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A recurring issue which has bedevilled parties has been the extent to which collateral should be taken into account when determining any replacement cost for a transaction being terminated early. The issues include whether collateral should be priced into the replacement at all and, if it is, what collateral terms apply. Is it the terms of an actual CSA (between the parties or with quoting banks) or a theoretical standard CSA? More recently there has been additional complexity to this as discount rates on cleared products in USD and EUR have diverged from the discount rates on their OTC counterparts, which are based upon the interest rates in the CSA.
The Cash Price dealer poll methodology often requires an artificial quotation (either due to assumed collateral terms and "mid" market pricing), which no dealer wants to provide. Many buy-side entities have been uneasy with the discretion afforded to the Calculation Agent where reference banks have been reluctant to provide quotations.
The issues have been so serious that some parties to affected transactions have been too unsure of the outcome to exercise options under them. But, for those transactions with mandatory early termination provisions, there is no choice. Many of these transactions have large notionals and/or long maturities, and so the difference in approach is often significant in economic terms.
The new ISDA 2021 Definitions (which are now nearing publication and will take effect in June 2021), contain a further attempt to resolve these issues. The 2021 Definitions will contain a new set of provisions to determine the cash settlement amount on an optional or mandatory early termination. It seems that market participants are now close to agreeing on a consensus position on the various alternative methodologies and the fallback position under the Cash Settlement Matrix, which might be expected to form the trading standard.
The 2021 Definitions will introduce two new methods for valuing interest rate transactions that are subject to early termination (though each method has more than one variant):
- Mid-Market Valuation (a theoretical valuation of the transaction's cash-flows, being the mid-point between the bid and offer values); and
- Replacement Value (based on firm quotations for the cost of replacement transactions for the party or parties designated as the "Protected Party").
At present, it seems that "Mid-Market Valuation (Indicative Quotations)" will be the default election for both optional and mandatory early termination where the parties are unable to agree the cash settlement amount. This would be based on quotations received from up to 5 Reference Banks, but falling back to Calculation Agent determination if too few quotations are received.
In addition, for both methods there are elections as to how the valuations should be made or quotations should be sought and whether the effect of any CSA should be taken into account and, if so, which CSA.
For Mid-Market Valuation, parties can select "No CSA", "Existing CSA" (being the one between the parties) or "Reference VM CSA" (with some standard elections). The discount rate to calculate the present value should be that in the Existing CSA (if there is one) or otherwise in the Reference VM CSA, but with a basis adjustment if the cash-flow is in a different currency from the cash settlement currency. Importantly, no adjustment is to be made for other factors, including non-performance risk, regulatory capital costs or funding costs.
For Replacement Value, either the CSA in place between the Protected Party (being the non-exercising party on an optional early termination and both parties on a mandatory early termination) and the Reference Bank or, if there is none, a Reference VM CSA should apply. There is also an election to allow for adjustments to be made to reflect the CSA in place between the parties to the transaction.
An issue that can arise in relation to Cash Price is whether any assumed CSA should be taken to have a zero floor for interest on cash collateral if that is what the actual CSA provides. Again the effect of this issue on valuations can be very significant. The 2021 Definitions will provide that, under the Reference VM CSA, negative interest will be applicable, although if Existing CSA is applicable, a zero floor will be assumed if that is what the Existing CSA provides.
Both methods will involve seeking quotations from Reference Banks, only falling back to Calculation Agent determination if too few quotations are received. What constitutes "too few" will be set at "fewer than 2 quotations", down from the "fewer than 3 quotations" originally proposed. It also looks likely that the non-Calculation Agent party will have the right to select further Reference Banks and seek quotations from them (thereby reducing the risk of Calculation Agent determination).
Assuming that the 2021 Definitions reflect the provisions and default elections currently proposed, these would go a long way to ensuring that transactions incorporating those Definitions would not become subject to many of the differences that have arisen around valuations on optional or mandatory early termination. Even when the default elections are agreed for the 2021 Definitions, it remains to be seen whether parties are willing to go along with these or will look to include other elections that they see as more favourable for them. Of course for cleared transactions, like most swaptions, they will not have a choice.
Unfortunately the new provisions will not fix the issues with legacy trades. For those transactions, at least those governed by English law, the existence of a new market standard will not affect the interpretation of transactions entered into before the 2021 Definitions take effect. The 2021 Definitions could, though, provide assistance to parties struggling to resolve disputes or breaks under existing transactions. Parties to legacy transaction could, for example, use the new provisions and elections as tools to adopt with legacy transactions through bilateral amendment.
If you wish to discuss the 2021 Definitions or any issues relating to optional early termination or mandatory early termination under the 2000 or 2006 Definitions, please get in touch with your usual contact here or any of those below.
Edward Miller, Partner | London
Guy Usher, Partner | London
John Delamere, Partner | London
Steven Burrows, Senior Associate | London