This is the second in a series of three articles discussing the impact of negative interest rates and interest rate switches on standard ISDA CSA documentation. You can find our first article in this series here.
In this article we consider how firms are taking action in respect of their CSAs following recent legal and market developments.
Banks withdrawing from ISDA Negative Interest Protocol
The end of 2020 saw a number of major banks withdraw their adherence to ISDA's Negative Interest Protocol. The banks' withdrawal was a surprise given the Protocol has been the primary vehicle for parties to amend the terms of their ISDA-published collateral agreements to account for the payment of negative interest amounts on cash collateral.
Adherence to the Protocol has never been universal, however, and now it is more obvious than ever that blanket adherence or switching may not be the best solution.
Protocol or non-Protocol solution?
The issue with Protocol adherence is this. When an institution adheres, it gives every one of its counterparties the right (a "free option") to remove the zero interest rate floor in a 1995 CSA for free – i.e. without paying compensation! The counterparty simply adheres to benefit from that free option.
No two portfolios are the same in terms of the impact of removing the zero interest rate floor. Before adhering, any reasonably sophisticated counterparty today would assess the impact of its adherence with all its counterparties who have currently adhered and who have not yet adhered but could do so in the future. Back in 2014, when the Protocol was published, few institutions were focussed on the value of their CSAs in the same way as they are today.
It is not a simple calculation, it involves consideration not only of the current portfolio of trades but also possible future trades, as well as the possibility of more currencies turning to negative interest rates in the future.
The same valuation approach should be applied when bilaterally agreeing to remove the floor from a CSA.
Regaining control
Withdrawal from the Protocol has given those banks control of when negative interest will apply with their counterparties who have not yet adhered to it. By adhering to the Protocol, parties automatically agree to pay negative interest with all other parties they trade with that have also adhered.
Withdrawal from the Protocol does not undo that agreement with their counterparties who had adhered prior to the effective date of withdrawal, but it does take back the free option they had granted to the rest of the world.
Negative rates in GBP or USD
Up to now the Protocol has only affected JPY, CHF, DKK, SEK and EUR. Of these, EUR is by far the most commonly used as eligible credit support under a CSA. With single currency CSAs now being almost universal, those portfolios are easily identified, assessed and rectified.
But there remains a looming prospect of negative interest rates in GBP and the same is not impossible either for USD. The population of GBP CSAs can be expected to be significantly smaller than either EUR CSAs or USD CSAs, and one might expect that parties to those CSAs would be more likely to have adhered to the Protocol in order to fix their (proximate) EUR CSAs (assuming they have some of each). We would therefore expect the bucket of unresolved GBP 1995 CSAs to be relatively small for most international banks.
Nevertheless there could be some significant UK insurers and other similar institutions on 1995 CSAs (as opposed to the newer VM CSAs) which carry large GBP exposures and where this could well be an issue. The advice is therefore to fix the issue now before negative interest in GBP kicks in and there is then current value which has to be unwound.
The prospect of USD interest rates turning negative brings into scope a far bigger universe than even EUR CSAs and adherence to the Protocol by US counterparties is noticeably thinner than in Europe (presumably as there has not been a current issue which needed to be fixed). Additionally, many USD CSAs are based on the 1994 New York law version upon which there is no equivalent determination to the Netherlands case as to its interpretation. The Negative Interest Protocol also fixes any issue with 1994 CSAs.
And for both these buckets, the Protocol is not a complete solution due to the withdrawal by a number of significant banking groups of their adherence. Indeed the withdrawal by those banks may have been in part motivated by the prospect of there being negative rates in other currencies like USD and not wanting to repeat the experience with further buckets of CSAs.
Unfortunately adhering parties who form the same view as those banks who have already withdrawn their adherence will now have to wait until 31 December 2021 for their withdrawal to take effect (as the Protocol only allows withdrawals to take effect on 31 December each year) so they will carry the free option risk for the remainder of 2021 at least.
New York law 1994 CSAs
With 1994 CSAs, whether a US court would take the same view as the English courts on facts similar to those in the Netherlands case is a question that would interest many.
However, applying the same analysis and reasoning that the English courts applied in the Netherlands case to the 1994 CSA would seem to get to the same result in terms of the contractual wording. So it is perhaps more a question of whether a New York court may be more inclined to read into the contract other terms or an interpretation based upon market practice than the English courts are willing to do.
The third and final part in this series of articles considers how the switch of interest payable under a CSA to an Alternative Reference Rate can give rise to some similar issues and the potential impact of that switch on the application of the Protocol to those CSAs.
In this article we consider how firms are taking action in respect of their CSAs following recent legal and market developments.
Banks withdrawing from ISDA Negative Interest Protocol
The end of 2020 saw a number of major banks withdraw their adherence to ISDA's Negative Interest Protocol. The banks' withdrawal was a surprise given the Protocol has been the primary vehicle for parties to amend the terms of their ISDA-published collateral agreements to account for the payment of negative interest amounts on cash collateral.
Adherence to the Protocol has never been universal, however, and now it is more obvious than ever that blanket adherence or switching may not be the best solution.
Protocol or non-Protocol solution?
The issue with Protocol adherence is this. When an institution adheres, it gives every one of its counterparties the right (a "free option") to remove the zero interest rate floor in a 1995 CSA for free – i.e. without paying compensation! The counterparty simply adheres to benefit from that free option.
No two portfolios are the same in terms of the impact of removing the zero interest rate floor. Before adhering, any reasonably sophisticated counterparty today would assess the impact of its adherence with all its counterparties who have currently adhered and who have not yet adhered but could do so in the future. Back in 2014, when the Protocol was published, few institutions were focussed on the value of their CSAs in the same way as they are today.
It is not a simple calculation, it involves consideration not only of the current portfolio of trades but also possible future trades, as well as the possibility of more currencies turning to negative interest rates in the future.
The same valuation approach should be applied when bilaterally agreeing to remove the floor from a CSA.
Regaining control
Withdrawal from the Protocol has given those banks control of when negative interest will apply with their counterparties who have not yet adhered to it. By adhering to the Protocol, parties automatically agree to pay negative interest with all other parties they trade with that have also adhered.
Withdrawal from the Protocol does not undo that agreement with their counterparties who had adhered prior to the effective date of withdrawal, but it does take back the free option they had granted to the rest of the world.
Negative rates in GBP or USD
Up to now the Protocol has only affected JPY, CHF, DKK, SEK and EUR. Of these, EUR is by far the most commonly used as eligible credit support under a CSA. With single currency CSAs now being almost universal, those portfolios are easily identified, assessed and rectified.
But there remains a looming prospect of negative interest rates in GBP and the same is not impossible either for USD. The population of GBP CSAs can be expected to be significantly smaller than either EUR CSAs or USD CSAs, and one might expect that parties to those CSAs would be more likely to have adhered to the Protocol in order to fix their (proximate) EUR CSAs (assuming they have some of each). We would therefore expect the bucket of unresolved GBP 1995 CSAs to be relatively small for most international banks.
Nevertheless there could be some significant UK insurers and other similar institutions on 1995 CSAs (as opposed to the newer VM CSAs) which carry large GBP exposures and where this could well be an issue. The advice is therefore to fix the issue now before negative interest in GBP kicks in and there is then current value which has to be unwound.
The prospect of USD interest rates turning negative brings into scope a far bigger universe than even EUR CSAs and adherence to the Protocol by US counterparties is noticeably thinner than in Europe (presumably as there has not been a current issue which needed to be fixed). Additionally, many USD CSAs are based on the 1994 New York law version upon which there is no equivalent determination to the Netherlands case as to its interpretation. The Negative Interest Protocol also fixes any issue with 1994 CSAs.
And for both these buckets, the Protocol is not a complete solution due to the withdrawal by a number of significant banking groups of their adherence. Indeed the withdrawal by those banks may have been in part motivated by the prospect of there being negative rates in other currencies like USD and not wanting to repeat the experience with further buckets of CSAs.
Unfortunately adhering parties who form the same view as those banks who have already withdrawn their adherence will now have to wait until 31 December 2021 for their withdrawal to take effect (as the Protocol only allows withdrawals to take effect on 31 December each year) so they will carry the free option risk for the remainder of 2021 at least.
New York law 1994 CSAs
With 1994 CSAs, whether a US court would take the same view as the English courts on facts similar to those in the Netherlands case is a question that would interest many.
However, applying the same analysis and reasoning that the English courts applied in the Netherlands case to the 1994 CSA would seem to get to the same result in terms of the contractual wording. So it is perhaps more a question of whether a New York court may be more inclined to read into the contract other terms or an interpretation based upon market practice than the English courts are willing to do.
The third and final part in this series of articles considers how the switch of interest payable under a CSA to an Alternative Reference Rate can give rise to some similar issues and the potential impact of that switch on the application of the Protocol to those CSAs.
