On November 3, 2011, the International Swaps and Derivatives Association, Inc. ("ISDA") released key provisions to the Standard Credit Support Annex ("SCSA") proposal. This is part of ISDA's initiative in improving standardization of over-the-counter ("OTC") derivative transactions, which in turn supports the overall goal of increasing efficiency in the derivative markets.
REASONS FOR THE SCSA PROPOSAL
Currently, the Credit Support Annex ("CSA") allows for a great deal of flexibility in parties' arrangements regarding collateralization of their trades. Parties can decide on, among other things, the type of assets that may be posted as collateral, haircuts, the relevant currencies, valuation time and date and the interest rate applicable. This flexibility means parties can customize the collateral arrangement according to their needs and wishes; however, it also means dealing with the complexity of multiple currencies and mismatches in settlement time and approaches in valuation, booking and modeling of CSA terms. The lack of congruency makes it difficult to price a trade and leads to collateral challenges and disputes. The issues associated with valuation, booking and pricing are exacerbated by the fact that the CSA applies throughout the term of the parties' derivative transaction, which, in many cases, is made up of multiple trades occurring over a lengthy period of time.
Concurrent with the industry's struggle with collateral issues in bilateral trades, regulators in a number of jurisdictions, including Canada, are pushing towards the standardization of OTC derivative transactions and the clearing of trades through central clearing counterparties ("CCPs"). Please see our earlier client alert, entitled Over-the-Counter (OTC) derivatives Market in Canada: on the Road to Reform and Regulation, regarding the approach of Canadian regulators to standardization and central clearing.
THE SCSA PROPOSAL
As a response to regulatory initiatives regarding OTC derivatives and the challenges faced by the industry, ISDA set up a working group to create a SCSA. According to ISDA, there are three primary objectives in the SCSA proposal:
1. Standardizing market practice by removing embedded optionality in the existing CSA;
2. Promoting the adoption of overnight index swap ("OIS") discounting for derivatives; and
3. Aligning the mechanics and economics of collateralization between the bilateral and cleared OTC derivative markets.
To achieve these objectives, a key provision proposed for the SCSA is that only cash would be used as eligible collateral for variation margin (although securities would still be permitted for "Independent Amounts"). Furthermore, for multi-currency arrangements, collateral calculation would be amended so that derivative exposures and offsetting collateral would be grouped into like currencies ("silos"). The current SCSA proposal appears to contemplate the US dollar, Euro, Pound Sterling, Swiss Franc and Japanese Yen as the currencies covered by the SCSA. Likely additional currencies, including Canadian dollars, would be added to the proposed silos over time. Each currency silo would be evaluated independently to generate a required movement of collateral in the relevant currency. If a movement of collateral is required, the collateral would be delivered in each currency or converted to a single currency with an interest adjustment overlay.
IMPLEMENTATION OF THE SCSA PROPOSAL
ISDA stressed that the SCSA is a market-driven initiative; accordingly, there will not be any requirement or restriction to use the SCSA when it is finalized and adopted. ISDA indicated that it will ask counsel in all jurisdictions to confirm that the SCSA would be covered in their opinion. In addition, the SCSA documentation will be finalized upon resolution of outstanding points and updated as new features are developed. As one of the objectives of the SCSA proposal is to align the mechanics and economics of collateralization between the bilateral and cleared OTC derivative markets, it is likely that many of the standardized terms in the final SCSA regarding margin and collateral will be consistent with those of existing CCPs.
There are significant logistical issues to be worked out before the implementation of the SCSA is possible, including the adoption of certain market infrastructure for the industry and making changes to internal technology and processes for participating firms. In its proposal, ISDA indicated that it will design and own an operating model whereby common market infrastructure elements, such as rate set, specification for certain calculations and electronic communication methods for margin calls and other data transmission between parties, will be adopted. Furthermore, a method by which parties will eliminate settlement risk ("Herstatt risk") needs to be developed. ISDA indicated that while the simplest mode of implementation relies upon a payment-versus-payment ("PVP") mechanism to eliminate settlement risk, such a mechanism does not yet exist, and to construct one will take considerable time. The Implied Swap Adjustment ("ISA") method may be used to eliminate settlement risk; however, adopting this method requires significant standardization of data and computation to be used across the market.
To work with these constraints, ISDA proposes to divide the implementation into two phases. During Phase 1, volunteer firms will be permitted to use the SCSA and may bilaterally accept settlement risk if they choose; however, parties to the SCSA will be required to use the ISA method upon demand of the other party. This means all firms participating in Phase 1 must be fully mobilized to use the ISA. In addition, ISDA will provide central infrastructure to support the ISA method. With respect to Phase 1, ISDA anticipates that development will occur in Q4 of 2011 and Q1 of 2012, with market testing in the Q2 of 2012. Phase 2 will be the wider market adoption of the SCSA, when a PVP mechanism is operative. During this phase, both PVP and ISA methods will be available to accommodate the needs of different market participants.
IMPLICATIONS OF THE SCSA PROPOSAL
While standardization of collateral arrangements will simplify market processes and reduce disagreement between parties for certain derivative trades, a CSA that allows only cash as eligible collateral may present legal issues for certain end users of derivatives and may be an unattractive option for market participants in certain jurisdictions, such as Canada, where, due to the current state of the law in the jurisdiction, it is disadvantageous to post (or accept) cash as collateral. Meanwhile, for arrangements where cash is used as collateral, certain currencies may not be sufficiently liquid for the adoption of OIS discounting to be appropriate. These factors would make the use of the SCSA problematic for certain segments of the market unless addressed appropriately.
One of the reasons why an OTC derivative market has developed is because parties want the flexibility to customize their trades and their business arrangements with counterparties. However, the same flexibility also creates divergent processes and practices for market participants and "opaqueness" perceived by regulators. Many issues that the SCSA proposal raises are similar to those raised by the regulators' efforts to standardize OTC derivative transactions. One of the key challenges for the industry and for regulators will be to determine how to structure the market to allow for flexibility and customization on the one hand, and standardization on the other. The SCSA proposal, if structured appropriately to address Canadian law, is in our view a positive step in the right direction toward the standardization sought by our regulators.
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