Friday 21 November 2014

The use of Independent Amounts under a CSA

When negotiating an ISDA Credit Support Annex you will often hear parties discussing “variation margin” and “initial margin”.  However neither of these terms is defined in the English Law or New York Law versions of the CSA.

In those documents the terms Credit Support Amount and Credit Support Balance are closely linked. Credit Support Amount means the risk exposure that needs to be collateralised. Credit Support Balance is the amount of collateral held for the risk exposure. 

Initial margin

Initial margin or “Independent Amount” as it is called in the CSA is a confusing term and can mean the amount that the parties may need to transfer at the start of their relationship or an agreed sum to be transferred later if the risk exposure on a particular transaction warrants it or the risk profile of a counterparty changes e.g. if its credit rating fall below a contractually agreed level.

An Independent Amount overcollateralises OTC derivatives risk exposure.  It can be taken to cover:

  • the estimated volatility of a particular Transaction where a credit officer considers it to be more than normally risky;

  • the time gap between a collateral call and the delivery of the collateral itself (e.g. emerging markets bonds can have a long settlement cycle); or

  • in relation to credit concerns relating to one or both parties where there would be linkage to a credit rating table or net asset value.

It can be a fixed money sum or be expressed as a formula (e.g. as a percentage of a Transaction's notional amount) or based upon low credit ratings or net asset value.  If an Independent Amount in a CSA is not stated it is deemed to be zero.

It is useful to remember that, where there is a conflict between them, the terms of a Confirmation would prevail over the terms in a CSA for the relevant Transaction concerned.  Therefore the parties could agree in a Confirmation on a case by case basis what the relevant Independent Amount would be even if the CSA states that Independent Amount is not applicable.

The term Credit Support Amount is often amended in a one way CSA where you are dealing with a hedge fund counterparty so that Independent Amount is ignored in the Credit Support Amount calculation. 

A problem arose with the Lehman Brothers’ insolvency because Independent Amounts were posted to Lehmans who then reused them.  They proved not to be recoverable by Transferors and Pledgors in many cases.  This lead ISDA to produce a White Paper in 2010 which proposed four ways for Independent Amounts to be segregated from other collateral under the CSA.

With the introduction of various regulations including the CFTC Collateral Segregation Rules, a counterparty has the option to demand that an Independent Amount must be segregated with an independent third party custodian.  However there are often operational challenges with these arrangements and additional safety comes at a price.

Variation margin

Variation margin is a term more correctly and formally used in the exchange traded derivatives market than in the OTC derivatives space. It is always part of the Credit Support Balance in the CSA.

Posted by Abigail Harding

Tagged: ISDA negotiation ISDA ISDA Credit Support Annex Collateral

Category: ISDA negotiation

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