Introduction

Anticipating upcoming regulatory requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) regarding margin segregation for uncleared swaps, earlier today the International Swaps and Derivatives Association Inc. (“ISDA”) published sample terms and provisions (the “Segregation Provisions”) that market participants may use in negotiating collateral segregation agreements with their counterparties.1 The Segregation Provisions also come in response to recommendations made by several industry associations2 addressing the risks taken by market participants when they post collateral in excess of the credit exposure borne by the other party (“Excess Collateral”) in the event that the other party becomes insolvent. Not long ago many market participants painfully experienced the reality of those risks in the context of the Lehman Brothers bankruptcy.

The purpose of the Segregation Provisions is to provide market participants with a menu of suggested provisions that they can incorporate in their collateral segregation arrangements and further customize to their specific needs.

This Alert describes the underlying regulatory requirements under Dodd-Frank, discusses recent industry initiatives regarding collateral segregation, and provides a brief summary of the Segregation Provisions.  

Regulatory Requirements

The Segregation Provisions are intended to facilitate the implementation of the reforms mandated by Dodd-Frank in the U.S.3 and the regulations proposed by the Commodities Futures Trading Commission (the “CFTC”) and other regulators earlier this year (the “Proposed Regulations”).4

The Proposed Regulations would impose strict margin requirements and would force swap dealers to collect initial and variation margin from many counterparties that may not currently post any collateral. In addition, for uncleared swaps between swap dealers and major swap participants, the Proposed Regulations would require all initial margin to be held by an independent, third-party custodian. For all other uncleared swaps, initial margin segregation would be optional and swap dealers and major swap participants would only be required to offer their counterparty the opportunity to have initial margin held in a segregated account with an independent, third-party custodian. Market participants may use the Segregation Provisions if they opt to have their initial margin segregated.

With respect to cleared swaps, initial margin posted to a clearinghouse will be segregated by the clearinghouse and regulators have proposed, and are still considering, several segregation models designed to protect market participants and enable them to transfer their initial margin together with their trades to a healthy dealer in the event that their dealer counterparty fails.5 Any additional initial margin required by a dealer in excess of that imposed by the clearinghouse would have to be physically segregated from dealer property and market participants may also use the Segregation Provisions in that context.

Industry Recommendations and Responses

Risks associated with overcollateralization have become the focus of both market participants and regulators, especially following the recent Lehman Brothers bankruptcy and the relative lack of protection experienced by certain market participants. In March 2010, ISDA, MFA and SIFMA released a paper addressing the risks incurred by market participants when posting Excess Collateral directly to their counterparties (the “White Paper”).6

The White Paper discusses alternative arrangements for holding initial margin depending on market participants’ risk and cost appetites and regulatory constraints. It recognizes that there are essentially three ways in which a party may hold initial margin, as follows:

  • direct holding, whereby the initial margin is delivered by the pledgor to the secured party, and the secured party holds the initial margin itself or through an affiliated entity;
  • third party custody, in which an unaffiliated bank, broker-dealer or other party operates under agreement with one of the two counterparties (usually the dealer) and simply provides typical custody and safekeeping services; and
  • tri-party custody, whereby an unaffiliated bank or other party providing tri-party custodial services operates under a three-way contract between it and the two derivative counterparties and agrees to release collateral to the counterparties based on predefined conditions.

The White Paper recommended that industry associations and market participants develop standard provisions that could be incorporated into initial margin segregation arrangements. As a result, a working group of ISDA member firms and custodians was formed; the Segregation Provisions are the product of the working group’s efforts.

The Segregation Provisions

The Segregation Provisions are intended to be used in the context of a tri-party custody arrangement amongst a pledgor, a secured party and an unaffiliated custodian. They address certain necessary modifications to the New York Credit Support Annex (“CSA”) and include provisions that the parties may incorporate into their agreement with the custodian (typically, a collateral control agreement) dealing with the release of the initial margin to the secured party or the pledgor depending on the occurrence of certain events and based on pre-defined conditions.

(a) Modifications to the CSA

Since a tri-party custodial arrangement results in the separation of initial margin from other collateral (typically variation margin) that may be posted by a pledgor, the standard CSA must be amended to create a separate pool of initial margin, with the result that the aggregate collateral is bifurcated into one pool of variation margin and another (segregated) pool of initial margin. To achieve this, certain technical amendments to the CSA are required. These amendments address, among other things, the creation of separate margin flows for each pool, initial margin valuation (especially when initial margin may be invested in cash equivalent instruments) and risk allocation provisions relating to the custodian’s actions or failure to perform.

(b) Collateral Control Agreement – Collateral Access Provisions

Tri-party collateral control agreements among a pledgor, a secured party and an unaffiliated custodian enable the secured party to perfect its security interest in the collateral and typically address a number of issues related to the release of collateral. Those issues include (i) events upon which the pledgor or the secured party may secure exclusive access to the collateral, (ii) actions that the moving party needs to take in order to obtain exclusive right to, and release of, the collateral, (iii) timing of the collateral release by the custodian, (iv) certain advance notification requirements that may be required by the parties and (v) dispute rights in the event that a party disagrees with the actions taken by the other party.

The Segregation Provisions address each of those issues both from the secured party’s and the pledgor’s perspectives and serve as a menu of provisions that the parties can further customize to document their business deal depending on their risk appetite.

Conclusion

Market participants should carefully structure their collateral segregation arrangements in a manner that suits their risk tolerance and business needs. Also, they should make sure that the documentation accurately reflects the business deal with their counterparty and their understanding of how, when and to whom the collateral should be distributed.

The Segregation Provisions provide a good starting point to identify the issues to be addressed and how they can be resolved. Further customization will often be necessary to address specific needs and enforceability issues. The Segregation Provisions serve a useful purpose of leveling the playing field for swap participants when facing dealers to enable a constructive discussion on these complex issues with market-driven solutions.