This client alert addresses the impact of negative interest rates on transactions and collateral documentation commonly used in the European commodity derivatives market. A spread clause is a provision of the paragraph, annex or addendum to an ISDA guarantee contract which provides that the interest rate or amount is determined by reference to one or more variable interest rates or any other mechanism whose interest rate(s) or any other mechanism may be increased or decreased by a specific number or mechanism for determining a number. An example would be that the interest rate used for an interest period would be the average of the EONIA rates for each day over the corresponding interest period plus or minus a certain number of basis points. Since such a provision reflects an agreement between the parties to use something other than a simple interest rate, market participants have decided that negative interest amounts in this case should not be subject to the Protocol without further discussion between the parties concerned. Accordingly, an ISDA ancillary agreement with such a provision would be exempt from amendments to the Protocol. The pressure on guarantee agreements is unlikely to ease in the coming months, as significant changes will be made to the next margin agreements for centrally uncompensated loans from September 2016. In this context, the issue of negative interest rates serves as a noisy red flag. Introduction As the Financial Times notes, “a fall in European interest rates into negative territory could profoundly affect the functioning of the financial system … ». However, this is not only a problem for interest payments in euros, but it currently also applies to the Swiss franc and the Danish krone, and this has also been the case in the past with other currencies such as the Hong Kong dollar. The use of negative interest rates as a monetary instrument is not new and, although less common, “there is nothing special about entering negative territory”1.
Impact of negative interest rates on collateral documentation on commodities The collateral documentation most commonly used by commodity market participants in Europe is the 1995 ISDA Credit Support Annex (the “ISDA CSA”) and the EFET Credit Support Annex (v.2.0, May 2010)3 (the “EFET CSA”). These Credit Support Annexes or CFAs are used to secure obligations under the ISDA Framework Agreement or, in the case of efet CSA, the EFET General Agreement on the Supply and Purchase of Electricity (f.2.1(a), Sept. 2007) (the “EFET Power”) or the EFET GENERAL AGREEMENT on the Supply and Purchase of Natural Gas (v.2.0, May 2007) (the “EFET Gas”). As mentioned earlier, there is nothing special about interest rates entering negative territory, but in a world accustomed to positive interest rates, a new approach to risk analysis and management is needed. Similarly, the effects of negative interest rates related to commodity trading documents prepared with positive interest rates in mind may have interesting implications. There may be other reasons to resort to negative interest rates, such as. B protect local export markets by limiting the appreciation of a national currency against other competing currencies. Such an appreciation can be caused by a rapid influx of “hot money” when a particular currency is considered a safe haven. This was the case for the central banks of Denmark and Switzerland, which sought to stem the tide of investors seeking refuge against the perceived risk of the euro. Each form of ISDA side agreement differs in terms of terminology, section or paragraph numbers, and other aspects.
They may also differ in the legal approach (e.g.B. transfer of title vs. security right). Therefore, changes to each ISDA warranty agreement are provided separately for each relevant ISDA warranty agreement. 24. If the amount of interest for an interest period is negative, when is the secured creditor required to pay that negative interest amount AV (absolute value of a negative interest amount) to the secured party? The effects of the ECB`s policy are already evident in the negative yields on euro bond markets. What is even more worrying is that the maturity of bonds sold at negative yields is rising, suggesting that hopes for a short-term economic recovery are fading. If this view continues, negative interest rates may well be passed on from the central bank to commercial banks and depositors. However, it does not follow that just because the policy interest rate is negative does not mean that money market or commercial loan rates will automatically follow. Although deposit rates have historically followed wholesale refinancing costs (which are typically higher than the central bank`s interest rate), commercial banks have a hard time explaining to depositors why they should pay the bank to keep their money (either through negative interest rates or other deposit account fees). The imposition of negative interest rates could lead depositors to decide to liquidate their deposits and keep their liquidity outside the banking system. As a result, commercial banks prefer to reduce operating costs or reduce profits, rather than simply passing on the additional financing costs to customers.
This can only be a short-term solution for a commercial bank, and therefore a prolonged period of negative interest rates by the central bank will ultimately have a negative impact on commercial lending. However, under the CSA, in which an amount of interest is incurred on the cash security held by the holder, it is generally payable to the supplier party. In the case of a negative interest rate, this may amount to an obligation on the supplier party to pay such interest to the security holder. The problem in ISDA-CSA as well as in efET-CSA is that, in its original version, there was no mechanism to recognize a payment obligation in relation to a negative interest amount or to require the supplier party to pay the absolute value of the negative interest amount to the collateral holder (the “negative interest obligation issue”). Negative interest rates as a monetary policy tool The current negative interest rate environment stems from the fact that a number of central banks set negative interest rates on reserve requirements that commercial banks must place with their central supervisory banks. These negative interest rates affect interest rates on surpluses that commercial banks may have with their central bank, and in turn on short-term money market rates for that banking system. The main problem is that the documentation does not address the issue of negative interest rates in relation to the amount of interest with sufficient clarity. The party receiving the guarantee (the “secured party” or otherwise identified) would not have a clear right to demand payment of negative interest, so it would be exposed to a recurring loss caused by a negative interest rate […].