Master Agreements, N i ett n

Credit and Collateral Collateral in Bilat

Bilat

Energy Markets

EEI Meeting with CFTC, SEC and

Prudential Regulators

October 25, 2010
ISDA Master Agreement – Day 0 Due Diligence

Prudent Extension of Unsecured Credit:• Swap dealers and energy companies, using ISDA Master Agreements, have p

extended unsecured credit and managed their exposures to each other

• Market participants perform extensive due diligence

• Credit review practices have evolved and matured over the past 15 years and 

• Review of credit ratings and supporting analyses

• Assessment of financial strength by reviewing financial statements: debt levels, ass

• Credit scoring (quantitative and qualitative factors, including evaluations based on 

equity and credit default default swap indicators) indicators)

• Regulatory support (e.g., mechanisms to pass through fuel and purchased power co

• Identification of available liquidity: bank lines and cash reserves

• Risk management practices

• Consideration of other exposures (e.g., lending relationship with the counterparty)

• Negotiated credit thresholds are incorporated in master agreements

• Scaled to reflect counterparties’ risk tolerance, creditworthiness and financial cond• Ensure against excessive exposure of swap dealers to energy companies

• Ensure against excessive exposure of energy companies to swap dealers

• Include Include fixed thresholds thresholds and credit rating matrix structures structures

• Margining of excess exposures

• Cash and non‐cash collateral

• Net exposure of all transactions (will likely include transactions that are not OTC sw

• Exposure includes accounts receivable, accounts p ya able and change in value of for
Key Features of the ISDA Master Agreement:

ISDA Master Agreement – Day 1 Negotiation and Execu

Key Features of the ISDA Master Agreement: Credit terms are bilaterally negotiated based on the parties’ due diligence The ISDA Master Agreement allows for physical power and gas transactions to be covered and credit terms and conditions that govern OTC swaps, and therefore enables netting of these different different types of bilateral bilateral transactions transactions

ISDA Master Agreement

Sets out terms for financial transactions and the credit

terms for physical power and gas transactions

Power Annex incorporates those terms and Gas Annex incorporates incorporates those terms and

conditions necessary to ensure

performance of physical gas transactions

l d

Power Annex incorporates those terms and

conditions necessary to ensure performance

of physical power transactions

h l d Financial Trades h l d

ISDA Collateral Annex nets the exposures across physical and financial transactions for margining 

Physical Power Trades Physical Gas Trade

 Margin amounts usually determined objectively

– Unsecured credit line (collateral threshold) typically a fixed dollar amount or a matrix of differen

associated with different credit ratings (as credit rating improves, threshold increases)

– Some parties also include objective or subjective measures to address material adverse change

creditworthiness or financial condition

 In rare cases, an upfront amount of collateral called an independent amount can be requirethe equivalent of initial margin required by exchanges

– Typically used only when degree of insecurity is such that there is concern about the ability to r

owed before the deadline by which valuation-based margin must be provided
Example of netting benefits: This example assumes that the swap dealer has net expo

ISDA Master Agreement – Day 2 Margining and Netti

counterparty related to physical transactions; the counterparty has exposure to the swap dea

to financial swap transactions; and the parties have agreed to a $5MM collateral threshold respect to net exposure for all transactions. Because on a net basis the swap dealer hcounterparty of $2MM, no collateral would need to be exchanged because the net exp

collateral collateral threshold threshold amount. Each party will revalue revalue outstanding outstanding positions positions on the next valu

valu

every day) to determine whether the net exposure of one party to the other exceeds the amount.

ISDA Master Agreement

Gas Annex

i il d

Power Annex

Phil ys ca Power Financial Trades hil G

Trades

Physical Gas

Trades

Physical Power transactions

are in the SDs favor in the

Financial OTC transactions are

in the counterparty’s favor in

Physical Gas 

the SDs favo

ISDA Collateral Annex

amount of $8MM the amount of $9MM 

COMBINED NET EXPOSURE OF $2MM UN

THE $5MM THRESHOLD; NO MARGIN REQU

Net Exposure Used for Margining Purposes

$ ;
Continuing example of netting benefits: On a future valuation date, the value of outst

ISDA Master Agreement – Day 3 Changes to Exposur

financial transactions has changed, altering the relative exposures of each party to the other is now exposed to the counterparty by $11MM. In response, the swap dealer would issue counterparty and the counterparty would be required to provide collateral of $6MM (the swin excess of the collateral threshold) to the swap dealer within the timeframe specified in Annex (generally (generally within one business business day). Each party will revalue revalue outstanding outstanding positions positions odate to determine whether the net exposure of one party to the other exceeds the collateral t

ISDA Master Agreement

Gas Annex

i il d

Power Annex

Phil ys ca Power Financial Trades hil G

Trades

Physical Gas

Trades

Physical Power transactions

are in the SDs favor in the

Financial OTC transactions are

in the counterparty’s favor in

Physical Gas 

the SDs favo

ISDA Collateral Annex

amount of $13MM the amount of $7MM 

Combined net exposure is $11MM, which exce

margining threshold amount by $6MM

Net Exposure Used for Margining Purposes

g g y $
Example of Credit Event: In addition to revaluing positions on subsequent valuatio

ISDA Master Agreement – Day 4 Ongoing Credit Revi

continually reevaluates the creditworthiness and financial condition of the other party. 

example, the swap dealer has determined that the counterparty has experienced a material acreditworthiness or financial condition as defined in the ISDA Master Agreement and/or ISDcausing the collateral threshold for the counterparty to be reduced from $5MM to zero. In 

dealer would issue a margin call to the counterparty counterparty and the counterparty counterparty would be additional collateral of $5MM even though the value of underlying transactions has not chang

ISDA Master Agreement

Gas Annex

Financial Trades

Power Annex

Physical Power Physical Gas

Trades Trades

Physical Power transactions

are in the SDs favor in the

amount of $13MM

Financial OTC transactions are

in the counterparty’s favor in

the amount of $7MM

Physical Gas 

the SDs favo

ISDA Collateral Annex

Combined net exposure is $11MM and now e

collateral threshold amount, requiring an adcollateral to be delivered to the Swap Dealer

Net Exposure Used for Margining Purposes

held by the Swap Dealer is now $11MM.
ISDA Master Agreement – Day 5 Regulation

Reg y g gy ulatory restructuring of energy markets: If rules g g overning margin requirementswaps mandate elimination of unsecured credit without taking into consideration legally e

netting and set‐off rights that allow parties to calculate exposure and exchange collateral, 

based on a single net amount for all transactions (including transactions that are not swap

rules may increase the exposure of swap dealers to some counterparties.

ISDA Master Agreement

Power Annex Gas Annex

Financial Trades Physical Power

Trades

Physical Gas

Trades

Physical Power transactionsare in the SDs favor in the

Financial OTC transactions arein the counterparty’s favor in

Physical Gas the SDs favo

ISDA Collateral Annex no longer nets exposures across physical and financial

transactions for margining purposes. Separate provisions apply to physical and financ

transactions.

are in the SDs favor in the

amount of $13MM

in the counterparty s favor in

the amount of $7MM

the SDs favo

$5MM

Swap Dealer exposure under the physical

transactions is now $18MM, requiring anadditional $7MM of collateral to be delivthe Swap Dealer.

Counterparty exposure under the financial

transactions is now $7MM, requiring $7MM of

collateral to be delivered to the counterparty bythe Swap Dealer.

The new regulatory structure in this example would require each party to post collateral to t

when on a net basis only one party would be exposed to the other. It would tie up a total of 

collateral as apposed to $11MM or $6MM in the prior examples.
Day 5 Continued – Unintended Consequences

• Margining Margining threshold threshold amounts amounts allocated allocated by swap dealers dealers to energy companie

companie

small and are the subject of a due diligence process that has been working:

– Aggregate capital drain that would come from not allowing margining threshold am

energy company would far outweigh the incremental benefit to the safety and sou

swap dealer.

– Such capital drain would likely lead to less investment, fewer jobs and more volati

rates.

– A better way to protect swap dealers would be to establish appropriate levels of ca

by swap dealers when dealing in OTC transactions with non‐swap dealers and non

participants that are not cleared or clearable.

• If swap parties are unable to continue to net financial transaction exposures 

power and gas transaction exposures as a result of the new regulations, unin

consequences would result:

– Separate margin requirements for OTC swaps would cause swap dealers and energ

revert to past practice of using separate agreements for different products.

– Additional capital may be required to satisfy margin calls (prior slides).– Capital may come in the form of loans, credit facilities, letters of credit, etc. that co

swap dealers’ total credit exposure – which the statute is intended to decrease.

• Many end‐user participants in energy markets, including EEI members and no

(i.e., munis and coops), are limited in their ability to pledge assets as collater

forms of capital capital and margin involve involve costs, requirements requirements should be appropria

appropria

Rules should not jeopardize netting benefit that causes ma

to be more liquid, and that enables enables swap dealers dealers and ene

companies to materially reduce their exposures to each o
Other Pertinent Issues

• Concepts of “Initial Margin” and “Variation Margin” are uniqu

cleared markets and do not have direct application to non

‐clea

– Variation margin on exchanges represents daily settlement of los– OTC market is structurall

y different • Collateral provided secures exposures: it is not used for daily settlement; settlem

• Providing additional margin on top of the amount necessary to cover exposure a

to the system; in

a closeout situation – even with

a zero threshold – it would hav

returned to the providing party

• Energy markets are not like market for mortgage

‐backed secur

and its derivative Collateralized Debt Obligation (CDO) market

– Prices and value are much more transparent – any valuation diffe

be resolved, so exposure aligns with true value at risk

– Asset‐based trading means risk is often “right‐way” risk: when m

increase, increase, so too does the value of the underlying underlying assets, assets, thereby thereby 

exposure to the financial system

• The ISDA Master Agreement is designed to work in tandem wi

bankruptcy law

– Swa

p

s and forwards are “Safe Harbored”

– The parties can exercise

a contractual right to terminate, liquidat

closeout all transactions, and set off margin held in satisfaction o

liquidated amount, notwithstanding the automatic stay that wou

otherwise apply under the federal bankruptcy code

– To the extent

a defaulting defaulting party is closed out owing amounts amounts grea

grea

posted collateral, the non‐defaulting party will be an unsecured c

(thus counterparties are keenly aware that prudent credit manag

vitally important to the health of their companies)
Points of Contact

Richard McMahon Aaron TrentExecutive Director, Finance

and Energy Supply

Manager, Financial A

202.508.5526

202.508.5571rmcmahon@eei.org

atrent@eei.org