On October 22, 2009, the International Swaps and Derivatives Association, Inc. (“ISDA”), the Securities Industry and Financial Markets Association (“SIFMA”) and the Managed Funds Association (“MFA”) announced the publication of the “Independent Amount Whitepaper” (the “Whitepaper”).  The Whitepaper is one of the deliverables described in the derivatives industry letter to the Federal Reserve Bank of New York and certain other regulators dated June 2, 2009.  The purpose of the Whitepaper, which was produced by the ISDA Collateral Committee, is to describe the use and risks of over-collateralization and under-collateralization associated with initial margin posted by derivatives market participants, commonly referred to in ISDA-based documentation as the “Independent Amount.”

The Whitepaper begins by describing the key mechanics of the ISDA Credit Support Annex (the “CSA”), the dominant collateralization document in the derivatives marketplace.  It goes on to explain that variation margin, reflected as the net mid-market mark-to-market value (known as “Exposure” of the secured party), is typically posted (often subject to a “Threshold” of uncollateralized exposure) by the pledgor.  The Whitepaper points out that the historical purpose of Independent Amount has been for an end user to provide a dealer with additional margin, a one-way “cushion to guard against the residual credit risk that may exist even under a collateralized trading agreement.”  Although the dealer may benefit from this additional cushion, the Whitepaper points out that the end user may assume the risk of loss in the event of a dealer insolvency, as its claim to return of collateral typically constitutes a general unsecured claim, ranking behind the claims of other creditors.

The Lehman bankruptcy has brought this risk to the forefront, as end users effectively over-collateralized Lehman by posting Independent Amounts which Lehman did not segregate but, rather, freely used (in accordance with its contractual right to rehypothecation).  The claims of these end users for the return of cash and securities from Lehman became general unsecured claims when Lehman became insolvent.  As the Whitepaper notes, although the Lehman insolvency proceedings remain ongoing, such claims against the Lehman estate are currently trading at under 20 cents on the dollar.  The Lehman case has brought increased awareness to the end user community about the risks inherent in posting Independent Amounts, along with a desire to ensure that such collateral is held in a more “portable” (i.e., bankruptcy-remote and immediately recoverable) manner.

The Whitepaper describes and considers the risks associated with three types of Independent Amount collateral delivery: (i) securities collateral pledged under a security interest form of agreement (e.g., ISDA’s New York law version of the CSA), (ii) cash collateral pledged under a security interest form of agreement and (iii) cash and securities delivered under a title transfer form of agreement (e.g., ISDA’s English law title transfer version of the CSA).  As the Whitepaper notes, collateral delivered under a title transfer regime may only be held directly by the secured party.  In contrast, collateral delivered under a security interest regime may be held by a party directly or through an unaffiliated custodian under an agreement with either one of the parties or under a triparty agreement.

ISDA, SIFMA and MFA expect to publish a second part to the Whitepaper later this year which will deal with alternative potential future market practices to address the risks inherent in delivering and holding Independent Amount collateral.