Overnight, the International Swaps and Derivatives Association, Inc. (ISDA) published the latest instalment in its roll-out of documentation developed in response to the United States Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
ISDA's Tri-Party IA Notices (Notices) are the latest addition to a suite of ISDA published templates to facilitate the negotiation of tri-party control agreements associated with non-centrally cleared over-the-counter (OTC) derivatives contracts.
What is a tri-party control agreement?
In derivatives markets, the parties to a transaction may be contractually required to post collateral as security to support their financial obligations under the transaction. This process of "margining" is expected to become mandatory for major participants under rules being designed by the Basel Committee for Banking Supervision and the International Organization of Securities Commissions. In many cases, derivatives dealers require end-users to post initial collateral over and above the dealer's actual exposure to the end user.
This initial margin is contractually referred to in ISDA documentation as the "Independent Amount", and although it gives comfort to dealers, it creates risks for end-users if collateral posted as an Independent Amount is intermingled with the dealer's assets. If the dealer becomes insolvent, the end-user may find itself in a queue to recover its initial margin with all of the insolvent dealer's other ordinary creditors. Full recovery in that situation is very unlikely.
To protect against this situation, parties can enter into a tri-party control agreement to ensure that the Independent Amount is retained in a segregated account by a custodian third party. In fact, the Dodd-Frank Act will require dealers and major swap participants in the case of non-centrally cleared derivatives to notify their counterparties that they have the right to require segregation of collateral. As a result of these requirements, tri-party control agreements are expected to become much more common.
How will the Notices assist?
Tri-party control agreements typically entitle the non-defaulting party to access collateral held by the custodian on the occurrence of specified events of default. For example, if the "secured" party is in default, the party that posted the collateral (Pledgor) would usually have a right to access the collateral. Alternatively, if the Pledgor is in default, the secured party may have that right.
Before it can access the collateral, the non-defaulting party must, under the terms of the tri-party control agreement, deliver a notice to the custodian certifying certain matters and notifying instructions for transfer of the collateral. The Notices published overnight by ISDA are templates designed to facilitate the negotiation of the form of such notices by the parties to the relevant tri-party control agreement.
The publication of the template Notices follows the previous release by ISDA of sample provisions of tri-party control agreements as templates to facilitate the negotiation of these documents. These are available on the ISDA "Sample Tri-Party IA Provisions" webpage, along with a memorandum that explains the background to the sample provisions and information on their use.
Implications for Australia
Australian participants in the OTC derivatives markets that will be affected by the Dodd-Frank Act will welcome this latest release by ISDA, as they seek to negotiate the suite of documentation that will be required once the OTC derivatives rules under the Dodd-Frank Act come into force.