Expenses - IM CSD Provision
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2018 ISDA Credit Support Deed (IM) (English law)
A Jolly Contrarian owner’s manual™ Expenses in a Nutshell™ Original text:
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Overview
title transfer CSAs
Paragraph 8 of the 1995 CSA is identical to the paragraoh 8 in the 2016 VM CSA.
security interest CSAs
Paragraph 10(a) of the 1994 New York law CSA (but for the (VM)s) identical to Paragraph 10(a) of the 2016 NY Law VM CSA.
security interest CSAs vs. title transfer CSAs
The bit about everyone being liable for their own costs is common to all CSAs. the difference is that taxes lie where they fall in the title transfer CSAs, but are the responsibility of the Pledgor in the security interest CSAs. The security interest CSAs also carry on in 10(b) and 10(c) to rabbit on a bit about taxes and enforcement costs on Posted Collateral.
IM CSD
The 2018 English law IM CSD is an odd hybrid: all parties are liable for their own taxes, there is all the additional bit about Posted Credit Support, but the Chargor is liable for the costs and taxes of returning Credit Support from the Segregated Account back to the Chargor (when no longer required as IM).
Summary
The starting point here, being a function of the common law of contract — not to mention common sense — is that every merchant is liable for its own costs and expenses of performing a contract, so if there you incur costs in running a collateral operation, as a general matter, they are for your own account.
Where this might change is as a result of a pledge. Specifically in the context of tax.
Bear in mind the pledge is designed purely as the Secured Party’s comfort it will be made whole if the Pledgor defaults, by the Pledgor handing over some assets as collateral, on the premise that the Pledgor will get them back. This is different from the title transfer CSA, where you get the collateral to keep and do with as you wish, and collateralisation works by way of offset.
Now, the idea is not to stick a Secured Party with any additional expenses as a result: if Pledgor delivers collateral to Secured Party to hold hostage, then if the Secured Party suffers any costs, be they by way of tax — the classic is a stamp duty or similar transfer tax — or perfection and registration of security, and then enforcement and realisation should the Pledgor default, these should be for the Pledgor’s account, as the Secured Party gets no benefit from incurring that cost. All the more so any costs and taxes the Secured Party should incur when transferring the assets back to the Pledgor at the end of the Transaction.
These considerations do not — quite so straightforwardly, at any rate — pertain to title transfer arrangements. Once you have the asset, it is yours. And you can control, somewhat, for transfer taxes by adjusting your Eligible Credit Support criteria.
This is not an entirely ironclad justification, by the way — especially when you take into account the effects of rehypothecation.
security interest CSAs
How to deal with stamp duties is the subject of Paragraphs 10(b) and 10(c), of which there is no equivalent in the English law document.
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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- JC’s “nutshell” summary of the clause
- Background reading and long-form essays
- An odd dissonance in the apportionment of close-out costs between those triggered by Events of Default and those by Termination Events