Introduction As the Financial Times notes, “falls in European interest rates into negative territory could profoundly affect the workings of the financial system …”. However, this is not just a problem for Euro interest payments, it is currently also true of the Swiss Franc and Danish Kroner, and has historically been the case for other currencies, such as the Hong Kong dollar. The use of negative interest rates as a monetary tool is not new and, although not that commonplace, “there is nothing special about going into negative territory”1.
There is a view that this is a temporary or short-term issue and therefore it will pass without the need to address it expressly in the transaction documentation. The alternative view, as articulated by members of the ISDA Collateral Steering Committee – who developed ISDA’s 2014 Collateral Agreement Negative Interest Protocol (the “ISDA Protocol”) – is that “any lack of consistency may have detrimental effects on market pricing transparency, and derivative market liquidity may be adversely impacted”2.
This Client Alert discusses the impact of negative interest rates on transaction and collateral documentation commonly used in the European commodity derivatives market.
Negative interest rates as a monetary policy tool The current negative interest environment stems from a number of Central Banks setting negative interest rates on the mandatory reserves commercial banks are required to place with their supervising Central Bank. These negative rates feed through to the interest on surpluses that commercial banks may have with their Central Bank and in turn to the short-term money market rates for that banking system.
However, quantitative easing, by the Federal Reserve Board in the United States, the Bank of England in the UK and, more recently, by the European Central Bank, has led to the lowering of long-term interest rates. By applying negative interest rates to reserve holdings, Central Banks can encourage the banks that they supervise to lend to customers more in order to stimulate economic growth.
There may be other reasons for resorting to negative interest rates, such as the protection of local export markets by limiting the appreciation of a national currency relative to other competing currencies. Such appreciation may be caused by a rapid inflow of “hot money” if a given currency is seen as a safe haven. This was the case for the Central Banks of Denmark and Switzerland as they attempted to stem the flood of investors seeking refuge from the perceived risk of the Euro.
It does not follow, however, that just because the Central Bank rate is negative, money market or commercial lending rates will automatically follow. Although historically, deposit rates have tracked wholesale funding costs (which are typically higher than the Central Bank rate), commercial banks find it difficult to explain to depositors why they should be paying the bank to hold their money (either through negative interest rates or through other running account charges). Charging negative rates could lead to depositors deciding to liquidate their deposits and hold their cash outside the banking system. Therefore, commercial banks prefer to cut operating costs or reduce profits rather than simply pass on additional funding costs to customers. This can only be a short-term solution for a commercial bank, and therefore a sustained period of negative interest rates by the Central Bank will eventually adversely impact commercial lending activities.
The impact of the ECB’s policy can already be seen in the negative yields available in the Euro bond markets. More worryingly, the tenor of the bonds being sold with negative yields is increasing, suggesting that the hope of short-term economic recovery is diminishing. If this view persists, negative interest rates may well begin to be passed through from the Central Bank to commercial banks and on to depositors.
Impact of negative interest rates on Commodity collateral documentation The most frequently used collateral documentation in Europe by commodity market participants are the 1995 ISDA Credit Support Annex (Transfer – English law) (the “ISDA CSA”) and the EFET Credit Support Annex (v.2.0, May 2010)3 (the “EFET CSA”). These credit support annexes, or CSAs, are used to collateralise obligations arising, respectively, under the ISDA Master Agreement and, in the case of the EFET CSA, the EFET General Agreement Concerning the Delivery and Acceptance of Electricity (v.2.1(a), Sept. 2007) (the “EFET Power”) or the EFET General Agreement Concerning the Delivery and Acceptance of Natural Gas (v.2.0, May. 2007) (the “EFET Gas”).
The most common forms of collateral provided under these CSAs by commodity market participants are cash and standby letters of credit4. The ISDA CSA collateralises exposure for multicurrency transactions under the ISDA Master Agreement and therefore, rates of interest, typically in USD, Euro and GBP, arise that are paid on the default termination currency of the CSA. In contrast, as the CSAs relating to the EFET Gas or EFET Power collateralise exposures for Euro only transactions, the negative interest rate risk is likely to be limited to Euro rates (e.g., EURIBOR). This limitation to Euro risk does not extend to EFET’s CSA documentation used for collateralising its obligations under its form of Master Netting Agreement (v1.0, June 2010) (the “EFET MNA”), which like the ISDA CSA, tracks exposures in multiple currencies, but is more likely, for reasons of geography and transaction portfolio type, to have currency interest calculations in Euro or GBP (or possibly Danish Kroner).
Typically, under the ISDA CSA – for the collateral delivered by the delivering party – the holder of the collateral agrees to pay the other party an amount of interest on any cash collateral held and any manufactured income on the benefit of collateral held which comprises securities (e.g., coupons on debt instruments, dividends on shares, etc.)5. Although negative yields exist on government and commercial bonds, negative coupons have not yet appeared, thereby avoiding the need for this to be addressed in the ISDA CSA (for now).
However, in the context of the CSA where an interest amount arises on the cash collateral held by the holder, this is usually payable to the delivering party. With a negative interest rate, this potentially amounts to an obligation on the delivering party to pay that interest to the collateral holder. The issue in the ISDA CSA, as well as in the EFET CSAs, is that, as originally drafted, there was no mechanism for either recognising a payment obligation in relation to a negative interest amount, or requiring payment by the delivering party of the absolute value of the negative interest amount to the holder of the collateral (the “Negative Interest Payment Obligation Issue”).
The absence of an express right in the CSA of the collateral holder to receive interest from the delivering party leads to a debate over whether there is an implied floor or a deemed zero interest rate applicable to the CSA. The counter to this argument is that with a negative interest amount, the relevant party transferring the absolute value of the negative interest amount becomes the delivering party. Even if there is an obligation to pay the absolute amount of the negative interest amount, what is the consequence for a failure to pay that amount? The ISDA Protocol enables the collateral holder to use available collateral (if any) held towards discharging the delivering party’s obligation. If there isn’t enough available collateral, an Event of Default would be triggered. This solution aims to reduce the risk of any dispute based on confusion over the respective obligations of each party (the “Dispute Risk Issue”).
Even if a zero interest rate were to be deemed to apply in this situation, this could lead to a mismatch between the collateral holder’s cost of funding for the underlying commodity derivative and its interest payment obligations under the CSA to the delivering party. The choice of applicable rate used to determine the interest amount may exacerbate this differential. For example, where swap valuation for exposure calculation purposes is done on the basis of LIBOR-based discount rates, but payments of interest on collateral held is paid on lower6 overnight indexed swap (OIS) rates7, what happens if the LIBOR rate is near zero (but still positive) but the OIS rate has become negative? In collateralised commodity portfolios, the underlying derivative may be funded by the collateral itself, although perhaps more so in the ISDA CSA context than under an EFET CSA.8 This would create a greater mismatch between the actual exposure and the value of the collateral held (the “Funding Mismatch Issue”).
Another issue related to the Funding Mismatch Issue arises in the context of the calculation of “Exposure” (as that term is defined under each of the CSAs). When negative interest rates are used in this calculation, it leads to higher close-out value being determined and therefore, a call for more collateral to be delivered than would be the case, absent the application of negative interest rates. In the event that a close-out amount has to be determined under an ISDA Master Agreement, the EFET MNA, EFET Power or the EFET Gas, it is necessary, as part of that exercise, to take into account payments and deliveries that would fall due after the transaction termination date. These payments are calculated on a net present value basis9. Where the applicable interest rate used in that present value determination is negative, it has the effect of increasing the amount rather than discounting it. This result would certainly make ‘discounted value’ a misnomer, and could potentially lead to more disputed valuations under the CSA’s dispute resolution mechanism. Delays in collateral delivery triggered by the resolution of such disputes will increase exposure pending their resolution.
The ISDA Protocol aims to resolve the Negative Interest Payment Obligation Issue by requiring the collateral delivering party to pay negative interest to the collateral holder. It thereby reduces the Dispute Risk Issue. It does not, however, seek to deal with the Funding Mismatch Issue (although it has made a point of addressing this problem in the context of the ISDA 2013 Standard Credit Support Annex).
The ISDA Protocol, however, has its limitations. Its scope does not extend to ISDA CSAs where the CSA:
- Is a one-way CSA (i.e., only one party has to post collateral)
- Contains a third-party credit support document (e.g., a guarantee) whose terms prevent amendment or modification to the CSA without that third party’s consent, authorisation or approval
- Provides for no payment of interest where the cash is held by a third-party custodian (e.g., because the collateral is held by way of Independent Amount)
- Provides for a rate of interest different from the rate specified in the CSA itself, e.g., by way to alternative financial indicator
- Already contains a provision whereby a negative interest amount will be deemed to be equal to zero, or where the CSA contains a provision that no interest amount is payable or the applicable rate of interest is zero
- Provides for the determination of the interest rate or amount with reference to variable rates that are themselves subject to an adjustment mechanism (e.g., the average of SONIA plus/minus a number of basis points
Conclusion All ISDA CSAs falling within the above list (the “Excluded ISDA CSAs”) are excluded from the scope of the ISDA Protocol. It is likely that the number of margining arrangements falling within the Excluded ISDA CSAs along with the EFET CSAs (for which there is currently no EFET equivalent to the ISDA Protocol) is not insignificant. Beyond margining arrangements on such standard form documentation, there are likely to be a very large number of bespoke margining arrangements (including those forming part of a structured commodity transaction) which suffer from the Negative Interest Payment Obligation Issue, Dispute Risk Issue or the Funding Mismatch Issue. For all such margining arrangements, the solution is to negotiate bilaterally amendments, which inevitably raises the prospect of parties seeking to use the opportunity to renegotiate unrelated credit terms in the documents.
As previously mentioned, there is nothing special about rates going into negative territory but in a world accustomed to positive rates, it does require taking a fresh approach to analysing and managing risk. Similarly, in the context of commodity transaction documentation drafted with positive rates in mind, the impact of negative interest rates can have interesting effects.