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Understanding the ISDA Credit Support Annex : Know Your Rights and Risks

Understanding the ISDA Credit Support Annex : Know Your Rights and Risks. CRAIG ENOCHS Jackson Walker L.L.P. International Energy Credit Association 2011 IECA Spring Education Conference March 20-22, 2011 Hilton Head Island, South Carolina. Discussion Topics. Overview of the CSA

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Understanding the ISDA Credit Support Annex : Know Your Rights and Risks

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  1. Understanding the ISDA Credit Support Annex: Know Your Rights and Risks CRAIG ENOCHS Jackson Walker L.L.P. International Energy Credit Association 2011 IECA Spring Education Conference March 20-22, 2011 Hilton Head Island, South Carolina

  2. Discussion Topics • Overview of the CSA • Key Provisions of the CSA • Security Interest • Credit Support Obligations • Conditions Precedent • Transfer Timing • Calculations of Value and Exposure • Substitutions of Collateral

  3. Discussion Topics Key Provisions of CSA (cont.) Dispute Resolution Holding and Using Posted Collateral Events of Default Certain Rights and Remedies Representations Costs and Expenses Additional CSA Obligations Paragraph 13 to the CSA 3

  4. Discussion Topics Credit Implications of Dodd-Frank Clearing Requirement and End-User Exception Segregation of Collateral Securing Uncleared Swaps Reporting and Recordkeeping Obligations Capital and Margin Requirements 4

  5. Discussion Topics Overview of the CSA Key Provisions of the CSA Paragraph 13 to the CSA Credit Implications of Dodd-Frank 5

  6. Overview of the Credit Support Annex • Paragraph 13 contains elections and amendments modifying Paragraphs 1 through 12 • Protects against mark-to-market exposure • Most often used by sophisticated trading counterparties • Requires consistent monitoring and back-office systems • Preferred over adequate assurances because allows 100% collateralization over threshold. 6

  7. Discussion Topics Overview of the CSA Key Provisions of the CSA Paragraph 13 to the CSA Credit Implications of Dodd-Frank 7

  8. Security Interest in Posted Collateral • Paragraph 2: Each Pledgor grants to the Secured Party a first priority continuing security interest, lien on, and right of Set-Off against all Posted Collateral. • When the Secured Party transfers the Posted Collateral back to the Pledgor, the security interest and lien shall be released immediately without further action. 8

  9. Security Interest in Posted Collateral • Practice Notes: • Only applies to “Posted Collateral”—not “Posted Credit Support”. • “Eligible Collateral” that is posted with a Secured Party is called “Posted Collateral”. • Most common Eligible Collateral elected in Paragraph 13 is Cash. • Security interest would not apply to other forms of credit support, such as Letters of Credit. • Primarily aimed at banks which may use Treasuries, bonds, equities or other assets as collateral. 9

  10. Credit Support Obligations • Paragraph 3(a): Delivery Amount. Upon a demand by the Secured Party: • If on any Valuation Date the Delivery Amount equals or exceeds the Pledgor’s Minimum Transfer Amount, then • The Pledgor Transfers Eligible Credit Support with a Value at least equal to the Delivery Amount. 10

  11. Credit Support Obligations • Paragraph 3(a): Delivery Amount (cont.): If on any Valuation Date the Delivery Amount equals or exceeds the Pledgor’s Minimum Transfer Amount: • Delivery Amount: the amount by which the Credit Support Amount exceeds the Value of all Posted Credit Support held by the Secured Party. • What is the Credit Support Amount? • Does it exceed the Value of all Posted Credit Support (e.g., Cash, Letters of Credit, etc.) currently held by the Secured Party? 11

  12. Credit Support Obligations • Paragraph 3(a): Delivery Amount (cont.): If on any Valuation Date the Delivery Amount equals or exceeds the Pledgor’s Minimum Transfer Amount: • Credit Support Amount: • Secured Party’s Exposure, plus • Pledgor’s Independent Amount, minus • Secured Party’s Independent Amount, minus • The Pledgor’s Threshold; provided if such value is negative, the Credit Support Amount is zero (0). 12

  13. Credit Support Obligations • Paragraph 3(a): Delivery Amount (cont.): If on any Valuation Date the Delivery Amount equals or exceeds the Pledgor’s Minimum Transfer Amount: • Exposure: • Defined in Paragraph 12 of CSA • The amount payable under Section 6(e)(ii) of the ISDA Master Agreement as if all Transactions terminated as of the Valuation Date. • Takes into account all forward mark-to-market positions. 13

  14. Credit Support Obligations • Paragraph 3(a): Delivery Amount (cont.): If on any Valuation Date the Delivery Amount equals or exceeds the Pledgor’s Minimum Transfer Amount: • Independent Amount • Elected by the parties in Paragraph 13 • Collateral “cushion” required to be maintained by Pledgor in addition to any other Delivery Amount. • Threshold • Threshold for each party is stated in Paragraph 13. • Most often credit ratings matrix that varies by counterparty. 14

  15. Credit Support Obligations • Paragraph 3(a): Delivery Amount (cont.): If on any Valuation Date the Delivery Amount equals or exceeds the Pledgor’s Minimum Transfer Amount: • Once you calculate any Delivery Amount, does it exceed the Pledgor’s Minimum Transfer Amount? • Minimum Transfer Amount: Designated by the parties in Paragraph 13. • Credit evaluation that varies by counterparty and the anticipated volume of Transactions under the ISDA. • E.g., $250,000 for larger counterparties, and $100,000 for smaller counterparties. 15

  16. Credit Support Obligations • Paragraph 3(b): Return Amount. Upon a demand by the Pledgor: • If on any Valuation Date the Return Amount equals or exceeds the Secured Party’s Minimum Transfer Amount, then • The Secured Party Transfers Posted Credit Support with a Value at least equal to the Return Amount. 16

  17. Credit Support Obligations • Paragraph 3(b): Return Amount (cont.): If on any Valuation Date the Return Amount equals or exceeds the Secured Party’s Minimum Transfer Amount: • Return Amount: The Value of all Posted Credit Support held by the Secured Party, minus the Credit Support Amount. • What is the Value of all Posted Credit Support (e.g., Cash, Letters of Credit, etc.) held by the Secured Party? • Does it exceed the Credit Support Amount? 17

  18. Credit Support Obligations • Paragraph 3(b): Return Amount (cont.): If on any Valuation Date the Return Amount equals or exceeds the Secured Party’s Minimum Transfer Amount: • Once you calculate any Return Amount, does it equal or exceed the Secured Party’s Minimum Transfer Amount? 18

  19. Conditions Precedent • Paragraph 4(a): Conditions Precedent. Each obligation to Transfer amounts under Paragraphs 3 (Delivery/Return Amounts) and 5 (Dispute Resolution) is subject to the condition precedent that: • No Event of Default, Potential Event of Default or Specified Condition has occurred and is continuing with respect to the other party; and • No Early Termination Date for which unsatisfied payment obligations exist has occurred or been designated under the Agreement. • Caution: Ipso Facto 19

  20. Transfer Timing • Paragraph 4(b): Transfer Timing. • If a demand is made by the Notification Time, then Transfers are made no later than close of business on the next Local Business Day. • If a demand is made after the Notification Time, Transfers are made no later than the second Local Business Day. 20

  21. Transfer Timing • Paragraph 4(b): Transfer Timing (cont.) • Practice Notes: • Notification Time elected by the parties in Paragraph 13 (e.g., 1:00 p.m. EST on any Local Business Day). • No distinction between various types of Eligible Credit Support elected in Paragraph 13, including Letters of Credit. • Operational Concerns: While Cash may be Transferred quickly, what about LOC issuances and amendments? • Does your company need to increase Transfer timing to avoid breach? 21

  22. Calculations of Value and Exposure • Paragraph 4(c): Calculations. All calculations of Value and Exposure will be made by the Valuation Agent as of the Valuation Time. • Practice Notes: • Valuation Agent and Valuation Time specified in Paragraph 13. • Ensures there is no gaming or manipulation of the snapshot of index prices used to calculate Exposure, as such amount may fluctuate throughout the day. • Note that if the Valuation Agent is always your counterparty, you are at their mercy. 22

  23. Substitutions of Collateral • Paragraph 4(d): Substitutions. • Generally, Pledgor may Transfer substitute Eligible Credit Support (“Substitute Credit Support”) to the Secured Party on any Local Business Day by providing notice. • The Secured Party then Transfers the Posted Credit Support being replaced back to the Pledgor no later than the Local Business Day following the date it receives the Substitute Credit Support (the “Substitution Date”). 23

  24. Substitutions of Collateral • Practice Notes: • Substitution terms often amended in the Paragraph 13 elections: • Secured Party’s consent for any substitution? • Eliminating the notice requirement? • Often used by Pledgor to increase liquidity by substituting a less liquid form of Eligible Credit Support (e.g., Letter of Credit) for previously-posted Cash. • The substituted collateral must be a type of Eligible Credit Support agreed upon by the parties in the Paragraph 13 elections. 24

  25. Dispute Resolution • Paragraph 5: Dispute Resolution: How can disputes arise? • Calculation of Delivery/Return Amount • What amount of collateral is a party obligated to deliver or return? • Value of Eligible Credit Support or Posted Credit Support • What is the Value of the collateral being posted or held? • May arise when dealing with fluctuating collateral, e.g. securities. 25

  26. Dispute Resolution • Paragraph 5: Dispute Resolution (cont.):Procedure for resolving disputes: • Disputing Party gives notice by close of business on the Local Business Day following the date of the demand or Transfer (as applicable); • The appropriate party will Transfer the undisputed amount no later than the close of business on the Local Business Day following the date of the demand or Transfer (as applicable); and • The parties will attempt to resolve the dispute informally. 26

  27. Dispute Resolution • Paragraph 5: Dispute Resolution: Procedure for resolving disputes (cont.): • If the parties fail to resolve the dispute by the Resolution Time (elected in Paragraph 13), then: • For disputes regarding Delivery/Return Amount: The Valuation Agent will recalculate using undisputed calculations or mid-market quotations from Reference Market makers. • For disputes regarding the Value of collateral: The Valuation Agent will recalculate the Value as of the date of the Transfer in the manner set forth in the Paragraph 13 elections. 27

  28. Holding and Using Posted Collateral • Paragraph 6(a): Care of Posted Collateral. • Secured Party is required to exercise reasonable care to assure safe custody of Posted Collateral, which means the same degree of care the Secured Party would use as to its own property. • Note that “Posted Collateral” is defined by the parties in Paragraph 13. • Typically means Cash. 28

  29. Holding and Using Posted Collateral • Paragraph 6(b): Eligibility to Hold Posted Collateral; Custodians: • The Secured Party generally may hold Posted Collateral or appoint a Custodian to hold Posted Collateral. • In Paragraph 13, most parties elect specific requirements and conditions to holding Posted Collateral: • Not a Defaulting Party • Only held in the U.S. • Ratings triggers 29

  30. Holding and Using Posted Collateral • Paragraph 6(b): Eligibility to Hold Posted Collateral; Custodians: • Why Use a Custodian? • Usually only preferred when a party doesn’t meet the conditions to holding Posted Collateral • Paragraph 13 generally requires that a Custodian be a “Qualified Institution” by meeting some form of credit rating and asset standards. • Custodians take time to establish and can be expensive. • ► Dodd Frank Note: Under the Act, a counterparty could unilaterally require a Custodian irrespective of the CSA. 30

  31. Holding and Using Posted Collateral • Paragraph 6(c): Use of Posted Collateral. • If the Secured Party is not a Defaulting Party or an Affected Party and no Early Termination Date has occurred, then the Secured Party has the right to sell, invest, assign, commingle or otherwise dispose of any Posted Collateral. • However, the Secured Party shall be deemed to be holding such Posted Collateral for purposes of calculating Delivery/Return Amounts and Disputed Amounts. • ► Dodd Frank Note: The Act could restrict a party’s ability to hold and use Posted Collateral. 31

  32. Holding and Using Posted Collateral • Paragraph 6(c): Use of Posted Collateral. • Practice Notes: • Rehypothecation of collateral is an important right that is generally favored. • In light of recent credit downgrades across the industry, some counterparties may limit the ability of a Secured Party to rehypothecate Cash and instead require the safekeeping of Posted Collateral in a segregated collateral account. 32

  33. Holding and Using Posted Collateral • Paragraph 6(d): Interest Amounts. • The Secured Party shall Transfer to the Pledgor the Interest Amount with respect to Posted Collateral at the time designated in Paragraph 13, so long as a Delivery Amount would not be created or increased by such Transfer. • Any Interest Amount not Transferred shall constitute Posted Collateral. • Practice Note: The Transfer of the Interest Amount is negotiated between the parties, usually on a monthly basis. 33

  34. Events of Default • Paragraph 7: Events of Default: An Event of Default occurs under Section 5(a)(iii)(1) (“Credit Support Default”) of the Agreement if: • A party (or its Custodian) fails to make any Transfer of Eligible Collateral, Posted Collateral or Interest Amount when required if not cured within two (2) Local Business Days after receiving notice of same. 34

  35. Events of Default • Paragraph 7: Events of Default: An Event of Default occurs under Section 5(a)(iii)(1) (“Credit Support Default”) of the Agreement if: • A party fails to comply with Paragraph 6(c) (“Use of Posted Collateral”) if not cured within five (5) Local Business Days after receiving notice of same. • A party fails to comply with any other obligation under the Annex (not otherwise a separate Event of Default) if not cured within thirty (30) days after receiving notice of such failure. 35

  36. Events of Default • Paragraph 7: Events of Default: Any default under Paragraph 7 of the CSA is an Event of Default under Section 5(a)(iii) of the Master Agreement: • Right to suspend payments and performance under Section 2(a)(iii) of the Master Agreement. • Right to suspend Transfers of Eligible Credit Support under Paragraph 4(a) of the CSA. • Right to designate an Early Termination Date and liquidate all Transactions under the ISDA. 36

  37. Certain Rights and Remedies • Paragraph 8(a): Secured Party’s Rights and Remedies. • When do Secured Party’s rights arise? • Event of Default as to Pledgor • Specified Condition as to Pledgor, or • Practice Note: “Specified Conditions” are Termination Events elected by the parties in Paragraph 13. • The occurrence or designation of an Early Termination Date with respect to the Pledgor 37

  38. Certain Rights and Remedies • Paragraph 8(a): Secured Party’s Rights and Remedies. • What rights are available? Unless Pledgor has paid all Obligations then due, Secured Party may exercise any of the following remedies: • All remedies available under applicable law; • Any rights and remedies under Other Posted Support • E.g., Drawing on outstanding Letters of Credit • Setoff of amounts payable by Pledgor against Posted Collateral held by Secured Party; or • Liquidate Posted Collateral and apply proceeds to any Obligations owed by Pledgor. 38

  39. Certain Rights and Remedies • Paragraph 8(b): Pledgor’s Rights and Remedies. • When do Pledgor’s rights arise? • The occurrence or designation of an Early Termination Date arising from an Event of Default or Specified Condition with respect to the Secured Party. • Practice Note: Pledgor’s rights do not arise until the occurrence or designation of an Early Termination Date—not merely upon the occurrence of an Event of Default or Specified Condition. 39

  40. Certain Rights and Remedies • Paragraph 8(b): Pledgor’s Rights and Remedies. • What rights are available? Unless Secured Party has paid all Obligations then due, the following shall apply: • Pledgor can exercise all remedies available under applicable law. • Pledgor can exercise any rights and remedies under Other Posted Support. • E.g., Drawing on outstanding Letters of Credit • Secured Party is obligated to immediately Transfer all Posted Collateral back to the Pledgor. 40

  41. Certain Rights and Remedies • Paragraph 8(b): Pledgor’s Rights and Remedies. • What rights are available? Unless Secured Party has paid all Obligations then due, the following shall apply (cont.): • If Secured Party does not Transfer back all Posted Collateral to Pledgor, then Pledgor may: • Set-Off amounts payable by Pledgor against any Posted Collateral held by the Secured Party; and • If amounts are not Set-Off, withhold payment of amounts due up to the Value of Posted Collateral until such Posted Collateral is returned. 41

  42. Certain Rights and Remedies • Paragraphs 8(a) and 8(b): Rights and Remedies • Practice Notes: • These sections recognize that the Non-Defaulting or Non-Affected Party should have the right to protect its collateral if the other party defaults. • Rights are different depending on whether the Pledgor or Secured Party defaults, but both sets of rights and remedies are equally important to protect a party’s Posted Credit Support. 42

  43. Certain Rights and Remedies • Paragraph 8(c): Deficiencies and Proceeds. Secured Party must Transfer to Pledgor any proceeds and Posted Credit Support remaining after liquidation, Set-Off and/or application of funds after all amounts payable are satisfied in full. • Pledgor remains liable for any unpaid amounts. • Paragraph 8(d): Final Returns. When no amounts may become payable by Pledgor with respect to Obligations under the ISDA, Secured Party will Transfer all Posted Credit Support and Interest Amounts back to the Pledgor. 43

  44. Representations • Paragraph 9: Representations. Each Party represents the following on the date the CSA is executed and each date the Pledgor transfers Eligible Collateral: • It has the power to grant a security interest and lien on the Eligible Collateral and has taken all necessary actions to effect same; • It is the sole owner of the Eligible Collateral it Transfers, and it Transfers such Eligible Collateral free and clear of liens or other encumbrances; 44

  45. Representations • Paragraph 9: Representations. Each Party represents the following on the date the CSA is executed and each date the Pledgor transfers Eligible Collateral (cont.): • Upon a Transfer, the Secured Party will have a valid and perfected first priority security interest and lien on the Eligible Collateral; and • The performance of its obligations under the CSA will not result in any other security interest, lien or encumbrance other than provided to the Secured Party. 45

  46. Costs and Expenses • Paragraph 10(a): General.Each Party generally pays for its own expenses in performing its obligations under the CSA. • Paragraph 10(b): Posted Credit Support.The Pledgor shall promptly pay all taxes or charges imposed with respect to Posted Credit Support held by the Secured Party upon becoming aware of same (except taxes with respect to the Secured Party’s use of Posted Collateral). 46

  47. Costs and Expenses • Paragraph 10(c): Liquidation/Application of Posted Credit Support. • All reasonable costs and expenses incurred in connection with the liquidation and/or application of Posted Credit Support shall be payable either by the Defaulting Party, or if there is no Defaulting Party, equally shared by the parties. 47

  48. Additional CSA Obligations • Paragraph 11(a): Default Interest. If Secured Party fails to make any Transfer of Posted Collateral or Interest Amount, such amount shall accrue interest at the Default Rate from the date such amount was required to be Transferred until the date actually paid. • Practice Note: • Note that the Default Rate under the ISDA is a penalty rate, with a higher rate than is paid for interest on Cash held as Posted Collateral. 48

  49. Additional CSA Obligations • Paragraph 11(b): Further Assurances. Upon demand by a party, the other party shall execute or deliver any financing statement, specific assignment or other document that may be necessary or desirable with respect to creating, perfecting, enforcing and/or releasing any security interest or lien granted under the Annex. • Practice Notes: • Beware of language granting to counterparty a power of attorney to execute security documents on your company’s behalf. • While permitted by Article 9 of the UCC, most companies require a board resolution or other corporate action to grant a power of attorney. 49

  50. Additional CSA Obligations • Paragraph 11(c): Further Protection. Pledgor will give notice to the Secured Party of, and defend against, any suits, actions or proceedings relating to Posted Credit Support Transferred by the Pledgor or that could adversely affect the security interest and lien granted under the CSA (unless such suit or action results from Secured Party’s exercising its rights to use Posted Collateral). 50

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