There may be such a thing as bad publicity, but there is no negative interest – at least, as would be payable under an unamended ISDA 1995 Credit Support Annex ("1995 CSA").
So held the English Commercial Court in a case1 brought by the Netherlands (the "State") against Deutsche Bank AG (the "Bank"). In a judgment of 25 July 2018, Robin Knowles J determined that the standard form English law 1995 CSA does not contemplate a legal obligation to account for negative interest.
Negative rates environment
Over the past years the European Central Bank and the central banks of Sweden, Switzerland, Denmark and Japan cut interest rates to levels below zero, and various instances of negative EURIBOR, EONIA and LIBOR rates have occurred.
Many transactional documents, particularly those entered into with an awareness of potential negative rates, now contain zero-floor language or specific provisions to account for negative interest amounts. However, the uncertainty surrounding interpretation of documents that did not expressly contemplate a negative rate environment has made this a long-disputed topic between market participants. This newest case assists in clarifying how standard ISDA documentation will be construed and will resolve certain of these debates.
The State and the Bank had entered into a number of derivative transactions under an English law ISDA Master Agreement. The 1995 CSA contained a unilateral obligation on the Bank (the Transferor) to post cash collateral to the State (the Transferee) whenever the State was net in the money under these transactions.
The State was obliged to pay interest to the Bank on such collateral at a rate of EONIA minus 0.04 per cent. As to this, Paragraph 5(c)(ii) of the 1995 CSA provided:
"Interest Amount. Unless otherwise specified in Paragraph 11(f)(iii), the Transferee will transfer to the Transferor at the times specified in Paragraph 11(f)(ii) the relevant Interest Amount to the extent that a Delivery Amount would not be created or increased by the transfer..."
In circumstances where the State had net credit exposure requiring the Bank to post collateral, and the agreed rate was less than zero for most of the relevant period, the State asserted that instead of paying zero interest (as a floor rate) to the Bank, it should instead receive "negative interest" from the Bank.
The State argued that, rather than requiring cash transfers, negative interest should be taken into account in the calculation of (accrued but unpaid) amounts payable between the parties as part of the Credit Support Balance, the definition of which concludes: "Any Equivalent Distributions or Interest Amount (or portion of either) not transferred pursuant to Paragraph 5(c)(i) or (ii) will form part of the Credit Support Balance."
The Court considered:
(a) the ISDA 2013 Statement of Best Practice for the OTC Derivatives Collateral Process (the 2013 Statement), which gives guidance that: (i) in a negative rate market the standard CSA should use a negative rate in Interest Rate and Interest Amount calculations; (ii) Negative Interest Amounts may be computed; and (iii) the Parties should either settle these amounts in the reverse direction to normal, or compound the negative interest balance into the Credit Support Balance;
(b) the ISDA 2014 Collateral Agreement Negative Interest Protocol (the "2014 Protocol"), which was introduced so that negative benchmark interest rates should flow through ISDA collateral agreements under certain circumstances and which contemplated that parties would amend Paragraph 5(c) of the CSA in this regard; and
(c) the ISDA User's Guide, containing a passage that focuses on the Transferee's obligation under the CSA to pay interest on amounts it holds as cash collateral under Paragraph 5(c).
The Court held that while the definition of "Interest Amount" was capable as a matter of language of allowing for a negative figure, in this case the agreement did not include an obligation on the Transferor if the Interest Amount was negative; any such obligation would have to be spelled out (and had not been).
The Paragraph 5(c)(ii) obligation to pay interest under the 1995 CSA was phrased so as to envisage only payment from the person holding the collateral (and not from the person posting the collateral, as would necessarily be the case with negative interest, given the unilateral credit support obligation). Further, the Judge noted that the paragraph began with the words "Unless otherwise specified in Paragraph 11(f)(iii)", and the Parties had not taken the opportunity to specify otherwise.
The Judge concluded that while positive interest was dealt with by the Paragraph 5(c)(ii) machinery, the State's argument required different machinery to deal with negative interest. He found no credible commercial rationale for such a choice; had the parties wanted to deal with negative interest, the obvious course was to bring it within Paragraph 5(c)(ii).
The ISDA User's Guide, which had been available to the Parties at the time of agreement, supported the Bank's interpretation. The 2013 Statement and 2014 Protocol had not been available to the Parties, though the Judge commented that these deserved respect and parties may be encouraged to follow them when contracting. However, the 2014 Protocol contemplated that Paragraph 5(c)(ii) would be amended to expressly cater for negative interest.
In the absence of such amendments, the Court considered that the standard form 1995 CSA did not include an obligation on a Transferor to account for negative interest.
While allowing only positive interest plainly leads to a lack of equivalence between the Parties, the same can be said of the unilateral credit support obligation. Commercial rationale proposed by the Judge included that the Parties may have wanted simplicity in their arrangements, or the fact that the State would not necessarily incur loss by holding cash in a negative rates market, as it was free (by agreement) to use the cash to generate income elsewhere.
Perhaps unsurprisingly, the Court has declined to imply terms into an agreement where it is not necessary to do so, and where parties could have drafted to cater for the situation. This decision, on a long-debated issue, clarifies that if the 1995 CSA is to deal with negative interest, it must be amended to expressly do so. For those market participants with legacy transactions who have been in negotiations on the subject for years, this judgment may crystallise a position, with imminent P&L impact as disputed interest positions on cash collateral are resolved. For future transactions, it should encourage parties to either follow the 2014 Protocol or otherwise comprehensively document their intentions with respect to negative rates.
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