The European Central Bank has announced that it will begin charging negative interest rates on deposits held with it from 11 June 2014. As market participants find themselves in a world of potential negative rates we look at a new way, and an old way, parties can manage this in their derivatives.
The New Way - ISDA 2014 Collateral Agreement Negative Interest Protocol
The snappily titled “ISDA 2014 Collateral Agreement Negative Interest Protocol” was published by ISDA last month. Whilst it currently has limited take up, it is designed to be used to modify ISDA’s suite of collateral agreements, including the Credit Support Annex1.
The Protocol amends the “Interest Amount” section of each collateral agreement entered into between two adhering parties to incorporate the concept of a negative Interest Amount. If the Interest Amount is a negative amount – defined in the Protocol as the “AV Negative Interest Amount”, then the person who would ordinarily receive a positive Interest Amount is required to transfer to the other the absolute value of that sum.
The requirement to post this amount may be discharged by a reduction in the balance of the amount of collateral previously posted or transferred by the payer, provided that enough of the balance is held in cash in the same currency as the Interest Amount due. Default interest accrues on any negative Interest Amount which is unpaid.
In relation to the Credit Support Annex, any unpaid negative Interest Amounts form an additional Unpaid Amount if the associated ISDA is closed-out.
The Protocol is not able to be applied to all collateral agreements entered into between two adhering parties – for instance it will not apply to collateral agreements which have bilaterally been amended to provide for negative interest rates or provide an alternative method of calculating the Interest Amount due in such circumstances. In addition it will not apply to “one-way” collateral agreements where it is the intention that only one party will or can be, in all circumstances, the person providing collateral or where a party’s “Threshold” is deemed to be infinity.
The Old Way - 2006 ISDA Definitions
The 2006 ISDA Definitions provide for a “Negative Interest Rate Method” which applies to all swap transactions incorporating these definitions, unless the parties specify otherwise.
The Negative Interest Rate Method provides that if a “Floating Amount” payable on a payment date is a negative number (either due to a negative interest rate or due to the addition of a negative spread to a positive interest rate), then the party who would ordinarily be due to pay that Floating Amount is deemed to owe zero and the other party is instead required to pay the absolute value of that Floating Amount to the other. If “Compounding” or “Flat Compounding” applies then all positive or negative period amounts are added together and the resulting amount is payable between the parties – if positive, it is payable by the party who would ordinarily be due to make such payment, and if negative, the absolute value is required to be paid by the other party.
Another option for the parties is to specify “Zero Interest Rate Method” instead. This provides that if a Floating Amount is negative, then the party who would ordinarily be due to pay the Floating Amount will be deemed to owe zero on that date, but the other person will not be required to pay the absolute value of that Floating Amount to the other.
Whilst for some market participants these provisions will be a useful tool in the management of their transactions, for others they may be less welcome and may even be something that they are unaware of, given that the Negative Interest Rate Method applies automatically and consequently there is no flag in any confirmation that this provision applies to a trade.
If negative interest rates become more common, it is reasonable to expect adherence to the Protocol or the negotiation of bespoke provisions in collateral agreements to grow. In addition, closer analysis of the operation of the 2006 Definitions may occur, particularly in relation to the application of the Negative Interest Rate Method.