Tag: Collateral


Segregation of Initial Margin Posted in Connection with Uncleared Swaps

The following post comes to us from Leigh R. Fraser, partner and co-head of the hedge funds group at Ropes & Gray LLP, and is based on a Ropes & Gray publication by Ms. Fraser, Isabel K.R. Dische, and Molly Moore.

Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act and Commodity Futures Trading Commission (“CFTC”) Rules 23.702 and 23.703 thereunder (together, the “Rules”), swap dealers are required to notify their counterparties that they have the right to require segregation with a third-party custodian of any initial margin (also known as “independent amounts”) posted to the swap dealer in connection with uncleared swaps. As a result of these new rules, the International Swaps and Derivatives Association (“ISDA”) recently published a form of notification and a set of frequently asked questions regarding these rules. All buy-side entities that trade in uncleared swaps with swap dealers (including buy-side entities that already post their margin with a third-party custodian, such as registered investment companies, and buy-side entities that do not post initial margin) should receive a copy of the notification from their swap dealer counterparties in the coming weeks or months and should plan to respond promptly to the notification in order to avoid any trading disruptions.

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Basel Committee and IOSCO Release Framework for Uncleared Derivatives Margin

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former commissioner at the U.S. Securities and Exchange Commission. The following post is based on a Davis Polk client memorandum; the complete publication, including tables and appendices, is available here.

The Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) on September 2 released their final policy framework on margin requirements for uncleared derivatives (the “Framework”). The Framework, which follows two proposals on the topic from BCBS and IOSCO (the “Proposals”), is intended to establish minimum standards for uncleared derivatives margin rules in the jurisdictions of BCBS and IOSCO’s members, which includes the United States.

The Framework is designed to provide guidance to national regulators in implementing G-20 commitments for uncleared derivatives margin requirements. In the United States, the Dodd-Frank Act, reflecting the same G-20 commitments, requires the SEC, CFTC and banking regulators to adopt initial and variation margin requirements for swap dealers and major swap participants (“MSPs”) under their supervision. [1] The U.S. regulators have proposed rules to implement these requirements (the “U.S. Proposals”), but have not yet adopted final rules, in part due to the ongoing BCBS/IOSCO efforts. The Framework is similar in concept to the U.S. Proposals, but differs in a number of significant respects. Appendix A summarizes the Framework and the three U.S. Proposals, highlighting a number of the key differences.

With the Framework finalized, we expect that U.S. regulators will work to issue final rules implementing uncleared swap margin requirements in the coming months.

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The Supply and Demand for Safe Assets

Gary Gorton is a Professor of Finance at Yale School of Management.

In the recent NBER working paper, my co-author, Guillermo Ordoñez of the University of Pennsylvania, and I develop a model to examine the important role collateral plays in the economy. Where do safe assets come from? Empirical evidence suggests that the private sector creates more near riskless assets when the supply of government debt is low and reduces privately-created near riskless assets when the supply of government debt is high. Krishnamurthy and Vissing-Jorgensen (2012) show that the net supply of government debt is strongly negatively correlated with the net supply of private near-riskless debt.

The substitution between public and private safe debt is also shown by Krishnamurthy and Vissing-Jorgensen (2012) who document that changes in the supply of outstanding U.S. Treasuries have large effects on the yields of privately created assets. Gorton, Lewellen, and Metrick (2010) also find this relationship between government debt and privately produced substitutes. They document that the share of safe assets in the U.S. economy, including both U.S. Treasury debt and privately created near-riskless debt has remained constant as a percentage of all U.S. assets since 1952. Xie (2012) shows that the issuance of asset-backed securities tends to occur when the outstanding government debt is low and Sunderam (2012) documents the same phenomenon with respect to asset-backed commercial paper.

By “safe assets,” we mean government debt and privately created high quality debt, in particular, asset-backed securities. Such safe assets are used to collateralize repo, derivative positions, and are needed as collateral in clearing and settlement. See IMF (2012). Further, because they are ”information-insensitive” (in the nomenclature of Dang, Gorton, and Holmstrom (2012)), they are highly liquid and hence can store value without fear of capital losses in times of stress, a form of private money.

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Secured Creditor’s Right to Credit Bid in Cramdown Plans

The following post comes to us from Douglas P. Bartner, partner in the Bankruptcy & Reorganization Group at Shearman & Sterling LLP, and is based on a Shearman & Sterling client publication.

In a 8-0 decision resolving a split between the Third and Seventh Circuit Courts of Appeals, the United States Supreme Court recently affirmed a secured creditor’s right to credit bid in a sale of its collateral pursuant to a cramdown plan. In RadLAX Gateway Hotel, LLC v. Amalgamated Bank, [1] the Supreme Court upheld the Seventh Circuit’s ruling that section 1129(b)(2)(A)(iii) of the Bankruptcy Code, the so-called “indubitable equivalent prong” of the cramdown requirements for secured creditors, could not be used to justify confirming a plan which sold secured lenders’ collateral without allowing the lenders to credit bid.

The Court, in an opinion written by Justice Scalia, held that the canons of statutory construction did not permit the general “indubitable equivalent” option for cramdown of secured creditors to override the more specific option set forth in clause (ii) of section 1129(b)(2)(A). That cramdown option provides that a secured creditor can be crammed down if its collateral is sold, “subject to section 363(k),” and its security interest attaches to the proceeds of the sale. Section 363(k) allows a secured creditor to credit bid in a sale unless the court, for cause shown, rules otherwise. The Court would not permit confirmation of a plan that contemplated a sale of collateral free and clear of a security interest where the holder of that security interest could not credit bid.

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Lehman Bankruptcy Court Interprets Safe Harbor Protections

The following post comes to us from James L. Bromley, partner and a leader of the global restructuring and insolvency practice at Cleary Gottlieb Steen & Hamilton LLP, and is based on a Cleary Gottlieb alert memorandum.

On April 19, 2012, the United States Bankruptcy Court for the Southern District of New York granted in part a motion to dismiss claims asserted by Lehman Brothers Holdings Inc. (together with its debtor-affiliates, “Lehman”) against JPMorgan Chase Bank, N.A (“JPMorgan”). [1] The claims at issue arose from JPMorgan’s efforts in the months leading up to Lehman’s bankruptcy to mitigate its exposure as Lehman’s primary clearing bank by requiring Lehman to post a significant amount of additional collateral and expand the scope of the obligations secured by that collateral. Lehman and its creditors’ committee challenged these transactions under the avoidance provisions of the Bankruptcy Code and asserted other causes of action, including common law claims for unjust enrichment and invalidation of the contractual amendments that improved JPMorgan’s position.

The decision applies the safe harbor protections of Section 546(e) to dismiss Lehman’s preference and constructive fraud claims. However, the court rejected JPMorgan’s efforts to apply Section 546(e) more broadly, allowing Lehman’s parallel common law claims to proceed even where they are based on similar allegations. The decision also applies a relaxed pleading standard to Lehman’s claims for actual fraud, under which it found that Lehman had adequately alleged facts to state a claim under Section 548(a)(1)(A). The decision thus provides support for a literal application of the safe harbor protections to dismiss certain claims at the pleading stage. However, the decision also suggests that even where a transaction falls within the scope of Section 546(e), artful pleading may permit plaintiffs to survive a motion to dismiss. The decision thus underscores the importance of considering potential litigation risks and costs when analyzing transactions with distressed counterparties.

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CFTC Rule on Protection of Swap Collateral

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former Commissioner at the U.S. Securities and Exchange Commission. This post is based on a Davis Polk client memorandum.

In adopting final rules on the treatment of cleared swap customer collateral, the CFTC has taken a major step in defining the architecture of market-wide swap clearing, a key pillar of the Dodd-Frank Act’s derivatives reform. After receiving intense arguments for divergent types of collateral protection, the CFTC adopted the “legal segregation, operational commingling” (“LSOC”) model.

The LSOC model is designed to eliminate the “fellow customer risk” to which futures customers are exposed. Under the LSOC model, if a customer of a futures commission merchant (“FCM”) defaults on a cleared swap margin obligation and the FCM is not able to satisfy the defaulting customer’s obligations, the derivatives clearing organization (“DCO”) has no recourse to funds of the FCM’s non-defaulting customers. Therefore, LSOC is intended to provide additional protection, albeit at an additional cost, to cleared swap customers beyond the current futures DCO model. In contrast, under the futures DCO model, any FCM customers’ swap collateral is available to the DCO upon a default of both the FCM and one of its futures customers. The CFTC has not extended the LSOC model to futures at this time, but will consider doing so.

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The Economics of Credit Default Swaps

The following post comes to us from Robert Jarrow, Professor of Finance at Cornell University.

Credit default swaps (CDS) are term insurance contracts written on the notional value of an outstanding bond. In the paper, The Economics of Credit Default Swaps, forthcoming in the Annual Review of Financial Economics, I study the economics of CDS using the economics of insurance literature as a basis for analysis. The first CDS were traded by JP Morgan in 1995. Since that time, CDS trading has grown dramatically. CDS contracts trade in the over-the-counter derivatives markets which is only loosely regulated. The CDS market exhibited exponential growth between 2001 and 2007. At its 2007 peak, total outstanding notional for CDS was over 62 trillion dollars. After the crisis, however, these numbers have halved to just over 30 trillion dollars in 2009. Most of this change in outstanding notional has occurred through “portfolio compression” as demanded by the regulators where long and short credit derivative positions on the same underlying credit entity held by the same institution are netted. The reduction is not due to decreased trading activity in CDS. This assertion is supported by the relatively stable outstanding notional of equity and interest rate and currency derivatives over this same time span.

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Tests of Ex Ante versus Ex Post Theories of Collateral

The following post comes to us from Allen Berger, Professor of Finance at the University of South Carolina; W. Scott Frame of the Federal Reserve Bank of Atlanta; and Vasso Ioannidou, Professor of Financial Intermediation at Tilburg University.

In our paper, Tests of Ex Ante versus Ex Post Theories of Collateral Using Private and Public Information, forthcoming in the Journal of Financial Economics, we test the empirical predictions generated by two broad classes of theories about why borrowers pledge collateral. The first set of theories motivates collateral as a way for good borrowers to signal their quality under conditions of ex ante private information. The second set of theories explains collateral as an optimal response to ex post contract frictions like moral hazard. A growing body of literature that empirically tests these models and the on-going financial crisis have raised significant academic and policy interest in understanding the role of collateral in debt contracts.

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Collateral, Risk Management, and the Distribution of Debt Capacity

This post comes to us from Adriano Rampini of the Finance Department at Duke University, and S. Viswanathan, Professor of Finance at Duke University.

In our paper, Collateral, Risk Management, and the Distribution of Debt Capacity, which is forthcoming in the Journal of Finance, we provide a dynamic model of collateralized financing in which collateral constraints are endogenously derived based on limited enforcement. In the model, firms have access to complete markets, subject to collateral constraints, and thus are able to engage in risk management. We show that there is an important connection between firm financing and risk management since both involve promises to pay by the firm, which are limited by collateral.

Our model predicts that firms with low net worth exhaust their debt capacity and hedge less, since financing needs override hedging concerns, consistent with the empirical evidence. In contrast, this evidence is considered a puzzle from the vantage point of the standard theory of risk management, which takes investment as given. Rampini and Viswanathan (2009) study an infinite horizon model and show that the same trade-off between financing and risk management obtains generally.

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