Amount (IM) is $30m. All being well, the upshot will be the client meets the Reg IM call with assets from another source, directs them to the Custodian, and the prime broker will hold $5mm of custody longs as its Margin Amount (IA). Therefore $95mm of the custody longs will be excess margin over which the PB has security, but which it must return on request.
  • Twist: Client fails to meet the Reg IM call.

Ideally, at this point, PB will want to say, okay, I know you’re meant to pay your regulatory initial margin to a third party custodian, not to me, but hang it, you didn’t, so until you do, I’m treating the whole $35mm sum as being Margin Amount (IA), so I will require it under the PBA. That means, pai-san, the “margin excess” of your $100m long custody portfolio is $65mm, not $95mm. So, sortyourself out and make that Margin Amount (IM) delivery, but I’m somewhat cool and the gang in the mean time.

Now, of course, the PB may hit the big red button and detonate the relationship at this time — buyside counsel will assume this outcome to be as sure as the night of utter destruction that follows glorious sunshine 🙄 — but it may all be a ghastly mistake; you know, the proverbial “error of an administrative or operational nature”, and in any case everyone (except buyside counsel) knows a prime broker won’t close out a juicy client unless it absolutely has to — six-way standoffs with over-levered family offices notwithstanding. And it having the freedom to recharacterise, temporarily, Margin Amount (IM) as Margin Amount (IA) seems as good a way as any to achieve that.

The fix is simple enough: Under the Allocated Margin Flow (IM/IA) Approach, to say,

“any amount that constitutes a Margin Amount (IA) under any Other CSA shall be reduced on an aggregate basis by the amount of the Chargor’s Credit Support Amount (IM) Posted Credit Support (IM)

Well, that’s what I’d do.

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See also

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References

  1. For a fuller discussion, see Independent Amount.
  2. 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. This gag comes to you direct from our “here all week, folks!” store of corking one-liners.