Interest - VM CSA Provision
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ISDA 2016 English Law VM Credit Support Annex
A Jolly Contrarian owner’s manual™ Interest in a Nutshell™ Original text:
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Overview
Interest Payment
Some development from the OG to the 2016 ISDA VM CSA that came about when ISDA’s crack drafting squad™, bless them, contrived in Para 5(c)(ii) to design an option no-one in their right mind would have wanted, namely to choose between Interest Transfer — in which you can have interest that accrues on your Credit Support Balance periodically paid to you — or Interest Amount, in which interest accruals are just capitalised and added to the Credit Support Balance, effectively folding all that into the weft and warp of daily transfers that you will be making anyway.
Interest Period
Some development from the OG to the 2016 VM CSA that came about when ISDA’s crack drafting squad™, bless them, contrived in Para 5(c)(ii) to design an option no-one in their right mind would have wanted, namely to choose between Interest Transfer — in which you can have interest that accrues on your Credit Support Balances periodically paid to you — or Interest Amount, in which interest accruals are added to the Credit Support Balance, effectively folding all that into the weft and warp of daily transfers that you will be making anyway.
To be fair to them, the OG only contemplated transfer of accrued interest, which in the context of a modern, daily margined swap business, is barking mad, so at least having the option to just capitalise interest is better than not having it.
But better still would be just straight out capitalising interest, with no option to transfer it. Perhaps this is just me.
Interest Amount
The sole observable changes between the 1995 CSA and the 2016 VM CSA are, as best as this poor boy can fathom, these:
- The (rather tedious) expression “... on the principal amount of the portion of the Credit Support Balance” amount has been massaged to the slightly more elegant “...on the portion of the Credit Support Balance”, although you’d have to say this is mostly likely to be a drafting error rather than some kind of late-life Damascene conversion in ISDA’s crack drafting squad™’s part to the merits of plain English.
- The last paragraph contemplates currencies other than sterling having an Act/365 day count fraction.
- The Negative Interest guff.
Summary
Interest Payer and Payee
If you can work out who the Interest Payer is, then Interest Payee is the other guy. Written in this elliptical way because, what with Negative Interest, it isn’t always intuitive who is paying and who is receiving interest.
Interest Payment
To be fair to them, the OG only contemplated transfer of accrued interest, which in the context of a modern, daily margined swap business, is barking mad, so at least having the option to just capitalise interest is better than not having it.
But better still would be just straight out capitalising interest, with no option to transfer it. Perhaps this is just me.
Interest Amounts under the 1995 CSA
It really ought to be quite simple, and in the 1995 CSA it is: if a Transferor has posted cash — probably less likely back in the day, but in the world of regulatory margin, de rigueur nowadays — then you get interest on it — as long as paying interest wouldn’t, in itself, trigger a call for a further Delivery Amount by the Transferor — thus precipitating a (short) game of operational ping-pong between the two parties’ back office teams.
How would that happen? All other things staying equal, it couldn’t: if the Transferee’s Exposure and the Value of the Transferor’s Credit Support Balance stayed the same as it was when variation margin was last called, the arrival of interest on any part of that Credit Support Balance increases its value and, since it was calibrated to equal an exposure exactly, ought to be spirited back to the Transferor: the Transferee otherwise would become indebted for the value of that interest to the Transferor, which for variation margin is not the idea.
But as we know, Exposures don’t just quietly sit there. If they did, there wouldn’t be any need for initial margin, and collecting even variation margin would be less fraught. So if the Transferee’s Exposure has increased, the arrival of that interest might serve to fill a hole in the existing coverage, in which case, why pay it away only to ask for it back again?
Interest Amounts under the 2016 VM CSA
But in the 2016 VM CSA things get a little more complex. There follows an excruciating torture session for innocent and well-loved members of Her Majesty’s vocabulary, and all to get across a simple point. In the premium content nutshell JC has tried to simplify the drafting but I am a bit jet-lagged and it is testing even my patience. But know this: Interest Payment is a fiddly, time-and resource-consuming pain which will inevitably lead to error, confusion and name-calling. Interest Adjustment — just adding accrued interest to your Credit Support Balance — is far simpler and more elegant: none of this Kafkaesque complexity for netting and offsetting individual payments. It all comes out in the wash.
When you might want Interest Payment
Now there is a “use-case” for the Interest Payment method — it’s pretty niche, though — which we will talk about over at the premium JC.
Interest Period
Sometimes known as a “calculation period”, a more general term that can refer to other, non-interest-related determinations, an “interest period” is the space in time between interest payments on an interest-bearing financial instrument. Common ones: annual and semi-annual (especially for fixed rate products, since QED the interest rate doesn’t periodically change so there’s no particular market risk consequence for paying interest more frequently and operationally it is a hassle). Now there is a credit risk consequence, credit being a function of duration, but it is, all told, at the short end and it relates to interest and not principal.
Anyhow: fixed rates tend to pay annually, semi-annually or quarterly and floating rates, being path-dependent and more susceptible to intra-period volatility, are more commonly, monthly, weekly or daily.
You may see some fastidious operations teams asking to modify this to be a calendar month thing. You have to wonder why.
Interest Amount
One might query whether “Daily Interest Compounding” should apply.
Interest compounds anyway at the end of each specified interest period (because it is paid out or added to the Credit Support Balance (VM), depending on which election you made at 11(g)(ii). If that period is “daily” then there's nothing really to be gained by Daily Interest Compounding. If the Interest Period is longer than that, there may be — but in the present environment (which, as those of you who lived through the Weimar Republic[2] may recall, CAN MOST DEFINITELY CHANGE) — the thought of daily compounding 1/365th of the bugger all interest you're getting paid anyway might seem like a fight it’s not worth dying in a ditch about[3].
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- JC’s “nutshell” summary of the clause
- Background reading and long-form essays
See also
- Interest Amount (VM)
- Interest Payment (VM)
- Interest Adjustment
- Interest Transfer
- Daily Interest Compounding