Holding and Using Posted Collateral (VM) - NY VM CSA Provision
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2016 ISDA Credit Support Annex (VM) (New York law)
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Crosscheck: Holding and Using Posted Collateral in a Nutshell™ Original text:
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Overview
The part of the New York law CSA that undoes all the sterling work that Paragraph 2 does to establish a Security Interest over collateral posted by a Pledgor to a Secured Party.
Note especially 6(c) Use of Posted Collateral — the rehypothecation/reuse right.
The 2016 version is all but the same as the 1994 version, except for a peppering of gratuitous “(VM)s”, until you get to Paragraph 6(d)(ii)(A). All that malarkey about interest transfers, adjustments and reductions at the back end of Paragraph 6(d) is new and, candidly, rather to be regretted. Here is a comparison.
Summary
Distributions
Handily, ISDA’s crack drafting squad™ captures all the forms of income that could kick off Posted Credit Support as “Distributions”:
“Distributions” means with respect to Posted Collateral (VM) other than Cash, all principal, interest and other payments and distributions of Cash or other property with respect thereto, regardless of whether the Secured Party has disposed of that Posted Collateral (VM) under Paragraph 6(c). Distributions will not include any item of property acquired by the Secured Party upon any disposition or liquidation of Posted Collateral (VM) or, with respect to any Posted Collateral (VM) in the form of Cash, any distributions on that collateral, unless otherwise specified herein.
Care of Posted Collateral
You can basically stop reading after “Without limiting the Secured Party’s rights under Paragraph 6(c)”. Because the Secured Party’s rights under 6(c) basically allow it to nuke your security interest the moment it receives your collateral. It can give your carefully pledged asset away.
In this way does security interest collateral arrangement with rehypothecation convert itself, for all intents and purposes, into a title transfer collateral arrangement.
Rehypothecation under a New York law CSA
Paragraph 6(c) is the classic part of your security interest CSA that converts it into a title transfer CSA, meaning — cough, as with much New York law frippery — that you might as well not bother with calling this a pledge or security interest in the first place.
So I give my asset to you, right, carefully only pledging it as security for my indebtedness to you, and protect myself from your credit risk because I retain beneficial ownership of the asset. It is mine, not yours, and should you explode into a thousand points of light, then, once I have settled my trading account with your administrator, I can have it back.
Right?
Except that, the moment you get it, unless we have agreed otherwise — and, by default, the CSA assumes we have not — you may unconditionally sell my asset, absolutely, to anyone you want to, at any time, or actually, damn the torpedoes, just take it onto your own balance sheet and hold it in your own name. Whereupon, my claim against you is for the return of my asset that you no longer have, or have put into your general bankruptcy estate, so you would have to go and buy it in the market, but since you have blown up, you can’t realistically do that, so I am, after all, your unsecured creditor and all this talk of security interests is a nonce.
Note that the Secured Party’s right to flog off the Pledgor’s asset evaporates should it commit an Event of Default, Early Termination Event or one of the CSA’s Specified Conditions but — courtesy of Paragraph 7(ii), the Secured Party’s right to call a default as a result of the Pledgor continuing to flog off its assets — there doesn’t seem to be an obligation to buy back assets once they’re sold, by the way — only kicks in after 5 Local Business Days, by which stage even the guys disconsolately wandering around outside the office clutching Iron Mountain boxes will have pushed off.
Oh, what sad times we live in.
Note the odd coda: references to Posted Collateral etc — where, for the purposes of calculating your credit support posting obligations, you are deemed to still hold it, even though in fact you don’t — is in part an attempt to state the bleeding obvious: just because you’ve hocked the assets off to someone else doesn’t mean you don’t still have to account to your counterparty for their value in the long run — and, we think, a rather feeble attempt to avoid having to create an “Equivalent Credit Support” concept. Since you've sent the particular asset your counterparty gave you into the great wide open, the thing you'll be giving back will be economically, but not ontologically, so in theory you don’t have to give back the exact same one, even if it does have to be identical with it. Perhaps a concern in 1994, though since ISDA’s crack drafting squad™ went full metal jacket on that enterprise in 1995 when crafting the 1995 CSA, it is not like we don’t have suitable, road-tested — if a little anal — language to capture the idea of equivalence.
But anyway.
Rehypothecation generally
Economically, to “rehypothecate” an asset you have been pledged is to take full legal and beneficial title to it, against an obligation to return an equivalent, fungible asset at a later date. This means you can sell the asset in the market, thereby realising funds with it, or use it as collateral in a market transaction elsewhere.
Legal beagles will be fascinated, while no one else will care, that in a New York law “rehypothecation” construct, the pledgor retains title to the rehypothecated asset at all times, even when it is sold outright in the market, whereas in an English law “re-use” construct, title to the asset passes outright to the person re-using it, and is replaced by a debt obligation to return an equivalent asset. Economically the two constructs are the same; it is just that the NY one makes no logical sense at all, while the English one makes perfect sense. Don’t @ me Americans: you know this is true.
Assets a counterparty posts you as collateral — especially as variation margin — are meant to be credit support for the amount that counterparty would owe you (your “exposure”) if you closed out the transaction today — the replacement value of the transaction, so to say.
This is all fine from a credit perspective, but there is a funding angle, too. That exposure is rather like indebtedness — it is as if you have lent your counterparty that money. If you are a prime broker, you probably have lent your counterparty that money. This is money your treasury department will gleefully, usuriously, charge you for using.
Now if only you could use these assets as collateral you owe someone else, or convert them into cash to repay your treasury department — like you could if that collateral was title-transferred to you — wouldn’t that be a fine thing? Well, as long as the collateral is only pledged to you, you can’t: it isn’t your asset to sell.
But this is exactly what rehypothecation allows you to do. But at a cost: the pledgor, who used to own the asset and could reclaim it in your insolvency (on settling its outstanding indebtedness to you) now becomes your unsecured creditor for the return of the “equivalent” asset. If you go bust, the pledgor must file a claim like all other creditors for the net value of the asset. This is why the pledgor will be grateful for the effects of close-out netting.
Interest transfer, adjustments and reductions: the squad falls down a rabbit hole
“George, you can type this shit, but I can’t say it.”
- — Harrison Ford, to George Lucas, about the script of Star Wars
If you have got as far into the ghastly bowels of ISDA speak that you have been trying to parse the meaning of Paragraph 6(d)(ii)(A)(I) — just the numbering should tell you to stay well clear — then God’s speed to you. JC only got through it because he was multi-tasking while on an all-hands client money remediation legal workstream weekly stakeholder check in call, and frankly even ritualistic satanic torture would appeal compared to that. But what is it saying?
So:
You are holding Posted Collateral that pays some kind of income, in cash. Cash being cash, it is yours instantly: you can’t custody it.[1] So you have to “manufacture” a corresponding payment. This is a finicky legalistic point — true, but finicky. But okay. You are about to make an equivalent cash payment to the Pledgor (Para 6(d)(ii)(A)) — but the Pledgor also owes you more Posted Collateral (Para 6(d)(ii)(A)(I)) (maybe the Exposure has moved in your favour). What to do?
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- JC’s “nutshell” summary of the clause
- Background reading and long-form essays
See also
Template:Csa Holding and Using Posted Collateral sa