The Dodd-Frank Act has ushered in a new marketplace where many more swaps and derivatives transactions than ever before are cleared by clearinghouses, which guaranty the performance of the parties and collect margin collateral on behalf of each to secure their exposure under the transaction. This unprecedented regulatory initiative is designed to protect against both counterparty risk and the systemic risk of a failed bank or dealer. The failure of Lehman, MF Global and other major swap providers have highlighted the need for these collateral protections.

While clearing provides added protection to the parties to a transaction against counterparty default, it also increases the cost of entering into the transaction. Because of this, for end users of derivatives, clearing often involves a commercial cost-benefit analysis. In many cases, the end user may prefer to not clear the transaction, especially when entering into a transaction with a creditworthy counterparty. Moreover, a recent ISDA study suggests that OTC derivatives are more useful for commercial end users than cleared derivatives in hedging commercial risk because they tend to be more customized to fit the needs of the end user.

Because of these commercial considerations, the architects of the Dodd-Frank Act provided an opt-out from mandatory clearing for non-financial commercial end users using derivatives to hedge commercial risk (see Practice Note, The Commercial End-user Exception to the Dodd-Frank Mandatory Swap Clearing Requirement). End users opting to avail themselves of this exception must negotiate their derivatives collateral arrangements the old fashioned way: bilaterally, under an ISDA Credit Support Annex (CSA). For these and other reasons, uncleared swaps and their accompanying bilateral credit support arrangements are here to stay, even in the Dodd-Frank era. The results of a recent ISDA survey concluded that 90% of uncleared derivatives transactions are now collateralized.

Title VII therefore also specifies certain margin collateral rules for parties that enter into uncleared swaps. These rules include optional third-party-custodian margin segregation rules for initial margin collateral posted in connection with uncleared swaps (see Title VII Optional IM-Segregation Rules), which are scheduled to take effect on May 5, 2014 for uncleared swaps entered into on or after January 6, 2014. Like the clearing mandate, these segregation rules offer added protection for the end user, as well as added cost.

Rules such as these have changed the playing field for end users negotiating collateral arrangements with banks and dealers (prior to these rules it was virtually impossible to obtain third-party collateral segregation of uncleared transactions with a financial counterparty, as market-making swap providers and prime brokers looked to preserve their rehypothecation rights with respect to posted collateral). However, these Dodd-Frank protections only provide as much protection as the end user can afford.

Fortunately, with the proper care and attention to certain negotiating points, counterparty collateral arrangements that provide cost-effective margin collateral protection for the end user are available. Because collateral management has important financial and risk-management ramifications for any end user of derivatives, it should be approached with an understanding of certain basic margin collateral negotiation principles.

In connection with this, Practical Law Finance highlights the following resources designed to assist end-user counterparties with navigating the topography of counterparty collateral negotiation:

These resources discuss the following important points, among others, to be considered by parties negotiating any type of margin collateral arrangement:

Many of these principles are also relevant to certain other types of secured transactions, including repos and securities lending transactions. And while there is typically little flexibility in negotiating margin collateral matters for cleared transactions, some of these principles (such as transfer timing and two-way posting) are relevant to negotiating cleared counterparty margin arrangements, including cleared swaps and derivatives transactions entered into under a futures or futures and options account agreement. (These arrangements are typically governed by the applicable clearinghouse rules giving the dealer less flexibility and therefore more negotiating leverage, as the clearinghouse clearing member, than under a bilaterally negotiated collateral arrangement.)

Under Section 724(c) of the Dodd-Frank Act, as reflected in CEA Section 4s(l) and CFTC Regulation 23.701, swap dealers (SDs) and MSPs must inform their non-SD/non-MSP swap counterparties of their right to segregation with an independent third-party custodian of initial margin collateral posted to the SD or MSP counterparty by the nom-SD/non-MSP in connection with uncleared swaps entered into between them (see Practice Note, The Dodd-Frank Act: Derivatives Margin Collateral Rules: Title VII Rules on Segregation of Uncleared Swap Margin Collateral).

CEA Section 4s(l) sets out the rights of swap counterparties to SDs and MSPs with respect to the segregation of money, securities or other property used to margin, guarantee or otherwise secure uncleared swaps. CFTC Regulation 23.701 covers the obligations of SDs and MSPs with respect to counterparty notification of these segregation rights. Parties have until:

In order to facilitate compliance with these rules, including the upcoming Regulation 23.701 compliance deadlines, ISDA has published:

These documents may be used by parties to new or existing uncleared OTC derivatives transactions entered into under an ISDA Master Agreement (ISDA Master) and New York law CSA if the end user counterparty elects custodial segregation of the initial margin collateral (referred to in the CSA as the independent amount or "IA") it posts in relation to the transactions entered into under that ISDA Master.

As noted in the ISDA market advisory, under these rules, prior to executing new uncleared swaps, SDs and MSPs must:

The ISDA market advisory also notes that potential market disruptions could occur if market participants wait until the above compliance dates to receive and respond to these notices. In order to avoid disruption, non-SD/non-MSP swap counterparties should be prepared to provide necessary contact information to their SD and MSP counterparties well in advance of these compliance dates in order to comply with CFTC Regulation 23.701.

As noted, the end user must make a commercial determination as to whether the benefits of collateral protection offered by segregation with an independent third-party custodian outweigh the costs of the arrangement. Obtaining affordable custodial and securities intermediary services will prove critical in determining the success of this rule in providing protection for end-user collateral posted in connection with uncleared derivatives transactions.