International Treasurer

Derivative Activity

The Journal of Global Treasury and Financial Risk Management

Collateral Support for Derivatives

By David Yeres and Joseph Levine Rogers & Wells
Summary: Two-way collateral arrangements between dealers and corporate end-users are now becoming the norm. Unlike dealer banks, many corporates are not accustomed to the role of secured lender, which is akin to receiving collateral in a derivative transaction. In many cases, corporates would do well to have an agent bank manage the collateral.

In addition to market risks, more corporates are realizing the need to guard against credit risk when using interest rate-, currency swaps and other derivatives. Two-way collateral arrangements offering protection based on the dealers and the corporates credit standing are thus becoming the norm for larger corporations. Corporates considering collateral protection, however, should learn about the implications of becoming secured lenders before agreeing to actual deposits. More to mark-to-market. The collateral requirements must be kept current by regularly marking-to-market, the swap transactions and the collateral. Tracking both ensures that the collateral amount closely matches the potential obligation (less any unsecured credit line and adjusted for changes in credit quality). Market valuation becomes a chore when counterparties use more than one type of instrument. Banks typically use government securities as collateral (as they have ample supply from their trading desks), but deposits can also be made in cash, money market instruments, deposit accounts, certificates of deposit, publicly quoted securities, credit balances or letters of credit issued by a third-party in favor of the secured party. Documents to arrange. The documents for any collateral arrangement should always contain a security interest, as the extender of credit does not want to rely on a mere right of setoff. Collateral arrangements between counterparties are normally contained in a collateral annex to a master swap agreement. The International Swap and Derivatives Association is nearing completion of a standard form (the

ISDA Mark-to-Market Credit Support Annex) to meet the growing variety of security arrangements used for collateral. The Annex will also give corporates (and their dealers) a more flexible framework to define their own procedures (see side bar). Procedures to perfect. Legal assurance of first right to the collateral (also known as perfection of the security interest) is the most critical procedure to address. If the collateral is cash a credit balance in a bank or brokerage accountor if negotiable instruments are used, the secured party must take possession of the collateral. To take possession of a deposit account, the account must be transferred into the name of the secured party or its agent. (General principles of agency prevent the debtor from acting as agent against itself for the secured party.) If securities are to serve as collateral, they can either be: (1) pledged to the secured party by transfer to the account of the secured party at the Depository Trust Company ( if it is a participant there); (2)held in the secured partys own name; or (3) held in the name of its agent or by a financial intermediary on behalf of the secured party (with notice from the intermediary to the debtor and secured party that it holds on behalf of the secured party). If the securities involved are government securities, as is often the case, the governmental regulations applicable to the securities are governing law. Corporates should also be aware of important jurisdictional considerationsi.e. where the security deposit will be maintainedbecause the security interests and perfection mechanisms must comply with both the law chosen by the agreement and the law of the jurisdiction in which the collateral is held. Idle funds to manage. It is especially important for corporates to address the issue of the use and/or investment of collateral. A secured party will often wish to put to use any cash or other collateral deposited with it. As a result, a right to freely use and/or repledge collateral (free use and rehypothecation) is often sought by counterparties. Absent other obligations, how the secured party uses the collateral it receives is not a concern to its counterparty until the collateral value exceeds the value of the net swap obligation. This is quite possible since each is a changing value subject to volatility and even some miscalculation risk.

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International Treasurer
In most cases, the depositor in an excess collateral position becomes an unsecured creditor of the secured party. When large sums are at stake, some counterparties may demand that collateral be held by a highly-rated, third-party agent bank. The party depositing collateral will not want to let funds lie idle. Often, the secured party will be obligated to invest the funds. The depositing entity will insist that interest, dividends and other earnings not needed in the collateral base be returned . An obligation to invest excess funds on behalf of a counterparty holds no advantage to the holder of the collateral. It does, however, create some potential problems. For example, the investment policies of either counterparty may complicate collateral valuation, impose duties on the secured party and may result in losses. To protect itself, the secured party will not want discretion over how excess funds are invested. Again, if large sums of money are involved, the secured party, thinly-staffed corporate treasuries in particular, may wish to have an agent bank do the investing.
May 2, 1994

The Journal of Global Treasury and Financial Risk Management

Make a decision tree.

Because the issues are complicated, establishing collateral procedures can be initially daunting. The flexibility and choices allowed under the new ISDA Annex make the process even more complex. Advanced planning, however, can make the establishment of collateral procedures much more manageable and save both parties in a transaction a great deal of time. Fortunately, the ISDA Annex itself can be used to guide the creation of a collateralization policy. It lays out many of the issues corporates must clarify before entering into collateral arrangements. The most important items to think through in advance include: (1) the computation of the amount of each party's transaction obligations which is the base from which all mark-to-market calculations proceed; (2) the computation of any unsecured line which may be tied to a party's current credit rating; (3) the procedure to value the collateral deposited; (4) the procedure to determine how the amount of shortfall is determined; (5) the call procedure for requiring the deposit of additional collateral; (6) the limitations on the use of any collateral deposited with a party and any safekeeping and investment procedures to be utilized; (7) a procedure for selecting and replacing any third party bank holding collateral--bank credit worthiness, indemnification and the management of collateral will be of concern to both parties; and (8) a mechanism whereby the parties can dispute one anothers collateral-related actions, and rely on predetermined outside sources to come to quick determinations, should be built into an agreement. Constructing a decision-tree such as this will help corporates seem more credible when they approach dealers for collateral in two-way arrangements. It will also help them negotiate to improve the arrangements to minimize credit risk.

Mr. Yeres and Mr. Levine are Partners with Rogers & Wells in New York, (212) 878-8000. They practice in the derivatives and secured lending areas.

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