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Substitution Rights under a Credit Support Annex

We recently received a request from one of our followers to write a blog on substitution rights.

Sam – we hope you find this useful.

In a Credit Support Annex (a “CSA”) the parties may negotiate a wide variety of eligible collateral that can be provided to cover a party’s risk exposure. 

It is probably useful to note here that there may be regulatory limitations on permitted types of collateral if the parties negotiate a CSA that needs to comply with uncleared margin rules.  If it does not, the collateral choices could be broader.

What is substitution?

During the life of the trading relationship, the posting party may wish to change the collateral that he previously delivered to his counterparty. This is usually collateral in the form of government bonds or perhaps high quality equities. It is very rare for cash collateral to be substituted.

There are a number of reasons why a posting party may want to substitute the collateral he has previously delivered with a different type of collateral.

These may include:-

• Needing to deliver securities to a different party either under another collateral agreement or perhaps under a repo transaction.
• Wanting to hold securities during the period when coupons are paid on bonds or where dividends are paid on equities or where a party wants to exercise his equity voting rights.
• To maximise collateral optimisation (i.e. posting the “cheapest to deliver” collateral).

Standard substitution position under the English Law Credit Support Annex

The English Law CSA is a title transfer document and therefore when the collateral giver (the Transferor) posts collateral to the collateral receiver (the Transferee), full legal title and ownership of collateral is passed to the Transferee who is obliged to transfer back equivalent collateral when his risk exposure is removed or reduced.

Paragraph 3(c) of the English Law CSA (both 1995 and 2016 versions) sets out the substitution process:-

1. The Transferor sends a notice requesting a substitution
2. The Transferee consents to the substitution request
3. The Transferor then provides the new collateral
4. Upon receipt of the new collateral, the Transferee returns the old collateral no later than the trade settlement date after he has received the new collateral.

Risks with no consent to substitution under an English Law Credit Support Annex

The key point to note is that the Transferee is required to provide consent before a substitution can take place.

The consent point was previously important under English law because if the Transferee were not completely free to consent or not he could have been deemed by a court not to be the true owner of the collateral. This could have led to the title transfer nature of the English Law CSA being recharacterised as a security interest or pledge which could fail for lack of registration if it were also deemed to be a floating charge in a liquidation situation.

This risk has been neutralised by the European Directive on Financial Collateral Arrangements in the European Union, Norway, Iceland and Gibraltar.  England adopted it in 2003.

Standard substitution position under the New York Law Credit Support Annex

The New York Law CSA is a security interest or pledge document. Under it the collateral giver (known as the Pledgor) retains an ownership interest in the collateral pledged to the collateral taker (known as the Secured Party).

Paragraph 4(d) of the New York Law CSA (both 1994 and 2016 versions) outlines the substitution process.

The parties agree in Paragraph 13 whether consent by the Secured Party to a substitution is required.  If no election is made then the fallback is that consent is not required and the following process is followed:-

1. the Pledgor notifies the Secured Party that he wants to substitute collateral.
2. the Pledgor delivers the new collateral.
3. the Secured Party returns the old collateral no later than the trade settlement date after he has received the new collateral.

Other risks with substitutions

The Transferor’s / Pledgor’s potential credit risk on the Transferee / Secured Party increases during the short period when the Transferee / Secured Party holds both the old and new collateral.  If he goes bankrupt in that short window then the Transferor / Pledgor can only rank as an unsecured creditor in his liquidation.  The market knows this risk and accepts it because it regards it as very remote.

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Posted by Abigail Harding

Category: ISDA negotiation

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