On March 1st, the International Swaps and Derivatives Association, Inc. (“ISDA”), the Managed Funds Association and the Securities Industry and Financial Markets Association jointly published a Whitepaper (the “Whitepaper”) on Independent Amount. On the same date, ISDA also published a market review of over-the-counter (“OTC”) bilateral collateralization practices (the “Market Review”). The Whitepaper and Market Review were developed for the purpose of better understanding current derivative market practices surrounding collateralization, a key method of mitigating counterparty risk in exchange-traded and, especially, OTC derivatives. The documents make specific recommendations (including for legislative and regulatory changes in certain jurisdictions) for market participants to improve or enhance their collateral management practices.
The Whitepaper examines the risks associated with both under-collateralization and over-collateralization of OTC derivatives exposures by posting “Independent Amounts” (or pre-agreed amounts that are typically fixed or reflect a percentage of the aggregate notional amount of transactions outstanding) under the ISDA Credit Support Annex, the predominant collateral document for OTC derivatives transactions. The Whitepaper separately addresses cash and securities under security interest and title transfer collateral documents, with a particular focus on the three ways in which securities are held as Independent Amounts via a security interest (i.e., directly by a secured party, through a bilateral custody arrangement between the secured party and custodian and through a tri-party arrangement among the pledgor, secured party and custodian). The Whitepaper then goes on to discuss the benefits and risks inherent in each method of holding collateral and describes several alternative holding arrangements for Independent Amounts that address those risks, to varying degrees.
In the Market Review, among other things, the publishing industry groups investigated the percentage of OTC derivatives trades, by asset type, that are subject to collateral arrangements and determined that 78% of all OTC derivatives trades were collateralized, including 97% of credit derivatives and 84% of fixed income derivatives. The Market Review further noted that many uncollateralized foreign exchange transactions were short-dated and that commodity and energy transactions were often subject to alternative forms of credit support, such as letters of credit. Nevertheless, the Market Review advanced numerous specific recommendations for the expansion and refinement of collateral practices by market participants, including the standardization of the format and delivery of margin calls, the standardization of provisions for tri-party holding arrangements and the use of thresholds for uncollateralized exposure that decline together with a counterparty’s credit rating.