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Current issues with ISDA Credit Support Annexes - Part 3

This is the third in a series of three articles discussing the impact of negative interest rates and interest rate switches on standard ISDA CSA documentation. The first two articles in this series may be found using the following links - Part 1 and Part 2. In this article, we consider the impact of changing interest rates in CSAs to Alternative Reference Rates and the impact that can have on negative interest rates in CSAs.

Transition to CCP Alternative Reference Rates

As discussed in our earlier article, the main clearing houses for OTC derivatives have changed the discount rates they use for valuing cleared OTC derivatives and calculating price alignment interest from EONIA to ESTR (flat) and from Fed-Funds to SOFR. LCH, for example, provided for cash compensation to be paid by members that benefited from the switch to those members that lost out and for compensatory basis swaps to be issued.

Uncleared OTC derivatives are typically valued using a discount rate based upon the interest rate payable on cash collateral under the CSA between the parties.  By far the most prevalent of those rates are EONIA for EUR and Fed-Funds for USD, creating a mismatch between the valuations of cleared and uncleared products.

Most banks acknowledge the need to reduce this gap by aligning the interest rates in their CSAs to the CCP discount rates. In the case of EUR CSAs those which reference EONIA will have to be changed by 3 January 2022 anyway when EONIA is phased out.

The discontinuance of EONIA is not something that will be remedied by the 2020 ISDA IBOR Fallbacks Protocol.

A change from EONIA to ESTR flat (as opposed to ESTR plus 8.5bp) or from Fed-Funds to SOFR each carries with it some value shift which any reasonably sophisticated market participant would be cognisant of – meaning, not only a change to documentation but also a valuation and potential compensation payment.  

To that extent, the switch is not dissimilar in terms of the valuation required to that to be considered when removing the zero interest rate floor in a CSA, albeit with less at play economically.  The fact that parties may expect compensation to be paid for an interest rate switch in a CSA merely highlights how inappropriate it is to use a Protocol solution to the bigger economic issue of the removal of zero interest rate floors in CSAs.

We understand that attempts to agree these compensation payments for interest rate switches are proving more difficult than first envisaged, particularly where dynamic portfolios are involved, as parties are not just looking at the current financial impact, but also the prospective impact over time when new trades are put on and others mature.

Transition from EONIA to ESTR plus 8.5bps – beware the Negative Interest Protocol

If parties are unable to agree compensation payments for an interest rate switch on EUR CSAs, then those CSAs may instead be amended to ESTR plus the 8.5bps spread. Although this does not alleviate the basis between cleared and uncleared OTC discount rates, it removes the commercial discussion on compensation as there is then no value shift.  However, parties adopting this approach need to take care if the Negative Interest Protocol may later be applicable to such a CSA.

Under the terms of the Negative Interest Protocol, CSAs are not be covered and amended by the Protocol to apply negative interest rates if they include a "Protocol Excluded Modifying Provision" (a "PEMP").

Any provision which provides that the interest rate or amounts of interest amounts to be transferred will be increased or decreased by a specified number or mechanism – in other words, which provides for a spread on the interest rate – is considered a PEMP.  As a result, CSAs including any spread in the interest rate calculation will excluded from the Protocol.  Therefore if parties change the CSA interest rate from EONIA to ESTR plus a spread they would cause a CSA, which would otherwise have been covered by the Protocol (if the adherence by both parties happened subsequently), to be taken out of scope of the Protocol and so the zero interest rate floor could not be taken out by means of subsequent adherence to the Protocol.

Of course the parties could agree bilaterally to treat the CSA as being covered by the Protocol despite the prior introduction of the spread but pity the parties who are not aware of this and neglect to do so.

We hope you enjoyed this series of articles. Please do get in touch with us if you would like to discuss any of the issues raised in any more detail.

Our colleagues at Donaldson Legal Consulting would be pleased to discuss any repapering requirements you may have on your CSAs and here is a link to a short article they have released on repapering CSAs.

Similarly, our colleagues at Fieldfisher Capital would be pleased to discuss any valuation issues you may have on your CSAs and here is a link to a short article they have released regarding that topic.

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