The turmoil in the financial markets and high commodity price volatility requires a re-thinking of risk management. Credit events which may have previously been unimaginable have occurred in the last eight months and keep occurring.

The lesson learned from the collapse of Lehman is that security in the form of a parental guarantee offers little protection and one must focus other forms of risk mitigants. This brings margining into the spotlight.

In this alert, aimed primarily at commodity trading houses, we provide a brief introduction to the key concepts of margining common to all types of margining agreements and we briefly highlight the additional measures which can be used to complement and improve your margining provisions.

Furthermore we address collateralisation in the context of physical commodities trading which is a hot topic for our target audience in consideration of the mix of financially and physically settled business they carry out and of the fact that physical transactions are increasingly documented alongside cash settled contracts under ISDA Master Agreement ("ISDA MA") terms.

What is Margining?

Margining is a technique to reduce or eliminate credit risk, namely the chance of incurring a loss as a result of the counterparty not fulfilling its contractual obligations. Margining consists of one party providing the other with funds that guarantee the performance of its obligations under existing transactions. If the party that has provided the margin fails to honour its obligations the other party is entitled to satisfy its credit by retaining the money.

The amount of credit risk a party bears at any given moment in time is referred to as 'exposure'. The exposure of a party to a derivatives transaction is made up of two components. One is the aggregate value to the party of the outstanding portion of existing transactions calculated at market price or "marked to market". The other component is the aggregate of the amounts ought to be paid and received by the party in respect of transactions that have already matured, commonly referred to as 'unpaid amounts'.

The mark to market can be thought of as the component of credit risk relating to the fluctuation of price over the time the contract is outstanding. We detail below how this component of credit risk is being increasingly addressed in the context of physically settled transactions.

It is helpful to work though a short example of margining in practice:

• Two parties will agree a 'threshold' for each other under the credit support terms;
• The threshold is analogous to a 'credit limit'; if one party's exposure exceeds the threshold applicable to the other party then the party with the exposure is entitled to receive margin equal to such excess.
• Like any credit limit the threshold applicable to a party is determined after a detailed examination of the potential credit risk being posed by such party. This may include an assessment of such party's financials and its external credit rating etc. The thresholds are negotiated by the parties and ultimately become a term of the margining agreement.
• The threshold may either be a set amount or it may vary in relation to external benchmarks of creditworthiness, most typically credit ratings.
• If, after the margin has been transferred the exposure decreases, an amount of collateral equal to the difference between the current and previous exposure can be demanded back from the party that transferred the margin in the first place. This is usually referred to as a 'return amount'.
• If a party fails to post or return margin, the other party will have the right to terminate the agreement and to close out all positions with that counterparty.
• In addition to the threshold, margining terms usually provide for a minimum transfer amount and rounding. The minimum transfer amounts sets the limit under which an exposure does not need to be margined despite the fact that it exceeds the threshold. The rounding provision sets the convention to which the parties must adhere for the purpose of establishing the amount of margin to be transferred or returned.
• Say Party A and Party B set the threshold at $2,000,000 each, the minimum transfer amount at $100,000 and that amounts must be rounded up or down to the nearest integral multiple of $10,000 then if Party A's exposure to B is $2,096,000 then Party A cannot ask Party B to post any margin. Conversely, if the exposure is $2,106,000 then, Party A is entitled to receive from Party B $110,000.
• The above example explains how the actual 'credit limit' is made up of the threshold amount combined with the minimum transfer amount and rounding.

Margining is typically mutual. It is however possible for one party to impose margining on the other if it has a lower credit standing.

Common Considerations: Provisions Universal to all Standard Margining Agreements

It is useful to examine the key provisions which are universal to all standard margining agreements commonly referred to as Credit Support Annex (CSA):

• The form of credit cover required
  It is necessary to agree the form of credit cover that is acceptable to both parties which may be required in the event of a margin call. The simplest form of credit cover is cash and there are many market participants who will only accept cash - a trend which is becoming more apparent over recent months. It is however not unusual, especially in commodities derivatives trading, that an irrevocable standby letter of credit is listed as an alternative to providing cash.
  
  Counterparties are free to choose any number of types of credit support, for example, surety bonds, third party guarantees and US treasury bills, notes or bonds.
• The credit threshold – striking the balance
  The threshold amount represents the net exposure that you are willing to bear before requiring further comfort through a margin call.
  
  Striking the right threshold balance is important as this is the key provision of the margining language. In volatile markets, counterparties can find themselves subject to repeated margin calls if the threshold is not set at an appropriate level. If the threshold is too high, it may never be breached; this limits the effectiveness of the credit comfort that the margining provisions provide. Counterparties will be reluctant to agree to a low threshold as frequent margin calls will eat into their operational liquidity and increase administrative burden. That said, what would have been considered only ten months ago as an excessively low threshold may now be considered appropriate. The same can be said about minimum transfer amounts. The availability of cash is obviously the other key driver when deciding whether or not to increase margining by lowering thresholds.
• The frequency of the valuation of the exposure
  Margining terms can provide for monthly, weekly or daily valuations of the exposure.
  
  The more frequent the valuation, the more frequent the margin calls.
  
  In highly volatile markets it is crucial to have frequent valuations.
  
  The effect of having, say, weekly valuations in respect of highly volatile underlying commodities, ranges between a missed opportunity to a credit risk disaster.
  
  Let us consider the missed opportunity first. Say in our example that Party A and Party B agreed to weekly valuation and each set Tuesday as the valuation date. On Monday 1st January, Party A is exposed to Party B by $2,200,000.
  
  On Tuesday 2nd January Party A makes a margin call for $200,000 which Party B honours. Between Monday 1st and Wednesday 3rd January, Party A's exposure goes up by another $500,000 reaching $2,700,000. The exposure remains substantially the same after the 3rd due to the market stabilising.
  
  On Friday the 4th, Party B files for bankruptcy. The bad news is that Party A will have to claim as part of Party B's insolvency. The good news it that Party A's $2,700,000 claim will be reduced by the $200,000 margin it is holding.
  
  It would have been of course much better news if Party A and Party B had agreed daily valuation. In fact, Party A would have been holding and additional $500,000 margin and would have reduced its claim by such amount, down to $2,000,000.
  
  We now consider the alternative credit risk disaster example. Again, the valuation takes place each Tuesday. On Monday 1st January Party B is exposed to Party B by $2,300,000. On Tuesday 2nd January Party B makes a margin call for $300,000 which Party A honours.
  
  Between Monday 1st and Wednesday 3rd January, due to a swing in the underlying market, the exposure is reversed so that Party A is exposed to Party B by $2,250,000. The exposure remains substantially the same after the 3rd due to the market stabilising. On Friday the 4th Party B files for bankruptcy. The bad news is again that Party A will have a claim in Party B's insolvency.
  
  The even worse news is that Party A's claim will be for the $2,250,000 plus the $300,000 margin B is holding. So Party A is facing a total loss of $2,550,000 notwithstanding the fact that the exposure as such was only $2,250,000. Had there been daily valuation, Party A would have reduced its claim to $2,000,000.
• The time by which the counterparty will need to perform the margin call
  The time by which the counterparty will need to perform the margin call is one local business day in the case of cash. Care should be taken should you wish to agree a longer timeframe because by the time a margin call is made, it is possible that the counterparty may already have solvency issues.

Ways to Improve Margining Terms - Thinking Outside of the Box

Here are some suggestions on how to fine tune margining terms and improve their efficacy:

• Have thresholds and minimum transfer amounts drop to zero in respect of a party if an event of default or potential event of default occurs in respect of such party or its credit support provider. This will allow margining of the entire exposure towards a counterparty that is on the brink of insolvency.
• For the same purpose, link the reduction of the thresholds (eventually down to zero) to external benchmarks. In the wake of the Lehman experience there may be a case for doubting the use of official credit ratings and instead, looking at other predictive tools; for example credit default swaps spreads - though such a use of credit default swaps entails its own set of issues and we have not yet seen CDSs being expressly referenced in the contracts.
• Have frequent exposure valuations, possibly daily ones.
• Provide, when possible, for margining in cash only.
• If standby letters of credit are contemplated as form of collateral, it is advisable to make sure that they are appropriately accommodated in the margining terms. Note that careful drafting is needed in both the English and New York law standard CSAs to the ISDA MA. This is necessary because letters of credit are in themselves neither compatible with the 'title transfer' nor with the 'security interest' approach.
• Also, when you provide standby letters of credit as form of collateral, make sure that the instrument provides for the right to draw under it upon the occurrence of an event of default as described in the underlying contract. This will enable the beneficiary of the letter of credit to draw under it irrespective of the designation of an early termination date under the terms of the underlying contract.
• The margining terms should also provide for the standby letter of credit held by a party to be worthless if the creditworthiness of the issuer of the instrument deteriorates substantially. This will entitle the exposed party holding the credit to ask for alternative collateral.

Price risk in the context of physically settled transactions

Margining has become more common in respect of physically settled commodities transactions. This is due to ISDA developing documentation which allows physically settled commodities to be brought under the ISDA MA terms. Presently the ISDA commodities documentation encompasses a range of commodities including bullion, oil, coal, electricity and natural gas as well as dematerialised commodities such as freight and emission allowances.

In the context of physically settled trading, price risk consists of the difference between the sales price (agreed at outset for the commodity at specified delivery terms) and the price for such commodity at the specified delivery terms at any time during the term of the transaction and prior to its settlement. Borrowing the terminology of derivatives trading, this is commonly also referred to a 'mark to market.'

Notably the margining of physically settled transactions encounters one major obstacle. Namely the fact that under the insolvency law of many jurisdictions, physically settled transactions cannot be terminated and liquidated upon the occurrence of an event of default. This is because the liquidator is entitled to force upon the solvent party the continuation of the contracts that are outstanding at the time the insolvency procedure was initiated.

This in turn means that the collateral held by the solvent party may be clawed back by the liquidator as an amount unduly paid under a transaction before its maturity.

One trend we have witnessed in physical commodities trading, crude oil in particular, is that parties are agreeing to provide security by means of a standby letter of credit drafted to specifically address the risk of price variations between the time the credit is delivered to the beneficiary and the time of settlement.

Say the seller in a fixed price contract as security against the buyer's failure to take delivery and pay for the goods. The seller may also require that the contract puts it in the condition to obtain from the buyer, if prices fall, additional security by means of a further standby letter of credit, by having the amount of the existing letter of credit increased or by providing alternative additional margin, most typically cash.

In other terms, dynamic collateralisation is increasingly becoming a feature of physically settled contracts. This is consistent with the increased use of the ISDA MA in conjunction with CSAs to document physically settled commodities transactions.

It must be stressed that when cash is provided as form of collateral it should be clearly stated in the contract that it is provided as a form of security rather than a pre-payment. This is because a pre-payment characterisation may, in the context of insolvency, prejudice the solvent party's right to retain such money in partial satisfaction of its credit.

Clearing as an alternative to bilateral margining

Clearing can be thought of as the alternative to bilateral margining. It consists of posting and receiving margin to and from a central counterparty in respect of OTC transactions. The central counterparty usually takes care of the settlement of the transactions.

Clearing poses its own set of issues as it shifts credit risk from the actual counterparty to the bilateral transaction to the clearing house. With more and more brokerage firms entering clearing services market such issues must be considered carefully.

Conclusion

We have discussed the mechanics of margining and some of key issues relating to it. We have also explained how margining is a vital tool in the present market characterised by high volatility and increased counterparty risk.

There is certainly a case for anyone engaging in trading, being it financially of or physically settled, to provide for margining terms in the relevant contract or fine tune existing provisions.

Bilateral margining remains a viable alternative to clearing if not for anything else because it provides more tailored and, often, cost effective solutions.

Striking the right balance between risk and reward has never been as crucial as it is now.

If you have any questions or would like additional information on the material covered in this Alert, please contact one of the members of Reed Smith's Energy, Trade & Commodities team listed, or the Reed Smith attorney with whom you regularly work.