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Organizations readying themselves to comply with UMRs face a litany of tasks that need to be completed in a timely manner. Another area firms will need to deal with are the legal documentation changes that come with U-OTC trading. Such trading becomes subject to the Rules and will require significant changes to legal documentation.

it is important to note that global regulators require that parties only enter new legal documentation once they have or are soon expected to cross the IM threshold. This means that a fund which has material swaps exposure (i.e., AANA above the thresholds) but which does not expect to cross the 50M IM threshold with any SD group does not need to redocument all its U-OTC trading relationships. This was initially a big concern for the market and has since been alleviated.

Nevertheless, where a manager expects that its Fund(s) might cross the IM threshold, it should be mindful that it can take many months to negotiate documentation and implement new operational procedures. As such, for managers who believe their fund(s) will eventually come into scope, it is wise to begin redocumenting in the near term.

Another important consideration is that the legal documentation will vary both in content and in structure depending on the custodians selected and the Collateral Segregation Model agreed on with your SD. It is therefore important to get a good handle on the operational framework to engage in productive legal negotiations.

Current Legal Documentation Framework

U-OTC trading is achieved in the market via the ISDA MA.^[1] Since 1985, ISDA has been developing market standard documentation which has helped with the standardization and use of U-OTC. Although the ISDA MA and much of the other documents ISDA published are standard, negotiation does take place at various levels (for instance, in the schedule to the ISDA MA). The standardization helps as it creates a contractual framework for all market participants to negotiate within. The exchange of margin (both VM and IA) for U-OTC occurs under the Credit Support Annex (“CSA”).^[2]

New Legal Documentation Framework

As noted previously, under the Rules, IM must be exchanged by both parties and held in segregated accounts. New documentation is required to create this new structure, primarily since holding collateral in segregated accounts involves the introduction of one or more third
parties to act as custodian for the segregated IM accounts. Parties may choose to use the same custodian or appoint different ones, but in either case, two distinct custody agreements will be required, as well as separate account control agreements.

1. IM CSA – 2018 Credit Support Annex For Initial Margin (IM) (Security Interest –
   New York Law)

This is the new form of Credit Support Annex which ISDA has published for the exchange of IM. Please note that for arrangements under English Law, parties would use the 2018 Credit Support Deed For Initial Margin (IM) (Security Interest – English Law).

Key Features and Negotiation Points:

• This document will govern the exchange of IM.
• How IM will be held – using segregated accounts and custodians.
• Which Margin Approach will be used.
• How IM will be determined (SIMM model or Grid, etc.) and by whom (Calculation Agent)
• Establish the threshold for posting of IM.
• Choice of applicable regimes – the Regime Table (i.e., the Rules of which jurisdictions will apply).
• Transfer timing, and minimum transfer amounts.
• Forms of collateral which may be delivered (i.e., what type of assets are eligible collateral).
• Resolving collateral disputes.
• Taking control of collateral (Notice of Exclusive Control).
• Custodian events – what events at the Custodian give rise to the other party to take the collateral from them. For instance, if custodian is failing to act in accordance with the ACA.

2. Custodian Agreement

If the fund does not already have a custodian agreement in place with a custodian who offers segregated IM services, then one will need to be put in place. It is important for managers to discuss capabilities with their custodian immediately. Although there are literally dozens of custodians offering segregation services, the custodians most used to date have been BNY Mellon, JPM Morgan, and State Street. Clearstream and Euroclear are also custodians, used primarily by European entities.

Key Features and Negotiation Points:

• As with any Custody Agreement there are several points which are important to negotiate.
• Custodian standard of care.
• Asset Control – Custodian segregation of assets/use of sub-custodians.
• Custodian liability/indemnification provisions.
• Representations and warranties.
• Termination without cause (i.e., length of time which custodian must provide services to you).
• Assignment and Amendment Rights.

3. Account Control Agreements (“ACAs”)
   

For each pair of IM postings, a separate ACA will be needed and will have three parties to it:

• ACA when SD is posting IM. Parties: SD, SD’s custodian, and fund.
• ACA when fund is posting IM. Parties: fund, fund’s Custodian and SD.

The ACA is necessary to enforce the security interest which each respective party has over the IM held by the other party’s custodian. What the ACA effectively provides is that the custodian will hold IM, and upon instructions of the secured party (i.e., the party to which the IM has been “posted” to) specifying that the transferor (i.e., the party which has posted the collateral) has defaulted on its obligations under the ISDA MA, then the custodian shall deliver the IM to the secured party.

The idea here is for IM to be held in safekeeping by a third party, with the secured party only able to take the collateral once the other party has defaulted. This achieves the ultimate goal of posting collateral (i.e., protecting the creditor), but also protecting the collateral since, if the secured party goes bankrupt, the collateral held in the custody account does not become available to its other creditors and should be returned to the transferor.

 Key Features and Negotiation Points:

• Establishing what events allow the secured party to take “control” of the account and instruct the custodian to deliver assets held in the segregated account to it (the “Notice of Exclusive Control” or “NEC”)
• The secured party should only be permitted to provide a NEC when a termination event has occurred under the ISDA MA with all transactions being affected transactions.
• Establishing the events or conditions under which the transferor of collateral can take its collateral back. This should typically occur when the secured party has defaulted under the ISDA, all transactions are being terminated, and the transferor has no further amounts payable to the secured party.
• Operational details regarding timing of the above, and notice details will be included in the ACA.

Onboarding issues/challenges – AML/KYC

As you can see from the document architecture above, the rules add significant complexity to a fund’s document architecture. It also brings new parties into the negotiation of some documents, meaning that up to four entities might be involved in negotiating one set of documentation between two parties. The ACAs can often take longer to negotiate than one would normally think. The reason for this is that not all SDs have active ACAs with all custodians.

Through the first phases of UMR, and as more participants are drawn in, it is expected that as parties become more familiar with this arrangement and more agreements are negotiated, that the time to negotiate ACAs as well as custody agreements will decrease. Custodians may limit the room of negotiation they offer to funds.

Documentation teams at SDs will also face a pinch to negotiate additional documents which did not previously exist.

Beyond document negotiation, the onboarding process may also pose challenges for two main reasons:

• Custodians have increasingly lengthy AML/KYC requirements. It can take months to clear AML/KYC at a custodian with them requiring very detailed information about a fund, its manager, directors, officers, and investors.
• Operational readiness. In integrating new clients, as well as offering new IM solutions to existing clients, custodians, SDs, and managers will have to coordinate new operational processes, systems, and reporting into their operational infrastructures.

For all of the above reasons, it is critical that managers with in-scope funds get a head start in implementing new documentation and sorting out operational procedures.  Managers who delay implementation may have difficulty getting documented in time and on well-negotiated and appropriate terms.  Managers should factor in a least four months to complete negotiation and onboarding.

[1] Parties generally use the 2002 ISDA Master Agreement, although few still use the 1992 ISDA Master Agreement.

[2] Many parties still use the 1994 New York Law Credit Support Annex (“1994 NY CSA”), although in recent years this has shifted to the 2016 NY Law Variation Margin CSA (“2016 VM CSA”).  The 1994 NY CSA contains provisions for the transfer of both IA and VM.  The 2016 VM CSA only includes provisions for VM, however the parties to new ISDA relationships routinely amend the 2016 VM CSA to include provisions for IA.