Security interest collateral agreements should be used for segregation, says Isda

Collateral that is intended to be segregated should be governed by a security interest form of collateral agreement, according to a paper published by three industry associations.

The independent amount white paper, written by the International Swaps and Derivatives Association, the Managed Funds Association and the Securities Industry and Financial Markets Association, says title transfer forms of collateral agreement cannot safely accommodate the segregation of independent amount due to the elevated level of recharacterisation risk, and only security interest agreements are able to support effective segregation.

Independent amount (also known as initial margin) is an additional cushion of collateral in excess of the market value of underlying derivatives trades, designed to offer extra protection to the dealer in the event of the default of an end-user.

The collapse of Lehman Brothers prompted many end-users, such as hedge funds, to reconsider their collateral management processes, with the aim of ensuring independent amount is bankruptcy-remote and is recoverable immediately following the collapse of a dealer. Independent amount was often transferred to Lehman with hypothecation rights – where the assets posted with the dealer are subsequently lent out to a third party. With Lehman free to rehypothecate the independent amount in certain jurisdictions, and with little segregation of client assets, many hedge funds were surprised to discover they had to file an unsecured claim for the recovery of these assets – meaning they are likely to get back less than what they had transferred.

Market practice in Europe is to use the credit support annex (CSA), which is a title transfer form of agreement under English law. Under this form, the transferor (a hedge fund) of collateral becomes an unsecured creditor once it delivers (by outright transfer of title) excess collateral. Regardless of what the transferee (a dealer) does with those assets, the risk to the transferor does not change. This means that, if the transferee decides to use the assets, it is using its own assets and not rehypothecating.

Therefore, the paper recommends that if collateral is intended to be segregated it should be governed by a security interest form of agreement. The paper suggests parties who use the English law CSA consider using hybrid title transfer/security interest documentation arrangements. One example would be to use the English law CSA for variation margin while employing the use of the credit support deed, a security interest document, for independent amount. Another method might be to employ the Isda 2001 margin provisions document, which contains both title transfer and security interest mechanisms.

The white paper was published in two parts and forms a part of the commitments made last year in the June 2 letter to the Federal Reserve Bank of New York by the Operations Management Group, a consortium of 27 broker-dealers, buy-side firms and industry associations. The first part, published on October 22 last year, examined the use and risks of independent amount. The second, published on March 1, details a range of different approaches to holding independent amount.

The paper details five methods of holding independent amount and makes a number of recommendations for future market evolution, initially discussed in Risk in December 2009. The first method examined is unrestricted direct dealer holding, whereby the assets are transferred to the dealer with the right of rehypothecation and no obligation to segregate the collateral. The method, which is estimated to be used in 90% of current security interest-based collateral agreements, is the most risky from an end-user's point of view, Lehman being an example. However, the paper recommends that, unless otherwise required by law or regulation, the option should be available between counterparties that are willing to accept the risks.

The four remaining methods are all variations on the theme of segregation, comprising the segregation of collateral directly by the dealer on its own books; segregation by a dealer affiliate; holding of collateral by a third-party custodian; and tri-party collateral agent holding agreement. The paper recommends that parties to an OTC derivatives contract should be free to contract bilaterally for the independent amount approach that best suits them.

The paper also notes that, because the alternative methods require segregation of collateral, it will be necessary to modify the standard New York and Japanese law CSAs to permit segregation of independent amount as a separate pool of collateral, as opposed to current language, which produces a blended collateral pool. It will also be necessary to modify the documents above as well as the credit support deed if there is a requirement to segregate cash collateral, which typically will not be possible if the dealer is a bank.