The current COVID-19 pandemic is leading to huge disruption in financial markets and larger collateral swings. Unexpected market movements can lead to increased margin calls under OTC derivatives contracts, causing liquidity problems for counterparties who may be unable to meet the increased collateral demands. Where collateral is required to be posted in respect of an OTC derivatives contract, if the collateral is not posted in a timely manner in accordance with the relevant contractual documentation, this may cause payment and delivery failures, which in turn may lead to events of default and termination of transactions. This note sets out practical considerations for derivatives market participants to take into account in respect of collateral OTC derivatives contracts.

When considering issues relating to collateral, counterparties will need to look at both the relevant regulatory framework and contractual terms of the relevant derivatives transaction.

Implementation of margin requirements

Whilst many participants in the OTC derivatives market will be subject to the obligation to post variation margin (reflecting the daily mark-to-market value of outstanding contracts and being the collateral collected by a counterparty to cover its current and potential future exposure), participants that are more systemically important also are required to post initial margin, being the collateral collected by a counterparty to protect itself against expected losses that could stem from movements in the market value of the derivatives position occurring between (i) the latest exchange of variation margin covering the exposure related to such market value of OTC derivatives contracts (i.e. the latest time when such market value of OTC derivatives contracts was calculated), before the default of either party and (ii) the time that the OTC derivatives contracts are replaced or the corresponding risk is hedged. Collateral collected as initial margin must be segregated from the other proprietary assets of the collecting counterparty, posting counterparty or third-party holder or custodian, as relevant.

The requirement to post initial margin is still being phased in, with only the most active OTC derivatives participants already subject to the requirements. There are, however, a large number of counterparties for whom the obligation to post initial margin was due to commence in September 2020 resulting in a large amount of complex operational and contractual arrangements needing to be put in place in a short time period. Due to the current COVID 19 pandemic, the Basel Committee on Banking Supervision ( BCBS) and International Organisation of Securities Commissions (IOSCO) have recently announced the deferral of the implementation of each of Phases 5 and 6 of the margin requirements by one year. This is certainly welcome relief, as market participants and trade associations have been calling for these implementation dates to be pushed back because of concerns that it would be very challenging to meet the documentation and operational requirements required for Phase 5 in particular in the current environment.

The BCBS and IOSCO have proposed that:

• Phase 5 covered entities (entities with an aggregate average notional amount (AANA) of non-centrally cleared derivatives greater then EUR 50 billion) will be subject to the margin requirements from 1 September 2021; and
• Phase 6 covered entities (entities with an AANA of non-centrally cleared derivatives equal to or lower than EUR 50 billion but greater than EUR8 billion) will be subject to the requirements from 1 September 2022.

This revised timeline will now need to be reflected in the margin frameworks in relevant jurisdictions although has been broadly welcomed by regulators at a national level.

In relation to OTC derivatives contracts where there is already an obligation to exchange initial margin, counterparties should review the models that they use to calculate the amount of initial margin required to ensure that it is still appropriate in light of current market conditions. For example, the International Swaps and Derivatives Association, Inc. (ISDA) has acknowledged that the recent volatility has raised some questions about the performance of the ISDA Standard Initial Margin model (SIMM) which provides a common, industry wide methodology. ISDA has stressed that the model is inherently conservative and that there is a safety buffer to ensure stability even in times of market volatility and also a clear governance framework, but this illustrates the complexity of the initial margin obligation in markets that are going through periods of stress.

Contractual terms

Derivative counterparties will also need to consider carefully the relevant contractual provisions covering collateral arrangements in their derivatives contractual documentation. The COVID-19 pandemic has raised a number of questions in this regard, including as to how these impact:

• Valuation disputes over collateral and outstanding transactions
  Counterparties should review the types of transactions and collateral that are subject to the relevant OTC derivatives contracts and also determine the amount of discretion given to the valuation agent to make determinations. Care should be taken to record accurately the basis on which valuations are made and, where possible, retain records of this in the case of future disputes. In particular, care will be needed in order to determine the applicable business days. If a jurisdiction in which a counterparty is located declares an unscheduled bank holiday due to the COVID-19 pandemic, resulting in the closure of commercial banks, this will impact when transactions can be valued and collateral transfers can be settled given that, typically, commercial banks in the relevant jurisdiction need to be open for business.
• Eligibility of collateral
  The fast moving pace of the COVID-19 pandemic has caused some collateral to cease to be eligible for the purposes of posting under an OTC derivatives collateral arrangement and some collateral to be subject to bigger valuation haircuts than otherwise would be the case for more normal market conditions. As the situation develops further, this will be a dynamic situation and so counterparties should monitor this closely to avoid potential defaults. Where there is a requirement to post cash, due diligence should be undertaken to understand whether there is a zero floor on the rate used to calculate interest on the posted amount or whether negative interest will also apply. This is particularly the case for currencies where governments have reduced interest rates to support national economies in light of the pandemic.

• Resolution of disputes
  Market standard derivatives documentation generally contains dispute resolution provisions, although a review should be conducted to make sure they are followed in the eventual event of a dispute, including any bespoke modifications or elections made to the standard terms. In addition to the terms contained in the relevant collateral arrangements, counterparties should also be live to any additional overarching dispute mechanics that they have agreed to be bound by as a result of regulatory initiatives or terms of business, for example those contained in the ISDA 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol.

• Force majeure events
  The events of the last few months have led to a number of questions as to the circumstances in which a force majeure event may occur and the impact this will have on OTC derivatives transactions generally and more particularly how this relates to collateral posting obligations. In relation to collateral posting, the effect will depend on the type of OTC derivatives contract entered into and it is important to understand the different consequences. For instance, the answer is likely to be different under an English law ISDA Credit Support Annex, where the force majeure termination event provided for in a 2002 ISDA Master Agreement will also apply to the English law ISDA Credit Support Annex, as compared to the position under an English law ISDA Credit Support Deed or New York law ISDA Credit Support Annex, which create a security interest and may not have the same treatment.
• Notice provisions
  Attention should be paid to ensuring that any notices are provided in line with the notice obligations in the contractual documentation. Where collateral calls are dealt with by a different function within an organisation from the department responsible for documentation, there can often be mismatches between the contractual requirements and the operational reality. Whilst in the normal course this is of less practical importance, in a more stressed environment this will be looked at more closely, especially in circumstances where a counterparty might be seeking to exercise rights to terminate as a result of a failure to post collateral.

  Similarly, different types of notice may require different methods for service. For example, under the 2002 ISDA Master Agreement, notices given in respect of any event of default or termination, including close-out notices, cannot be given by electronic messaging service or email. Where notices cannot be given electronically because of any lockdowns or closures, consideration will need to be given as to how to effect delivery and this will to a large extent depend on the governing law of the contract.

• Defaults and failure to comply with collateral posting obligations
  Finally, where there are defaults or other failures to comply with obligations under collateral documentation, counterparties should be familiar with the legal and operational processes that are required to enforce or otherwise appropriate collateral and how this interacts with the obligations to pay amounts due under the close-out provisions of the relevant contract. Considerations that need to be taken into account include the valuation of collateral upon a default, the location of the collateral, interaction with any third parties such as custodians and, with security collateral arrangements, exercising rights of control over relevant accounts.

Location of documentation and templates

Whilst great progress has been made in recent years in ensuring that arrangements for OTC derivatives transactions are properly documented, it is helpful in times of market stress to ensure that documentation is fully available and complete. Account also should be taken of ancillary documentation (such as terms of business) and terms that are incorporated by reference into the main contracts (such as ISDA protocols) to ensure that a complete picture of rights and obligations is available. We also advise that template notices are prepared in advance so that, in the case of a default or other event, it is possible to exercise rights in a timely manner, especially in circumstances where markets are likely to be moving very quickly such that quick control and valuation of collateral will be critical.

Next steps

Market participants should start carefully reviewing their relevant derivatives transaction documentation, including any Confirmations, Schedules, definitions and credit support documents in order to obtain a complete picture of any elections or modifications made and relevant requirements so that they are in an informed position in case they need to take any action quickly in the event of further market volatility and increased margin calls in the current environment.

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