Cherry-picking fears as banks pull negative rates commitments

As UK mulls negative rates, banks desert Isda protocol and traders warn of gaming the system

BoE-negative-rates-threat montage

As negative UK rates look more likely, a number of banks have pulled out of an industry commitment to make payments on collateral posted to cover mark-to-market derivatives losses in a negative rates environment – amid growing concerns about cherry-picking these payments. has learned that Citi, Commerzbank, Deutsche Bank, JP Morgan and Royal Bank of Canada have all revoked their adherence to an industry protocol – managed by the International Swaps and Derivatives Association – which is effectively triggered if rates dip below zero. 

For firms remaining in the protocol, outstanding trades with those that have withdrawn are unaffected. However, any new firm that subsequently adheres to the protocol will have different terms in place with those entities that have revoked their adherence.

"[Withdrawing firms] may have realised that signing left them in a difficult commercial position as they’d effectively made a free offer for their counterparties to adhere to negative rates if and when it suits them,” says Guy Usher, a partner at Fieldfisher. “Yet those banks couldn’t force anyone to adhere or agree bilaterally to negative rates – so the protocol was operating on a one-way basis [for them].”

A typical Isda credit support annex (CSA) provides that when one party receives cash variation margin from the other, it is supposed to pay interest on that amount, based on the overnight rate in the relevant currency. This has typically been Sonia in the UK, Eonia or €STR in euros, and Fed Funds or the secured overnight financing rate in US dollars (see figure 1).

If rates slide into negative territory, however, that party might argue it is entitled to receive – rather than pay – interest on the collateral posted by the initial party.

The protocol was designed to remove the confusion and confirm that negative rates applied. But while many banks signed up after Eonia went negative in 2014, users of other currencies like sterling didn't need to as the rate was positive. But as the UK approaches negative rate territory, this means the signed-up banks have essentially given clients a free option that allows them to cherry-pick by working out if they’re going to win by adhering to the protocol or not. 

That means a bank could be in a situation where clients that would owe negative interest rates decline to sign and therefore do not make the payments to the dealer, but the bank has to make payments to counterparties on the other side of the trade that had signed.

Banks couldn’t force anyone to adhere or agree bilaterally to negative rates – so the protocol was operating on a one-way basis [for them]
Guy Usher, Fieldfisher

“Imagine you have a large portfolio involving two counterparties who are hedging each other, and your risk-sensitivity exposure is at zero. You have $1 billion coming in on one side and $1 billion coming out on the other side. You’re thus perfectly hedged – until one counterparty suddenly stops paying the daily accrued mark-to-market [interest],” says the former global head of flow rates at a major dealer.

In this scenario, suddenly a large asymmetry is appreciating, he says: "You’ll be paying $1 billion but you won’t be receiving the accrued interest you should be given from your counterparty paying the other $1 billion. That’s a simple portfolio involving two counterparties – imagine a large portfolio with multiple counterparties.”

It’s likely for this very reason that banks such as Citi and Deutsche Bank have decided to revoke their adherence to the protocol, says Usher. 


“Some market participants haven’t signed up to the protocol as they don’t ever want to pay negative interest rates on a positive balance,” says a senior rates executive at one European bank. “If you haven’t signed the protocol, then it allows you to game the system because you can look at your portfolio and decide whether it would be beneficial or not to sign.”

The withdrawal of some dealers might also dissuade some clients from signing up. A counterparty might have a balanced book of unresolved CSAs with its banks and may be overall neutral about adhering to the protocol but, says Usher, “if adherence now will only resolve some of those CSAs, then signing may complicate the situation for them”.

“As the protocol only applies to trades within the time period you were signed up to it, anyone who subsequently signs up can’t enforce a negative interest rate on those banks who have now withdrawn from it.”

Another option would be to agree to apply the terms of the protocol bilaterally between two counterparties, says Usher. This would be privately negotiated between the parties and could involve payment of compensation.

Rate debate

The debate over whether the Bank of England’s monetary policy committee (MPC) will introduce negative UK interest rates has been ongoing since the start of the Covid pandemic. UK GDP fell by 20.4% during Q2 2020 alone – the largest decline since quarterly records began, according to the Office for National Statistics. It’s thought that negative interest rates are one of the remaining tools for the central bank to stimulate economic growth.

In October 2020, the BoE sent an open letter to market participants asking them how operationally ready they would be for negative interest rates. While this wasn’t designed to encourage banks to start preparing for negative rates, the central bank said, it sought “to understand firms’ operational readiness and challenges with potential implementation, particularly in terms of technology capabilities”.

It’s a letter that some market participants have taken as a clear sign that negative rates are on the horizon.

“The Bank of England has said on numerous occasions that negative rates are in their toolkit and they wouldn’t say that if they weren’t willing to use them,” says a global head of G10 interest rates at a European dealer.

In this scenario, market participants warn, disputes over whether negative interest should be payable on the collateral posted to cover mark-to-market losses within derivative transactions could proliferate.

One such dispute has already arisen between the state of the Netherlands and Deutsche Bank, when the former took the German bank to court over negative rates in 2019. The Court of Appeal ruled that Deutsche Bank did not have to pay negative interest on collateral posted to cover mark-to-market losses on derivatives trades dating back to 2001 as the Netherlands had not signed the Isda 2014 Collateral Agreement Negative Interest Protocol, which amends existing CSAs to apply negative interest rates.

The ruling has created a clear market precedent that negative interest is only payable when all parties have signed the protocol. But the former global head of flow rates doubts that many UK market participants have done so, given that negative rates has never been a reality for the UK up until now – thus leaving the door open to contract disputes.

“We’re not yet in a position where there is consensus on this topic. A lot of counterparties have not yet signed the protocol, don’t want to sign the protocol, or are not concerned with signing the protocol – in which case, negative rates become a bilateral issue between counterparties,” he says.



The European bank senior rates executive, whose bank remains signed up to the protocol says the dealer “felt responsible” to do so. However, he says, he doesn’t begrudge other banks for deciding to revoke their own adherence.

“In my mind, withdrawing from the protocol is perfectly acceptable as you prevent that free option from people gaming the system by not signing up themselves,” he says.

According to the global head of G10 interest rates at a European dealer, however, revoking adherence to the protocol goes against market practice.

“It strikes me as strange that any bank would break from standard market practice on this issue. Perhaps they think revoking is more beneficial from a commercial point of view as they may attract more business by not charging negative interest? But that does go against the grain of what we’ve already seen banks do in the market – so it strikes me as odd that a bank would decide to do that,” he says.

Citi and Commerzbank declined to comment on their rationale for leaving the protocol. Deutsche Bank, JP Morgan, and the Royal Bank of Canada did not respond to a request for comment before publication (see table A).

Ed Parker, partner at Mayer Brown, says that signing the protocol should be a priority for the market in order to prevent any disputes: “Problems arise when that protocol hasn’t been incorporated into an Isda CSA, and this opens the door to cherry-picking between negative rates and positive rates on posted cash, where there is a choice between currencies to post.”

In a perfect world, every party to a derivatives transaction would be signed up to the protocol, he says.

US not positive on negative rates

Jerome Powell
Federal Reserve
Fed chairman Jerome Powell says negative rates are not under consideration

While a similar discussion over the introduction of negative rates is taking shape in the US, market participants believe that such a situation is far less likely to occur in dollar rates, given the implications it could have for the US’s $5.1 trillion money markets.

“One of the main issues in the US is the way their markets are set up with money market funds – you can’t receive negative rates on those funds. So, introducing negative rates would destabilise the whole market,” says a global head of G10 interest rates at a European dealer, adding that this is clearly something the Fed or any central bank would want avoid. “The US introducing negative rates is very hard to envision. They would likely use every other tool possible before even contemplating it.”

Federal Reserve Chairman Jerome Powell indicated in May that the bank wasn’t thinking of turning to negative interest rates: “I know there are fans of the policy, but for now it’s not something that we’re considering.”

According to a senior European rates source, the US turning negative would likely have a much bigger impact on the derivatives market than that of the UK, given that the majority of derivatives CSAs make reference to dollars or euros, not sterling.

“Bearing in mind that the US is the global currency of trading, the situation would be much worse than in the UK. Negative US rates wouldn’t just affect the US economy or US transactions but would affect global transactions in US dollar swaps – it would be a much bigger problem,” he says.

He offers the low volume of sterling deals versus dollar deals with clients in Asia as an example.

“Maybe these clients never signed up to the protocol as they’re not involved in euros and so never had a need to do so. I don’t know for sure, but I could see the scope for dollars being more comparable to euros than sterling,” he says.

Correction, January 29, 2021: This article has been updated to note that legacy trades with a counterparty that subsequently revokes its adherence to Isda’s negative rates protocol are unaffected.

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