Documentation Risk
The Difference Between Cleared & Uncleared Documentation
As the old bilateral derivative contracts are transferred to a clearinghouse, becoming Cleared Derivatives and some swaps will remain Uncleared Derivatives. Until 2016, the forgoing detailed the documentation swap dealers and their clients had with each other. The documentation provides the framework from which all other decisions regarding counterparty credit risk are made.
Cleared Derivatives Documentation
Cleared Derivatives, swap contracts which will be submitted to the clearinghouse will require different documentation. A Central Counterparty (CCP) will stand as counterparty to both buyer and seller (payer or receiver). Like all clearinghouses, CCP’s will have Clearing Members. These Clearing Members will face the clients. Clients would be asset management firms, pension funds, insurance companies, corporations, etc. CCP structure is similar to a futures clearinghouse, please read more about Clearinghouse’s here.
The clients will need to change their documentation to include this clearinghouse process. From the Asset Manager’s viewpoint, they will need an agreement with their clearing banks as well as an onboarding agreement, giving the clearing bank permission to onboard their positions to the clearinghouse.
Uncleared Derivatives Documentation
Uncleared derivatives will end the decade a much smaller portion of a bank’s risk than in 2010. Since 2016, Banks and Counterparties will exchange Initial Margin. While Variation Margin, daily mark-to-market, has been required for all derivatives, Initial Margin is new.
Initial Margin is the good faith deposit posted with a third-party custodian in a segregated account. Initial Margin Requirements will be phased in over 5 years from September 1, 2016 – September 1, 2021, with Phasing from 1-6 depending on the Average Aggregate Notional Amount for an observation period. On the deadline date, September 1, the Initial margin will be exchanged for all open positions. The additional documentation will include the custodial relationship as well as the Collateral Eligibility Agreement which will include Collateral Transformation rights.
I’ve left the ISDA Master Agreement information in this text, as there will be some positions which will continue to be covered by the Agreement.
The ISDA Master Agreement
The ISDA Master Agreement is an overarching contract covering all derivatives contracts with a customer. Even from the first iteration in 1992, most of the terms were standardized. Today in a post-Dodd-Frank era The ISDA Master Agreement for Uncleared Derivatives is even more standardized than before.
Specified Entities
On that basis, a Specified Entity is an affiliate of a counterparty which is covered by the Master Agreement for Cross Default in the event of bankruptcy or default of a subsidiary. The fifth Termination Event is called Credit Event Upon Merger (Section 5(b)(v) in 2002 ISDA Master Agreement). The aim is to draw in those members of your counterparty’s group (such as its parent or asset-rich fellow subsidiaries) whose relationship is so close to your counterparty that if an Event of Default happened to them it would be very likely to affect your counterparty seriously too. A specified entity is one that is crucially important to the Parent Company or financially substantial companies to a Holding Company:
- Sometimes these Specified Entities are specifically named and sometimes a general term “Affiliates” is used.
- “Affiliates” essentially means any other company in your counterparty’s group. Specified Entities can be proposed to apply to all the above sub-sections or just to Section 5(a)(v) (Default under Specified Transaction).
In all cases which Specified Entities apply to each party is a credit decision. Specified Entities is a way of collapsing down all transaction at once. This can provide an advantage to the customer who may have profitable swaps on one entity and losing swaps in another. Cross default may mean the counterparty doesn’t have to pay a loss it cannot afford. Big companies are often able to negotiate that Specified Entities will not apply.
- Smaller ones may be able to limit Specified Entities to Material Affiliates only. This would have to be defined but could cover those which account for, say, 15–20% of group pre-tax profits or assets.
- Credit Support Providers are automatically included in these four Section 5 events and do not need to be named separately as Specified Entities for them.
While Specified Entities are not always needed, a counterparty which is a corporate holding company whose main financial substance of the corporate’s holding company is in those subsidiaries, the bank’s credit officer may want them as Specified Entities.
The Addendum A
Addendum A includes very specific terms and conditions.
The Standard Collateral Support Annex (SCSA)
Another document which has become more standardized is the SCSA, which spells out the threshold level when collateral will be required. Today this includes:
- Derivatives Risk: because it’s a leveraged product, the risk is always much greater than the notional amount of the contract. As time passes the derivatives line needed changes.
- The amount of derivatives line required depends on the contracts years to maturity
- he notional amount of the contract
- The time difference between the pay leg and receive leg of the contract
- i.e., A bank paying every quarter and receiving every six months has more counterparty credit risk than a contract where the bank is receiving quarterly and paying semi-annually.
The Standard Initial Margin Method (SIMM)
The SIMM codified uncleared derivative contracts and made them all more standard so as to place all counterparties on the same level.