Negotiating and Documenting Swaps, OTC Derivatives and Credit and Collateral Support Agreements by Storm-7 Consulting

NEGOTIATING AND DOCUMENTING Swaps. OTC Derivatives and Credit and Collateral Support Agreements

NEGOTIATING AND DOCUMENTING: SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS Storm-7 Consulting

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NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017

TABLE OF CONTENTS TABLE OF CONTENTS ......................................................................................................................... 2 LIST OF TABLES ................................................................................................................................... 9 LIST OF FIGURES ............................................................................................................................... 10 CHAPTER 1: AN OVERVIEW OF SWAPS MARKETS, SWAPS INSTRUMENTS, AND FORWARDS INSTRUMENTS .................................................................................................................................... 11 1

CHAPTER 1 ABBREVIATIONS ................................................................................................. 11

2 AN OVERVIEW OF GLOBAL SWAPS MARKETS, SWAPS INSTRUMENTS, AND FORWARDS INSTRUMENTS. ......................................................................................................... 12 3

GLOSSARY OF SWAPS TERMS .............................................................................................. 18

AN OVERVIEW OF SWAPS MANAGEMENT POLICIES ......................................................... 20

4.1

Cross Currency Swaps in Debt Management ................................................................... 20

4.2

Swap Covered Foreign Currency Borrowing .................................................................... 21

4.2.1

Advantages of Cross-Currency Swaps ......................................................................... 22

4.2.2

Disadvantages of Cross-Currency Swaps .................................................................... 22

4.3

Using cross currency swaps in public debt management ................................................. 22

4.4

Motivations for swap-covered foreign currency borrowing ............................................... 23

4.5

The risks of swap-covered funding ................................................................................... 23

4.6

External debt and rollover risk ........................................................................................... 23

FOREIGN EXCHANGE RISKS .................................................................................................. 24 5.1

Currency risk ..................................................................................................................... 24

5.2

Interest rate risk................................................................................................................. 24

5.3

Replacement risk............................................................................................................... 24

5.4

Domestic market liquidity .................................................................................................. 24

5.5

Transaction Risk................................................................................................................ 24

5.6

Translation Risk................................................................................................................. 25

5.7

Economic Risk................................................................................................................... 25

FOREIGN EXCHANGE RISK MANAGEMENT ......................................................................... 26 6.1

Hedging Strategies ............................................................................................................ 26

6.2

Best Practices for Exchange Rate Risk Management ...................................................... 26

HEDGING INSTRUMENTS FOR MANAGING EXCHANGE RATE RISK ................................. 27 7.1

Foreign Exchange Risk Management ............................................................................... 28

7.2

FX Risk Management Options .......................................................................................... 28

7.3

Non-Hedging FX Risk Management Techniques .............................................................. 28

7.4

FX Forward Hedges .......................................................................................................... 29

7.5

FX Options Hedges ........................................................................................................... 29

7.6

Why Hedge Foreign Exchange Risk? ............................................................................... 29

7.7

Managing Foreign Exchange Risk .................................................................................... 29

7.8

Financial Hedging.............................................................................................................. 30

SUMMARY OF SWAP TYPES .................................................................................................. 30

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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AN OVERVIEW OF INTEREST RATE SWAPS ........................................................................ 33 9.1

Fixed for Floating Swap .................................................................................................... 33

9.1.1

Swaps Rationale ........................................................................................................... 34

9.2

Basis Swap ........................................................................................................................ 34

9.3

Overnight Index Swap ....................................................................................................... 34

9.3.1

OIS as Market Indicator Tools ....................................................................................... 35

9.4

Non-Deliverable Swap ...................................................................................................... 35

9.5

Forward Rate Agreements ................................................................................................ 36

9.6

Interest Rate Options ........................................................................................................ 36

AN OVERVIEW OF OTHER SWAPS INSTRUMENTS ........................................................ 36

10.1

Currency Swaps ................................................................................................................ 36

10.1.1

Currency Swap Risks ................................................................................................ 37

10.1.2

Currency Swap Benefits ............................................................................................ 37

10.1.3

Currency Swap Example ........................................................................................... 37

10.2

Commodity Swap .............................................................................................................. 38

10.2.1

The Characteristics of Commodity Swaps ................................................................ 39

10.2.2

The Parameters of Commodity Swaps ..................................................................... 39

SWAP SPECIFICATIONS..................................................................................................... 40

11.1

Example Fixed for Floating IRS (ICAP, 2013, pp.3-5) ...................................................... 41

11.1.1

Types of Commodity Swaps ..................................................................................... 44

11.2

Credit Default Swap .......................................................................................................... 44

11.3

Inflation Rate Swap ........................................................................................................... 45

11.4

Total Return Swap............................................................................................................. 46

11.5

Currency Forward.............................................................................................................. 47

11.6

Commodity Forward .......................................................................................................... 48

11.7

Valuation Principles ........................................................................................................... 48

CHAPTER 2: OPERATIONAL AND LEGAL RISKS AFFECTING SWAPS ...................................... 50 12

CHAPTER 2 ABBREVIATIONS ............................................................................................ 50

SWAPS RISKS AND SWAPS RISK MANAGEMENT .......................................................... 50

13.1

Duration Risk ..................................................................................................................... 51

13.2

Counterparty Credit Risk ................................................................................................... 51

13.2.1

Counterparty Risk Methodologies ............................................................................. 51

13.3

Operational Risk ................................................................................................................ 52

13.4

Replacement Risk ............................................................................................................. 52

13.5

Market Risk ....................................................................................................................... 52

13.6

Currency Risk .................................................................................................................... 53

13.7

Liquidity Risk ..................................................................................................................... 53

13.8

Rehypothecation Risk ....................................................................................................... 54

13.9

Legally Segregated Operationally Commingled (LSOC) .................................................. 54

13.9.1 13.10

LSOC without Excess and LSOC with Excess ......................................................... 55 Close Out Risk .............................................................................................................. 55

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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Legal Risk ...................................................................................................................... 56

13.12

Legal Risk and Netting .................................................................................................. 59

LEGAL OPINION ANALYSIS ................................................................................................ 60 ®

14.1

ISDA Opinions ................................................................................................................. 60

14.2

ISDA Opinion Library ....................................................................................................... 61

CASE LAW ANALYSIS AND RISK CASE STUDIES ........................................................... 62

15.1

Hazell v The Council of the London Borough of Hammersmith and Fulham and Others . 63

15.2

IMPORTANT POINTS TO REMEMBER ........................................................................... 63

15.3

Jefferson County Bankruptcy ............................................................................................ 64

15.3.1

Overview ................................................................................................................... 64

15.3.2

Background ............................................................................................................... 64

15.3.3

Controversy ............................................................................................................... 64

15.3.4

Bankruptcy Filing ....................................................................................................... 65

15.3.5

Bankruptcy Settlement .............................................................................................. 65

15.3.6

Settlement Details ..................................................................................................... 65

15.3.7

Impact........................................................................................................................ 66

15.3.8

Corruption and Legal Costs ...................................................................................... 66

15.3.9

The Future ................................................................................................................. 66

15.4

Marme Inversiones 2007 S.L. v The Royal Bank of Scotland Plc .................................... 66

15.5

IMPORTANT POINTS TO REMEMBER ........................................................................... 67

15.6

Dexia Crediop S.p.A (Dexia) v Comune di Prato .............................................................. 67

15.7 Italian Administrative Supreme Court (Decision No 5962 Judgement of the Consiglio di Stato, 27 November 2012) ............................................................................................................. 68 15.8

Lehman Brothers Holdings Inc. ......................................................................................... 68

15.9

1994 Procter and Gamble ................................................................................................. 69

15.10

Enron and Prepaid Commodity Swaps ......................................................................... 70

CHAPTER 3: NEGOTIATING AND DOCUMENTING SWAPS AGREEMENTS ............................... 71 16

CHAPTER 3 ABBREVIATIONS ............................................................................................ 71

SWAP PROCESS OVERVIEW ............................................................................................. 72

PRE-TRADE LEGAL AND COUNTERPARTY PROCESSES .............................................. 72

TRADE EXECUTION ............................................................................................................ 73

POST-TRADE PROCESSES................................................................................................ 73

20.1

Automated Swap Systems ................................................................................................ 74 ®

21 NEGOTIATING AND DOCUMENTING ISDA MASTER AGREEMENT PROVISIONS FOR SWAPS .............................................................................................................................................. 74 21.1

Terms and Conditions ....................................................................................................... 74

21.2

Payment Procedures ......................................................................................................... 75

21.3

Governing Law, Jurisdiction, and Disputes ....................................................................... 75

21.4

Competent Legal Authority in the Event of a Dispute ....................................................... 79

KEY SWAPS ISSUES ........................................................................................................... 79

22.1

Events of Default ............................................................................................................... 79

22.1.1

Failure to Pay or Deliver ............................................................................................ 80

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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Breach of Agreement; Repudiation of Agreement .................................................... 81

22.1.3

Credit Support Default ............................................................................................... 81

22.1.4

Misrepresentation ...................................................................................................... 82

22.1.5

Default under Specified Transaction ......................................................................... 82

22.2

1992 Agreement ................................................................................................................ 84

22.3

2002 Agreement ................................................................................................................ 84

22.3.1

Cross-Default ............................................................................................................ 85

22.4

1992 Master Agreement .................................................................................................... 86

22.5

2002 Master Agreement .................................................................................................... 86

22.6

Cross-Acceleration ............................................................................................................ 86

22.7

Specified Entity.................................................................................................................. 86

22.7.1

Bankruptcy ................................................................................................................ 87

22.7.2

Merger Without Assumption ...................................................................................... 88

22.8

Set-Off Rights .................................................................................................................... 88

22.9

Safe Harbor Rights ............................................................................................................ 89

22.9.1

Forward Contract under 11 U.S.C. §101(25) ............................................................ 90

22.9.2

Swap Agreement under 11.U.S.C. §101(53B) .......................................................... 90

22.10 23

Termination Risk ........................................................................................................... 92

TERMINATION EVENTS ...................................................................................................... 92

23.1

Illegality ............................................................................................................................. 92

23.2

Force Majeure Event ......................................................................................................... 93

23.2.1

Deferral of Payments ................................................................................................ 94

23.3

Tax Event .......................................................................................................................... 94

23.4

Tax Event Upon Merger .................................................................................................... 95

23.5

Credit Event Upon Merger ................................................................................................ 95

23.6

Additional Termination Event ............................................................................................ 96

23.7

Termination Notices .......................................................................................................... 96

EARLY TERMINATION ......................................................................................................... 97

24.1

Event of Default Termination............................................................................................. 97

24.2

Termination Event Termination ......................................................................................... 97

24.3

Automatic Early Termination ............................................................................................. 98

TERMINATION VALUE ......................................................................................................... 98

25.1

The Loss Method............................................................................................................... 99

25.2

The Market Quotation Method .......................................................................................... 99

25.3

The Close-Out Method ...................................................................................................... 99

25.4

Cancellation or Break Clauses .......................................................................................... 99

25.5

Cure Periods ..................................................................................................................... 99

25.6

Mismatch Risk ................................................................................................................. 100

25.7

Political Risk .................................................................................................................... 101

25.7.1 25.8

Political Risk in the ISDA Master Agreement .......................................................... 103

Force Majeure ................................................................................................................. 103

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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World Bank Group Sample Force Majeure Clause 1 .............................................. 104

25.8.2

World Bank Group Sample Force Majeure Clause 2 .............................................. 105

25.8.3

World Bank Group Sample Force Majeure Clause 3 .............................................. 107

CREDIT RATINGS .............................................................................................................. 109

26.1

Credit Ratings General Background ............................................................................... 109

26.2

Why assessing banks' creditworthiness is difficult .......................................................... 109

26.3

Accounting for external support: stand-alone versus all-in ratings ................................. 109

26.4

Accounting for systemic risk ............................................................................................ 109

26.5

Accounting for earnings volatility..................................................................................... 110

26.6

Ratings Case Study: Fitch ............................................................................................... 110

26.6.1

Fitch Information Used to Determine a Rating ........................................................ 110

26.6.2

Fitch Surveillance of Ratings ................................................................................... 111

26.6.3

Fitch Sovereign-Related Risk   ............................................................................... 111

26.6.4

Fitch Emerging Markets .......................................................................................... 112

26.6.5

Fitch Criteria Development ...................................................................................... 113

26.6.6

Fitch Timing of the Process ..................................................................................... 113

26.6.7

Fitch Long-Term International IFS Ratings Scale ................................................... 114

26.6.8

Fitch Corporate Finance Obligation – Long-Term Ratings Scale ........................... 115

26.6.9

Fitch Long-Term Issuer Credit Ratings Scale ......................................................... 116

26.6.10

Fitch Credit Ratings and Rating Scales .................................................................. 117

26.6.11

Rating Methodologies for Banks ............................................................................. 118

26.6.12

Differences Across Ratings Agencies ..................................................................... 119

26.6.13

Fitch Credit Ratings Scale ....................................................................................... 120

26.6.14

Fitch Short-Term IFS Ratings Scale ....................................................................... 120

26.6.15

Fitch Short-Term Ratings Scale .............................................................................. 121

CHAPTER 4: CREDIT SUPPORT AND COLLATERAL NEGOTIATION AND DOCUMENTATION FOR SWAPS ...................................................................................................................................... 122 27

CHAPTER 4 ABBREVIATIONS .......................................................................................... 122

NEGOTIATING AND DOCUMENTING THE ISDA CSA ................................................... 123

28.1

Overview of Counterparty Risks...................................................................................... 123

28.2

ISDA 2015 Margin Survey Results ................................................................................ 124

28.3

Overview of Types of CSA .............................................................................................. 124

28.4

1994 CSA (Security Interest – New York Law) ............................................................... 125

28.5

1995 English Credit Support Deed (Security Interest) .................................................... 125

28.6

1995 English Annex (Transfer – English Law) (Outright Transfer) ................................. 125

28.7

ISDA 2013 Standard Credit Support Annex (Security Interest - New York Law) ........... 125

28.8

ISDA 2013 Standard Credit Support Annex (Transfer - English Law) ............................ 125

28.9

ISDA 2014 Standard Credit Support Annex (Security Interest - New York Law) ........... 126

28.10

ISDA 2014 Standard Credit Support Annex (Transfer - English Law) ........................ 126

28.11

2016 Credit Support Annex for Variation Margin (VM) (Title Transfer – English Law)126

28.11.1

Independent Amount Provisions ............................................................................. 126

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 28.12 ISDA 2016 Credit Support Annex for Variation Margin (VM) (Security Interest - New York Law) 127 28.12.1

Independent Amount Provisions ............................................................................. 127

28.13

1994 ISDA Credit Support Annex (Subject to New York Law Only) ........................... 127

28.14

ISDA 1995 Credit Support Annex (Subject to English Law) ....................................... 127

28.15

Key Credit Provisions .................................................................................................. 128

ISDA CSA Paragraph 11 (English) or 13 (New York) Elections ......................................... 129

29.1

Security Interest .............................................................................................................. 130

29.2

Threshold Amount and Minimum Transfer Amount ........................................................ 130

29.3

Credit Support Amount .................................................................................................... 130

29.4

Independent Amount ....................................................................................................... 130

29.5

Segregation of Independent Amounts ............................................................................ 131

29.5.1

Direct Holding of Independent Amount ................................................................... 131

29.5.2

Third Party Custody Holding of Independent Amount............................................. 131

29.5.3

Tri-Party Collateral Agent Holding of Independent Amount .................................... 131

COLLATERAL ..................................................................................................................... 132

30.1

Collateral Exposure ......................................................................................................... 132

30.2

Eligible Collateral............................................................................................................. 133

30.2.1

LCH Eligible Collateral Policy.................................................................................. 133

30.2.2

SwapClear Eligible Collateral Policy ....................................................................... 135

30.3

Valuation Date, Valuation Time, Notification Time.......................................................... 135

30.4

Collateral Calls ................................................................................................................ 136

30.5

Transfer Timing ............................................................................................................... 136

30.6

Distributions and Interest Amount ................................................................................... 136

30.7

Failure to Deliver Margin and Cure Periods .................................................................... 137

30.8

Collateral Management Dispute ...................................................................................... 137

CREDIT POLICIES AND STRATEGIES............................................................................. 137

31.1

OTC Derivatives Policy ................................................................................................... 137

31.2

CSA Policy ...................................................................................................................... 138

31.3

Credit Risk Policy, Collateral Management, and Credit Enhancement Techniques ....... 138

31.4

Valuation Percentages or 'Haircuts' ................................................................................ 139

31.5

Bankruptcy-Remote Entities ............................................................................................ 140

LIQUIDITY MANAGEMENT ................................................................................................ 140

32.1

Liquidity Risk ................................................................................................................... 140

32.2

Contingent Liquidity Risk ................................................................................................. 140

32.3

BIS Principles for the management and supervision of liquidity risk .............................. 140

32.4

Custodial Services Offerings ........................................................................................... 142

COLLATERAL AND MARGIN TECHNOLOGY FIRMS ...................................................... 143

33.1

Bloomberg MARS Collateral Management ..................................................................... 143

33.2

CAARS Collateral Management...................................................................................... 144

33.3

NEX TriOptima (Tri Resolve and Tri Reduce) ................................................................. 145

33.3.1

TriResolve ............................................................................................................... 145

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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TriReduce ................................................................................................................ 146

NEX ENSO ...................................................................................................................... 148

33.4.1

ENSO Core ............................................................................................................. 148

33.4.2

ENSO Edge ............................................................................................................. 148

33.4.3

ENSO Control.......................................................................................................... 149

33.4.4

ENSO Locate .......................................................................................................... 149

33.4.5

ENSO Color............................................................................................................. 149

33.4.6

ENSO Broker Vote .................................................................................................. 150

33.4.7

Reporting and Extracts ............................................................................................ 150 ®

CHAPTER 5: THE ISDA MASTER AGREEMENT 2012: A MISSED OPPORTUNITY? ............... 151 34

CHAPTER 5 ABBREVIATIONS .......................................................................................... 151

INTRODUCTION ................................................................................................................. 151

AN OVERVIEW OF THE ISDA MASTER AGREEMENT 1992 .......................................... 153

AN OVERVIEW OF THE ISDA MASTER AGREEMENT 2002 UPDATES ........................ 156

LEGAL DEVELOPMENTS AFFECTING THE ISDA MASTER AGREEMENT FRAMEWORK 158

LAYING THE GROUNDWORK FOR THE ISDA MASTER AGREEMENT 2012 ............... 160

THE ISDA MASTER AGREEMENT 2012 ........................................................................... 161

CONCLUSION .................................................................................................................... 165 ®

CHAPTER 6: THE ISDA MASTER AGREEMENT: THE DERIVATIVES RISK MANAGEMENT ST TOOL OF THE 21 CENTURY? ....................................................................................................... 179 42

CHAPTER 6 ABBREVIATIONS .......................................................................................... 179

OVERVIEW ......................................................................................................................... 179

INTRODUCTION ................................................................................................................. 180

RISK MANAGEMENT AND FINANCIAL MARKETS .......................................................... 180

RISK MANAGEMENT AND OTC DERIVATIVES MARKETS ............................................ 182

RISK MANAGEMENT AND THE ISDA MASTER AGREEMENT ....................................... 184

SIGNIFICANT DEVELOPMENTS IN THE ISDA MASTER AGREEMENT FRAMEWORK 191

CONCLUSION .................................................................................................................... 194

DEFINITIONS...................................................................................................................... 196

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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LIST OF TABLES Table 1: Chapter 1 Abbreviations ......................................................................................................... 11 Table 2: Gross Notional Outstanding Volumes of IRD in US$ trillions ................................................. 13 Table 3: Adjusted Compressed Notional Outstanding (ACNO) Volume: IRD, US$ trillions ................. 14 Table 4: The Derived Gross Notional Outstanding Measure (DGNO) of Market Size in IRD, US$ trillions ................................................................................................................................................... 14 Table 5: Clearing Obligations for the United States, Japan, and the European Union (EU) (Rahman, 2015, p.288) .......................................................................................................................................... 17 Table 6: Managing Foreign Exchange Risk Stages .............................................................................. 29 Table 7: Different Types of Swap Instrument........................................................................................ 30 Table 8: Example Swap Terms ............................................................................................................. 49 Table 9: Chapter 2 Abbreviations ......................................................................................................... 50 Table 10: CHAPTER 3 Abbreviations ................................................................................................... 71 Table 11: Overview of the Swap Process ............................................................................................. 72 Table 12: ISDA 2002 Master Agreement Breach of Agreement Excluded Events ............................... 81 Table 13: Transaction and Specified Transaction................................................................................. 83 Table 14: 1992 ISDA Master Agreement Default under Specified Transaction Defaults ..................... 84 Table 15: 2002 ISDA Master Agreement Default under Specified Transaction Defaults ..................... 84 Table 16: Master Agreement Events of Default and Cure Periods ..................................................... 100 Table 17: Chapter 4 Abbreviations ..................................................................................................... 122 Table 18: Eligible Collateral Schedule (Adapted from ETF Securities, 2017) .................................... 132 Table 20: Chapter 5 Abbreviations ..................................................................................................... 151 Table 21: Chapter 6 Abbreviations ..................................................................................................... 179

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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LIST OF FIGURES Figure 1: Size of Global OTC Derivatives Markets by Outstanding Gross Notional Value (Rahman, 2015, p.285) .......................................................................................................................................... 15 Figure 2: Size of Global OTC Derivatives Markets by Outstanding Market Value of Contracts (Rahman, 2015, p.285) ......................................................................................................................... 15 Figure 3: Average Daily Turnover by Notional Value of Global OTC Derivatives in April 2013 (Interest Rate Derivatives) (Rahman, 2015, p.286) ............................................................................................ 16 Figure 4: Average Daily Turnover by Notional Value of Global OTC Derivatives in April 2013 (FX Derivatives) (Rahman, 2015, p.286) ..................................................................................................... 16 Figure 5: Fixed for Floating Swap Mechanics ....................................................................................... 33 Figure 6: Fixed-Floating Commodity Swap Mechanics ........................................................................ 38 Figure 7: Commodity-for-interest Swap Mechanics .............................................................................. 39 Figure 8: Credit Default Swap ............................................................................................................... 45 Figure 9: Inflation Rate Swap Mechanics ............................................................................................. 46 Figure 10: Zero Coupon Inflation Swap ................................................................................................ 46 Figure 11: Forward Contract used to Exchange £100,000 into Euros .................................................. 48 Figure 12: Duration Gap Equation ........................................................................................................ 51 ®

Figure 13: Definition of Market Quotation (1992 ISDA Master Agreement, Multicurrency, CrossBorder) .................................................................................................................................................. 55 ®

Figure 14: Definition of Loss (1992 ISDA Master Agreement, Multicurrency, Cross-Border) ............. 56 Figure 15: Model Clause for International Chamber of Commerce Rules (New York Seat) ................ 78 Figure 16: Section 10 of the 2002 ISDA Master Agreement............................................................... 103 Figure 17: Secured Party is Under-Collateralized .............................................................................. 132 Figure 18: Secured Party is Over-Collateralized................................................................................. 133 Figure 19: Example Eligible Collateral Definition (Collateral Asset Definitions) ................................. 133

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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CHAPTER 1: AN OVERVIEW OF SWAPS MARKETS, SWAPS INSTRUMENTS, AND FORWARDS INSTRUMENTS OUTLINE ■ ■

■

An Overview of Global Swaps Markets, Swaps Instruments, and Forwards Instruments. An Overview of Interest Rate Swaps (IRS) (Fixed for Floating, Basis, Overnight Index, NonDeliverable Swaps, Forward Rate Agreements, Interest Rate Options). An Overview of Currency Swaps, Commodity Swaps, Credit Default Swaps, and Total Return Swaps, Currency Forwards, Commodity Forwards. Swaps Specifications and Swap Leg Conventions.

CHAPTER 1 ABBREVIATIONS

■

Table 1: Chapter 1 Abbreviations ABBREVIATION

TERM

ACNO

Adjusted Compressed National Outstanding

AFCT

Adjustment Factor for Cleared Transactions

AGNO

Adjusted Gross Notional Outstanding

BIS

Bank for International Settlement

Basis Point

CCPs

Central Counterparties

CDS

Credit Default Swap

CHF

Swiss Franc

CIRCUS

Combined Interest Rate and Currency Swap

CPI

Consumer Price Index

CRP

Commodity Reference Price

DNGO

Derived Gross Notional Outstanding

EFTA

European Free Trade Association

EONIA

Euro OverNight Index Average

European Union

EUR

Euro

EURIBOR

European Interbank Offered Rate.

FIR

Fixed Interest Rate

FLIR

Floating Interest Rate

FLRD

Floating Rate Debt

FLRP

Floating Rate Payer

FRAs

Forward Rate Agreements

FRD

Fixed Rate Debt

FRP

Fixed Rate Payer

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 ABBREVIATION

TERM

FSMA

Financial Services and Markets Act 2000

GBP

Great British Pound

GNV

Gross Notional Volume

IRD

Interest Rate Derivatives

IRO

Interest Rate Option

IRS

Interest Rate Swap

JPY

Japanese Yen Regional

LIBOR

London Interbank Offered Rate

NDS

Non-Deliverable Swap

NPV

Net Present Value

OIS

Overnight Index Swap

OISR

Overnight Index Swap Rate

ORMS

Optimal Rate Management Strategy

OTC

Over-the-counter

PEN

Peruvian Sol

PTA

Purified Terephthalic Acid

RPI

Retail Price Index

SONIA

Sterling Overnight Index Average

TONAR

Tokyo Overnight Average Rate

TRS

Total Return Swap

United Kingdom

United States

USD

United States Dollars

AN OVERVIEW OF GLOBAL SWAPS MARKETS, SWAPS INSTRUMENTS, AND FORWARDS INSTRUMENTS.

ISDA (2014). The Value of Derivatives. The International Swaps and Derivatives Association. •

Derivatives users are institutional customers, corporations, investment managers, governments, insurers, energy and commodities firms, international banks, regional banks and financial institutions.

•

Derivatives are transacted around the world in more than 30 currencies.

•

Derivatives are used in the manufacturing, transportation, and international trade sectors, and are also used to hedge fuel costs, to hedge financing costs, and to hedge exposure in international markets to exchange rates.

•

It was noted that the total notional outstanding amount for all over-the-counter (OTC) th derivatives instruments was $693 trillion (as of 30 June 2013).

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 •

Interest rate swaps were the largest market with total notional outstanding of $437 trillion, forward rate agreements formed $89 trillion total notional outstanding, foreign exchange derivatives held $81 trillion outstanding, options held $50 trillion outstanding, credit default swaps held $25 trillion outstanding, equity derivatives held $7 trillion outstanding, and commodity derivatives held $3 trillion outstanding.

•

In terms of non-clearable interest rate derivatives, swaptions and cross-currency swaps held the highest amount of notional outstanding at $30 trillion each, options held $12 trillion notional outstanding, inflation swaps held $3 trillion notional outstanding, and other types of non-clearable interest rate derivatives held $4 trillion notional outstanding.

ISDA (2015). ISDA Research Note OTC Derivatives Market Analysis: Interest Rate Derivatives. (January) The International Swaps and Derivatives Association. •

The Bank for International Settlements (BIS) reported a 3.6% decrease in Interest Rate Derivatives (IRD) gross notional outstanding figures in the six months to 30 June 2014 (from $584.4 trillion to $563.3 trillion).

•

The proportion of the market being cleared has increased significantly since December 2007, with an estimated 69.3% ($230.6 trillion) of the IRD market cleared by June 2014.

•

Approximately 95% of clearable IRD products are already being cleared, and other currencies and IRD products may be cleared over time.

•

Total Over-the-counter (OTC) derivatives notional outstanding was $691.5 trillion at the end of June 2014 according to the BIS.

•

Although useful the gross notional outstanding metric is not adjusted for the effects of clearing and compression. Clearing means that the size of the market is overstated as cleared trades are reported twice in BIS statistics, and compression means that the size of the market is understated because offsetting tickets are torn up.

Table 2: Gross Notional Outstanding Volumes of IRD in US$ trillions Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Jun-12

Dec-12

Jun-13

Dec-13

Jun-14

399.1

432.1

449.9

465.3

504.1

494.4

489.7

561.3

584.4

563.3

54.4

75.8

107.7

124.2

141.9

152.8

170.7

201.8

227.7

230.6

54.4

75.8

107.7

124.2

141.9

152.8

170.7

195.5

213.0

206.8

n/a

3.0

9.1

15.6

JSCC gross national outstanding

n/a

3.3

5.6

8.2

(AGNO) Adjusted Gross National Outstanding

338.7

356.3

342.2

341.1

362.2

341.6

319.0

369.5

356.7

332.7

(RGNO) BIS Reported Gross National Outstanding (AFCT) Adjustment Factor For Cleared Transactions LCH Clearnet (single counted) gross national outstanding CME gross national outstanding

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Pct (%) Cleared Gross National Outstanding

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Jun-12

Dec-12

Jun-13

Dec-13

Jun-14

16.1%

21.3%

31.5%

36.4%

39.2%

44.7%

53.5%

56.1%

63.8%

69.3%

RGNO

BIS reported gross notional outstanding volume of interest rate derivatives from December 2007.

AFCT

CCP data used to determine the level of bilateral IRD outstanding that has been cleared and double counted. This metric represents the adjustment factor for cleared transactions. At 30 June 2014 the AFCT was $230.6 trillion.

AGNO

The notional outstanding size of the market referred to as Adjusted Gross Notional Outstanding (AGNO) would be $332.7 trillion if there was no cleared volume in the IRD space.

ISDA (2015, p.8) notes that "Compression is an administrative process where offsetting trade tickets are netted into a single line item. Although the risk profile is unchanged, this procedure has the effect of reducing gross notional outstanding because the process produces a net notional result. In order to further refine the AGNO metric, we must therefore add back compressed volume in order to better understand the market for interest rate derivatives." Table 3: Adjusted Compressed Notional Outstanding (ACNO) Volume: IRD, US$ trillions

(ACNO) Adjusted Compressed National Outstanding Adjusted CCP compression Non-CCP compression

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Jun-12

Dec-12

Jun-13

Dec-13

n/a

94.7

113.8

125.2

131.8

134.1

184.9

n/a

41.7

60.1

72.6

80.9

83.9

134.2

n/a

52.9

53.7

52.6

50.9

50.3

50.7

Jun-14

ISDA (2015) notes that the BIS reported a 3.6% decrease in IRD gross notional outstanding figures in the six months to 30 June 2014, from $584.4 trillion to 563.3 trillion. However, after factoring out the impact of clearing and compression it was found that the Gross Notional Volume (GNV) had actually increased 5.5% during this time. ISDA (2015) notes that the IRD gross notional outstanding reported by the BIS (year-end 2011 through June 2014) increased by 11.7%. However, after factoring out the impact of clearing and compression, GNV has increased slightly more than the BIS amount (13.3%) (ISDA, 2015). Table 4: The Derived Gross Notional Outstanding Measure (DGNO) of Market Size in IRD, US$ trillions

(RGNO + ACNO) Market Without Compression (RGNO) BIS Reported Gross National Outstanding (AGNO) Adjusted Gross National Outstanding (ACNO) Adjusted Compressed

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Jun-12

Dec-12

Jun-13

Dec-13

Jun-14

n/a

598.8

608.2

614.9

693.1

718.50

748.2

393.1

432.1

449.9

465.3

504.1

494.4

489.7

561.3

584.4

563.3

338.7

356.3

342.2

341.1

362.2

341.6

319

359.5

356.7

332.7

n/a

94.7

113.8

125.2

131.8

134.1

184.9

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National Outstanding (DGNO) Derived Gross National Outstanding

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Jun-12

Dec-12

Jun-13

Dec-13

Jun-14

n/a

456.9

455.4

444.2

491.3

490.8

517.6

Rahman, A. (2015). Over-the-counter (OTC) derivatives, central clearing and financial stability. Central Bank of England Financial Market Infrastructure Directorate. •

As of 2014 the OTC derivatives market had grown to approximately US$630 trillion in terms of outstanding notional value.

•

Approximately 50% of interest rate contracts and 20% of credit derivative contracts outstanding globally are now centrally cleared.

•

Since the introduction of the clearing obligation in the United States (US) in 2013, 80% of new interest rate contracts and 70% of new credit derivative contracts have been centrally cleared.

•

The United Kingdom (UK) is the single largest global venue for OTC derivatives activity, accounting for almost half of all global activity in interest rate derivatives, and over a third of global activity in foreign exchange derivatives contracts. It is home to four Central Counterparties (CCPs) which account for most of the cleared activity in OTC interest rate derivatives globally, and a substantial proportion of the cleared activity in the other asset classes.

•

To date, regulators around the world have focused on four main interest rate derivatives contract and one main type of Credit Default Swap (CDS): (1) plain vanilla Interest Rate Swaps (IRS); (2) basis swaps; (3) Forward Rate Agreements (FRAs); Overnight Index Swaps (OIS); and CDS Index contracts.

Figure 1: Size of Global OTC Derivatives Markets by Outstanding Gross Notional Value (Rahman, 2015, p.285)

Figure 2: Size of Global OTC Derivatives Markets by Outstanding Market Value of Contracts (Rahman, 2015, p.285)

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Figure 3: Average Daily Turnover by Notional Value of Global OTC Derivatives in April 2013 (Interest Rate Derivatives) (Rahman, 2015, p.286)

Figure 4: Average Daily Turnover by Notional Value of Global OTC Derivatives in April 2013 (FX Derivatives) (Rahman, 2015, p.286)

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2017 Table 5: Clearing Obligations for the United States, Japan, and the European Union (EU) (Rahman, 2015, p.288) Jurisdiction

Asset class

Effective from

Currencies(b)

Maturities

United states

IRS Basis FRA OIS CDS Indices

11 March 2013

USD, EUR, GDP, JPY

28 days- 50 years (30 years for JPY)

USD, EUR, GDP USD, EUR

3 days- 3 years 7 days- 2 years Mainly 5 years, some 3, 7, 10 years

IRS Basis IRS Basis CDS Indices

1 November 2012

JPY

Up to 30 years

JPY, EUR

Up to 10 years

JPY

5 yearsÂŠ

USD, EUR, GDP, JPY

28 days- 50 years (30 years for JPY)

USD, EUR, GDP

3 days- 3 years 7 days- 3 years 5 years 28 days- 15 years 28 days- 5 years 3 days- 2 years 3 days- 1 year

Japan

1 July 2014 1 November 2012

IRS Basis FRA OIS CDS Indices IRS FRA

2016

In consultation

EUR SEK CZK, DKK, HUF, NOK, PLN SEK NOK, PLN

Darringer, B.S. (2014). Swaps, banks, and capital: an analysis of swap risks and a critical assessment of the Basle Accords treatment of swaps, University of Pennsylvania Journal of International Law, Vol. 16, Issue 2, pp.1-79). Derivatives are extremely important because they facilitate the ability to transfer and accept risks, enabling entities to hedge against fluctuations in profits which may be caused by changes in exchange rates, interest rates, commodity prices, or equity prices. Complex risks that are bound together in traditional instruments can be teased apart and managed more effectively and inexpensively because transaction costs in the derivatives markets are very low. Efficiency gains are created when risks are shifted to those best able to bear them (Darringer, 2014, p. 265). One of the first major interest rate swaps occurred in August 1981 when the World Bank issued $290 million Eurobonds and swapped the interest and principal on those bonds with IBM for Swiss francs and German marks. It was put together by Salomon Brothers. In 1992 the amount of outstanding interest rate and currency swaps was almost $3 trillion. Historically swaps could be used to circumvent capital controls that had been put in place. For example, the swap takes the financial transaction outside of the jurisdiction of a regulatory body. In the 1970 foreign exchange controls were put in place in the UK in order to prevent an outflow of British capital. The British Government had imposed taxes on foreign exchange transactions in order to stimulate domestic investment. During such period companies were undertaking a series of backto-back loans in order to circumvent the foreign exchange controls and to avoid paying foreign exchange taxes. These arrangements were subsequently reformulated as swaps agreements leading to more sophisticated interest rate swaps and cross-currency swaps with banks and investment houses. Backto-back loans were more time consuming as they involved two legally distinct loans and they were characterised as on-balance-sheet transactions. In their early years swaps were considered off-balance-sheet and could incorporate a right-of-offset in the event that a counterparty defaulted under the swap agreement. Swaps were subsequently created as a means to circumvent these foreign-exchange controls. Derivatives are financial instruments ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 whose value derives from changes in the value or level of the underlying financial instrument. For interest rate swaps there is no initial net investment and settlement occurs at a specified date in the future or over a series of future dates. The typical purpose behind a swap agreement is to balance the asset-liability structures of each swap counterparty. The market for U.S. dollar IRS (under 10 years) is highly competitive, there are lots of swap dealers on the market, bid/ask spreads are typically less than 5 basis points (bp), and bid-offer spreads for IRS vary roughly between 1 and 10 bp.

GLOSSARY OF SWAPS TERMS

TERM

DESCRIPTION

Amortization Effect

A business uses amortization to spread the cost of an intangible asset over its useful life, or the life of the intangible asset in the business. An intangible asset is one without a physical presence, such as a patent. This amortization process reduces a company's assets and stockholders' equity on its balance sheet. An amortized loan is a loan with scheduled periodic payments that consist of both principal and interest. An amortized loan payment pays the relevant interest expense for the period before any principal is paid and reduced. In banking and finance, an amortizing loan is a loan where the principal of the loan is paid down over the life of the loan (that is, amortized) according to an amortization schedule, typically through equal payments. ... Compare with a sinking fund, which amortizes the total debt outstanding by repurchasing some bonds.

Bank AAA-Subsidiaries

AAA is the highest possible rating assigned to an issuer's bonds by credit rating agencies. An AAA-rated bond has an exceptional degree of creditworthiness, because the issue can easily meet its financial commitments. The ratings agencies Standard & Poor's (S&P) and Fitch Ratings use the AAA to identify bonds with the highest credit quality, while Moody's uses AAA is the top credit rating. A type of foreign bank that is incorporated in the host country but is considered to be owned by a foreign parent bank. The subsidiary bank only needs to operate under the host country's regulations. One of the drawbacks of operating a subsidiary bank is that the amount of loans that the bank can make is much less than what a foreign branch bank can make. However, one benefit that makes up for that drawback is a subsidiary bank's ability to underwrite securities.

Comparative advantage

There are different spreads available in fixed rate corporate bond markets and floating rate markets. These spreads result from credit risk being a function of time to maturity of a bond.

Credit Risk Anomolies

Theoretically swaps are equivalent to an exchange of bonds carried out by corporate entities (i.e. corporate bonds) but according to Litzenberger (1992) they do not exhibit the same features: (1)

the swap rates that are quoted do not reflect credit rating differences between counterparties;

(2)

the swap spreads do not display the volatile cyclical behaviour of corporate bond spreads;

(3)

bid-ask spreads (around 5bp) are much lower than those on

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DESCRIPTION corporate bonds and sometimes even government bonds. Litzenberger, R. H. (1992). Swaps: Plain and Fanciful. The Journal of Finance, Volume 47, Issue 3, (July), pp.831-850.

Diffusion Effect

The diffusion effect is the pattern of risk associated with the time pattern of financial prices and their tendency to take on wider, more dispersed, values over time. The diffusion effect implies greater risk as a swap matures. The first effect of the passage of time on potential exposure is that it increases the probability that the underlying variable will drift substantially away from its initial value. This diffusion effect is determined by the volatility of the underlying variable and its other stochastic properties. The second effect of the passage of time, called the amortization effect, is the reduction in the number of years of cash flows that need to be replaced. The amortization effect is the pattern of risk associated with the decline in the number of cash exchanges between counterparties as a swap matures. The amortization implies reduced risk as a swap matures.

EURIBOR

The Euro Interbank Offered Rate (Euribor) is a daily reference rate, published by the European Money Markets Institute, based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market (or interbank market).

Events of Default

An event of default is an action or circumstance that causes a lender to demand full repayment of an outstanding balance sooner than it was originally due. ... An event of default enables the lender to seize any collateral that has been pledged and sell it to recoup the loan.

Forward Curve

Future Curve also called Forward Price Curve is the current price for a commodity in a specific location on a specified date in the future. A Future Curve consists of a series of forwarded prices plotted together, reflecting a range of today's tradable values for specified dates in the future.

Forward Delta

Forward delta is 1 (defined as change in the value of the forward with respect to an instantaneous change in the price of the underlying, holding everything else constant). ... The opposite when asset prices fall, you need to deposit variation margin and need to borrow at higher rates.

Hedging

Hedging refers to the combinations of trades on financial derivative instruments and/or security positions which do not necessarily refer to the same underlying asset. Trades on those instruments and/or positions are concluded with the sole aim of offsetting risks linked to positions taken through other instruments and/or positions.

In-the-money swap

A swap is considered to be 'in-the-money' if the expected net present value (NPV) of cash receipts minus cash payments is positive, i.e. the swap owner must be paid by the counterparty to exit the swap.

LIBOR

The London Interbank Offered Rate. LIBOR is the mean interest rate that banks charge each other for short-term, unsecured loans. The term rates (e.g. overnight to one year) are published on a daily basis. The interest charges on financial retail products (e.g. loans, credit cards,

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DESCRIPTION mortgages) are linked to one of these LIBOR rates.

Mark-to-market

When a counterparty marks its portfolio of swaps to market, this means that it calculates the NPV of all expected cash flows to be paid or received under the swap. The floating side of the swap can be calculated as an estimation using the term structure of interest rate future contracts or forward interest rates.

Netting

Netting refers to the combinations of trades on financial derivative instruments and/or security positions which do not necessarily refer to the same underlying asset. Trades on those instruments and/or positions are concluded with the sole aim of offsetting risks linked to positions taken through other instruments and/or positions.

Out-of-the-money swap

A swap is considered to be 'out-of-the-money' if the expected NPV of cash receipts minus cash payments is negative, i.e. the swap owner must pay the counterparty to exit the swap.

Spot Rate

The price quoted for immediate settlement on a commodity, a security or a currency. The spot rate, also called "spot price," is based on the value of an asset at the moment of the quote.

Swap Dealers

These typically tend to be large commercial banks, investment banks, or securities firms, as well as end-users who are also banks, financial institutions, and large industrial firms.

Tenor

This refers to the maturity of a swap.

Zero Curve

A zero curve is a special type of yield curve that maps interest rates on zero-coupon bonds to different maturities across time. Zero-coupon bonds have a single payment at maturity, so these curves enable you to price arbitrary cash flows, fixed-income instruments, and derivatives.

Zero Delta

A delta neutral position is one in which the overall delta is zero, which minimizes the options' price movements in relation to the underlying asset.

AN OVERVIEW OF SWAPS MANAGEMENT POLICIES

A corporate may hold investments that are subject to variations in the value of the underlying assets held due to market movement. The present value of future liabilities will be subject to change caused by fluctuation in the discount rate used in the liability valuation process (i.e. changes in $ yield rates required at each time horizon). A corporate can manage interest rate risk by matching assets to liabilities using numerous practices such as matching liability cash flows using zero coupon bonds, matching the average duration of assets and liabilities, or using derivatives to create an immunisation overlay (hedge).

4.1

Cross Currency Swaps in Debt Management

Cross Currency Swaps can increase the number of funding and risk management operations at a debt manager's disposal, by exchanging debt servicing flows in a given currency for another. Cross Currency Swaps can be used to facilitate the transformation of the composition of the debt portfolio, often reducing financial risks, or executing funding operations in a more cost effective manner. ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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Cross Currency Swaps can help reduce foreign exchange exposure by swapping payout flows in a foreign currency for payments in a local currency. The instruments allow debt managers to dedollarise or euroize their portfolios rapidly allowing them to move closer to the desired currency composition. Cross Currency Swaps can also be used to delink funding from foreign currency exposure thereby helping them to access funding sources that were normally out of their reach. This can help debt managers in diversifying funding sources and reducing refinancing risk. Cross Currency Swaps can also be used to reduce funding costs by exploiting arbitrage opportunities. The main benefits of Cross Currency Swaps are to achieve the desired composition of the debt portfolio, to tap new markets and investors, and to extend maturities. A steepening of the yield curve will make strategies for converting fixed rate debt (FRD) to floating rate debt (FLRD) even more attractive. Notwithstanding an issuer's optimal rate management strategy (ORMS), the term debt issuance process may often overweigh the issuer's rate sensitivity towards fixed rate exposure. In order to ensure that Cross Currency Swaps are managed effectively, firms must ensure that they have a complete infrastructure in place that allows them to effectively monitor their use of Cross Currency Swaps. This will include putting in place over-the-counter (OTC) derivatives policies, credit risk policies, collateral and liquidity management systems, valuation systems, accounting systems, settlement systems, and collateral monitoring systems.

4.2

Swap Covered Foreign Currency Borrowing

The benefits of entering into a Cross-Currency Swap: (1)

Cross-Currency Interest-Rate Swaps allows firm to switch its loan from one currency to another. They also allow it to choose whether it have fixed- or floating-rate interest;

(2)

the swap allows firm to borrow in the currency which will gives it the best terms. The firm can use Cross-Currency Interest-Rate Swaps to switch the loan back into any currency it chooses;

(3)

Cross-Currency Interest-Rate Swaps can reduce foreign currency exposures. The firm can use money it receives in foreign currency to pay off its loans when it switches them;

(4)

the firm can protect itself against changes in interest rates by creating fixed-rate loans.

Cross-Currency Swap features: (1)

any bank can provide Cross-Currency Interest-Rate Swaps. The firm does not have to use the bank who provided the original loan;

(2)

banks can tailor Cross-Currency Interest-Rate Swaps to meet your needs. Banks provide Cross-Currency Interest-Rate Swaps for loans in all the major currencies. Maturities are generally up to 5 years but can be longer;

(3)

banks can arrange a Cross-Currency Interest-Rate Swaps before the loan is received. These are generally known as Forward-Start Cross-Currency Interest-Rate Swaps;

(4)

the firm can cancel a Cross-Currency Interest-Rate Swap at any time, but this may be very expensive if interest rates or foreign exchange rates have changed and work against it.

Parameters of a Cross-Currency Swap: (1)

Start date;

(2)

Maturity date;

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(3)

the exchange rate used between the two currencies;

(4)

the notional amounts on which the interest flows are calculated;

(5)

the exchange of notional amounts at maturity;

(6)

exchange, or not, of notional amounts at start date;

(7)

the frequency of the interest payments (Quarterly, Semi-annual or Annual);

(8)

the interest rate basis (Money market, Bond Basis).

Like FX forwards, three things influence the price and value of a Cross Currency Swap: (1)

The yield on currency one;

(2)

The yield on currency two;

(3)

The spot exchange rate.

There are three clear target markets: (1)

investors who wish to purchase foreign assets but seek to eliminate foreign currency exposure;

(2)

Debt issuers who can achieve more favourable rates by issuing debt in foreign currency;

(3)

Liability managers seeking to create synthetic foreign currency liabilities.

4.2.1 Advantages of Cross-Currency Swaps (1)

Off Balance Sheet;

(2)

Can be cheaper than the cash markets (i.e. issuing foreign currency bonds directly);

(3)

Can elect to exchange principal at the start if desired;

(4)

Simple documentation compared to cash markets (i.e. issuing a bond, arranging a loan);

(5)

Can be customised;

(6)

Can be reversed at any time (albeit at a cost or benefit).

4.2.2 Disadvantages of Cross-Currency Swaps (1)

Unlimited loss potential.

4.3

Using cross currency swaps in public debt management

By exchanging debt servicing flows in a given currency for another, cross currency swaps (CCS) increase the number of funding and risk management operations at a debt manager's disposal. CCS are a vehicle for reducing the FX exposure by swapping payout flows in foreign currency for payments in local currency. CCS also offer debt managers the possibility to delink funding from foreign currency exposure, encouraging them to access funding sources that were normally out of their reach and thus helping to diversify their funding sources, which is a key vehicle for reducing refinancing risk.

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2017 As with any financial instrument, the usefulness of CCS depends on the application being made. To be able to execute a CCS in the market, a complete infrastructure needs to be in place including legal agreements, credit risk policies, collateral and liquidity management, and systems for valuation, accounting and settlement.

4.4

Motivations for swap-covered foreign currency borrowing

There are two commonly cited explanations for the use of swaps: (1)

risk management; risk management is undeniably an important motivation for the general use of currency swaps. However, changes in operations and financial structures cannot explain swap-covered borrowing; by definition, such borrowing is intended to replicate risks, not to transform them.

(2)

comparative advantage; comparative advantage is a more convincing motivation for swap-covered foreign currency borrowing. Indeed, central banks in countries with large volumes of swap-covered borrowing frequently cite comparative advantage as the key motivation for such borrowing.

4.5

The risks of swap-covered funding

The use of foreign currency bonds to raise local currency debt indirectly can pose risks to the financial stability of both the borrower and the borrowing economy. Swap-covered debt is a more complex product than direct borrowing, so puts greater demands on the risk management capacity of the borrower and the regulator in terms of currency risk, counterparty risk, rollover risk, and interest rate risk. Of these the most important is probably rollover risk.

4.6

External debt and rollover risk

An important concern associated with synthetic local currency borrowing is a rapid increase in external indebtedness. Where it has been widely used, there are typically large gross or net external debt positions. Many of the potential motivations discussed above suggest that borrowers previously restricted to borrowing local currency directly may be able to access cheaper funding or a wider pool of funding by overcoming market rigidities. The bulk of swap-covered financing involves financial intermediaries, and so maturity mismatch is a potential concern. Maturity mismatch may lead to rollover risk on two levels, during the tenor of the swap and at maturity of the swap. If the swap does not match the foreign currency debt and local currency assets in terms of tenor and coupon structure, as well as currency, then the borrower may face currency risk, rollover risk and interest rate risk. Even if the swap matches assets and liabilities, rollover risk will re-emerge at maturity of the swap if the debt needs to be rolled over (for example, if net external debt is large). The same is true for wholesale funding in local currency. Both tend to be less stable than the domestic deposit base which typically benefits from deposit insurance. Non-resident investors may be a particularly unstable funding source, providing funding during expansions when the local currency is expected to appreciate, and withdrawing funding during times of stress if the local currency is expected to depreciate. The ability to substitute domestic funding for large volumes of external funding (direct or swap-covered) may be very limited Swap-covered borrowing requires rollover in both funding and hedging markets. This added complexity may increase risk relative to external local currency funding. Swap-covered borrowing may allow a borrower to diversify funding sources. Among integrated financial systems, however, market liquidity is likely to be highly correlated so that diversification of the funding base may offer little scope for reducing rollover risk.

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2017 Diversifying the funding base from the domestic market (in the periphery) to the US markets (the centre) may normally be considered a good approach to reducing liquidity risk as US markets are normally very liquid and may be resilient to stress in the periphery. Stress in the centre, however, is likely to spread to smaller markets in the absence of exchange controls. A sharp rise in the cost of foreign currency funding may translate rapidly to a rise in the cost of local currency funding. With some degree of segmentation among markets, however, there may be some scope to reduce market risk.

FOREIGN EXCHANGE RISKS

5.1

Currency risk

The ability to hedge currency risk is a major potential benefit of swap-covered borrowing for an emerging economy that has difficulty borrowing in its own currency. It can potentially benefit from access to international financial markets without currency mismatch if a non-resident can successfully issue local currency debt to provide a swap counterparty (if exchange controls do not prohibit).

5.2

Interest rate risk

Even if borrowings are structured so that currency and tenor are hedged, interest rate risk could still be a problem if local currency income and local currency payments under the cross currency swap are not matched. For example, if a domestic bank swaps foreign currency payments for fixed term local currency payments, but has floating rate local currency income (or vice versa) it may face difficulty if monetary policy is adjusted rapidly. Liquid local currency interest rate swap markets help manage interest rate risk.

5.3

Replacement risk

Swaps are generally traded in over-the-counter markets. While this allows customization of products, without central clearing the two borrowers assume each other's credit risk. Various hedged risks, including currency risk, can re-emerge if one counterparty to the swap defaults. When one counterparty fails, the other may be left with a mismatched position due to interest rate or currency fluctuations. For example, suppose the minor currency resident holds minor currency principal as collateral but has US dollar liabilities at maturity. If the minor currency depreciates sharply, losses could be substantial. Bilateral netting and collateral arrangements are widely used to reduce the risks associated with a counterparty default. Central clearing may reduce risks further by providing a highly rated central counterparty, requiring positions to be marked to market daily, and making use of multilateral netting through offsetting long and short positions.

5.4

Domestic market liquidity

A potential concern regarding synthetic debt is that offshore issuance may take liquidity from the domestic market. Swap-covered borrowing itself does not necessarily reduce the size of the local currency market. Rather, it changes the composition of issuers in the market from domestic borrowers to non-resident borrowers. However, if non-resident borrowers prefer to issue on the offshore markets, there may be a loss of liquidity in the domestic market.

5.5

Transaction Risk

Transaction risk is the exchange rate risk associated with the time delay between entering into a contract and settling it. The greater the time differential between the entrance and settlement of the contract, the greater the transaction risk, because there is more time for the two exchange rates to fluctuate. Transaction risk refers to the potentially detrimental effect of changes in the exchange rate during the period between commitment to a contract and its subsequent settlement. Transaction risk creates difficulties for individuals and corporations dealing in different currencies, as exchange rates can fluctuate significantly over a short period of time. This volatility is usually reduced, or hedged, by entering into currency swaps and other similar securities. When two companies ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 working in different currencies enter into a contract together involving a monetary transaction, the interval between entering the contract and payment represents a period of potential currency risk due to the volatility of exchange rates, which can fluctuate considerably within a short period of time. In order to protect their financial position from this risk, companies often buy FX hedging products such as a forward contract or an options contract. The potentially adverse effects of transaction risk can be severely damaging. A sudden movement in the exchange rate means a purchasing company may have to pay a lot more capital in order to complete payment for the transaction in the supplier's currency. It has the potential to wipe out or cut profits, and can even lead to a default on payment. Companies often engage in transactions involving more than one currency. In executing these transactions, companies must repatriate any foreign currencies received as payment. This repatriation occurs at a market exchange rate which is vulnerable to fluctuation. These transactions usually comprise a lag between execution and settlement. In this respect, transaction risk is the risk that the relevant exchange rate will unfavourably fluctuate during this lag, resulting in potentially serious losses to the company in question. To illustrate, suppose there is a three-day lag between a transaction's execution and settlement. The company is receiving payment in GBP which they must repatriate into USD -- their local currency. Transaction risk is the risk that the GBP-USD exchange rate will decrease during this three-day lag. Transaction risk increases as the time lag widens between a transaction's execution and settlement. Just as transaction risk comprises the risk of loss, it also comprises the possibility of gains should a favourable exchange rate movement occur.

5.6

Translation Risk

The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. It is the risk that foreign exchange rate fluctuations will adversely affect the translation of the subsidiary's assets and liabilities, denominated in foreign currency, into the home currency of the parent company when consolidating financial statements. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk. This poses a serious threat for companies conducting business in foreign markets. Exchange rates usually change between quarterly financial statements, causing significant variances between the reported figures. Companies attempt to minimize these transaction risks by purchasing currency swaps or hedging through futures contracts. Exchange-rate risk, also called currency risk, is the risk that changes in the relative value of certain currencies will reduce the value of investments denominated in a foreign currency. A type of foreign exchange exposure caused by the effect of unexpected currency fluctuations on a company's future cash flows. Also known as operating exposure, economic exposure can have a substantial impact on a company's market value, since it has far-reaching effects and is long-term in nature. Foreign exchange exposure is the risk associated with activities that involve a global firm in currencies other than its home currency. Essentially, it is the risk that a foreign currency may move in a direction which is financially detrimental to the global firm.

5.7

Economic Risk

Economic risk concerns the effect of exchange rate changes on revenues (domestic sales and exports) and operating expenses (cost of domestic inputs and imports). Economic risk is usually applied to the present value of future cash flow operations of a firm's parent company and foreign subsidiaries. So, economic risk is the chance that macroeconomic conditions like exchange rates, government regulation, or political stability will affect an investment, usually one in a foreign country. It is caused by the effect of unexpected currency fluctuations on a company's future cash flows and market value, and is long-term in nature. The impact can be substantial, as unanticipated exchange

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2017 rate changes can greatly affect a company's competitive position, even if it does not operate or sell overseas. Economic exposure deals with unexpected changes in exchange rates - which by definition are impossible to predict - since a company's management base their budgets and forecasts on certain exchange rate assumptions, which represents their expected change in currency rates. In addition, while transaction and translation exposure can be accurately estimated and therefore hedged, economic exposure is difficult to quantify precisely and as a result is challenging to hedge. Economic exposure matters most to companies conducting foreign business, as it directly impacts their operations. However, with increased global trade, the effects of economic exposure are felt by all consumers as it can impact the prices paid for foreign goods.

FOREIGN EXCHANGE RISK MANAGEMENT

6.1

Hedging Strategies

Indicatively, transaction risk is often hedged tactically (selectively) or strategically to preserve cash flows and earnings, depending on the firm's treasury view on the future movements of the currencies involved. Translation, or balance sheet, risk is hedged very infrequently and non-systematically, often to avoid the impact of possible abrupt currency shocks on net assets. This risk involves mainly longterm foreign exposures, such as the firm's valuation of subsidiaries, its debt structure and international investments. To reduce the impact of exchange rates on the volatility of earnings, the firm may use an optimization model to devise an optimal set of hedging strategies to manage its currency risk. Hedging the remaining currency exposure after the optimization of the debt composition is a difficult task. A firm may use tactical hedging, in addition to optimization, to reduce the residual currency risk. Moreover, if exchange rates do not move in the anticipated direction, translation risk hedging may cause either cash flow or earnings volatility. Therefore, hedging translation risk often involves careful weighing the costs of hedging against the potential cost of not hedging. Economic risk is often hedged as a residual risk. Economic risk is difficult to quantify, as it reflects the potential impact of exchange rate moves on the present value of future cash flows. This may require to measure the potential impact of an exchange rate deviation from the benchmark rate used to forecast a firm's revenue and cost streams over a given period. In this case, the impact on each flow may be netted out over product lines and across markets, with the net economic risk becoming small for firms that invest in many foreign markets because of offsetting effects. Under these circumstances, the firm could best hedge its economic exposure by creating payables (e.g., financing operations) in the currency that the firm's subsidiary experiences the higher cost inflation (i.e., in the currency that the firm's value is vulnerable).

6.2

Best Practices for Exchange Rate Risk Management

Identification of the types of exchange rate risk that a firm is exposed to and measurement of the associated risk exposure. This involves determination of the transaction, translation and economic risks, along with specific reference to the currencies that are related to each type of currency risk. In addition, measuring these currency risks—using various models (e.g. VaR)—is another critical element in identifying hedging positions. Development of an exchange rate risk management strategy. After identifying the types of currency risk and measuring the firm's risk exposure, a currency strategy needs to be established on how to deal with these risks. In particular, this strategy should specify the firm's currency hedging objectives—whether and why the firm should fully or partially hedge its currency exposures. Furthermore, a detailed currency hedging approach should be established. It is imperative that a firm details the overall currency risk management strategy on the operational level, © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 including the execution process of currency hedging, the hedging instruments to be used, and the monitoring procedures of currency hedges. Creation of a centralized entity in the firm's treasury to deal with the practical aspects of the execution of exchange rate hedging. This entity will be responsible for exchange rate forecasting, the hedging approach mechanisms, the accounting procedures regarding currency risk, costs of currency hedging, and the establishment of benchmarks for measuring the performance of currency hedging. (These operations may be undertaken by a specialized team headed by the treasurer or, for large multinational firms, by a chief dealer.) Development of a set of controls to monitor a firm's exchange rate risk and ensure appropriate position taking. This includes setting position limits for each hedging instrument, position monitoring through mark-tomarket valuations of all currency positions on a daily basis (or intraday), and the establishment of currency hedging benchmarks for periodic monitoring of hedging performance (usually monthly). Establishment of a risk oversight committee. This committee would in particular approve limits on position taking, examine the appropriateness of hedging instruments and associated VaR positions, and review the risk management policy on a regular basis. Managing exchange rate risk exposure has gained prominence in the last decade, as a result of the unusual occurrence of a large number of currency crises. From the corporate managers' perspective, currency risk management is increasingly viewed as a prudent approach to reducing a firm's vulnerabilities from major exchange rate movements. This attitude has also been reinforced by recent international attention on both accounting and balance sheet risks.

HEDGING INSTRUMENTS FOR MANAGING EXCHANGE RATE RISK

Within the framework of a currency risk management strategy, the hedging instruments allowed to manage currency risk include both OTC and exchange-traded products. Among the most common OTC currency hedging instruments are currency forwards and cross-currency swaps. Two types of forwards contracts are often used: (1)

outright forwards (involving the physical delivery of currencies);

(2)

non-deliverable forwards (which are settled on a net cash basis).

The two most commonly used cross-currency swaps are: (1)

the cross-currency coupon swap; The cross-currency coupon swap is defined as buying a currency swap and at the same time pay fixed and receive floating interest payments. Its advantage is that it allows firms to manage their foreign exchange rate and interest rate risks, as they wish, but it leaves the firm that buys this instrument vulnerable to both currency and interest rate risk.

(2)

the cross-currency basis swaps. Cross-currency basis swap is defined as buying a currency swap and at the same time pay floating interest in a currency and receive floating in another currency. This instrument, while assuming the same currency risk as the standard currency swap, has the advantage that it allows a firm to capture prevailing interest rate differentials. However, the major disadvantage is that the primary risk for the firm is interest rate risk rather that currency risk.

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2017

For exchange-traded currency hedging instruments, the main types are currency options and currency futures. The most common type of option structure is the plain vanilla call, which is defined as buying an upside strike in an exchange rate with no obligation to exercise. Its advantages include its simplicity, lower cost than the forward, and the predicted maximum loss—which is the premium. However, its cost is higher than other sophisticated options structures such as call spreads (buy an at-the-money call and sell a low delta call). Currency futures are exchange-traded contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date. Their characteristics differ from forward rates, both in terms of the available traded currencies and the typical (quarterly) settlement dates. Comparing currency forward and currency futures markets, the size of the contract and the delivery date are tailored to individual needs in the forward market (i.e., determined between a firm and a bank), as opposed to currency futures contracts that are standardized and guaranteed by some organized exchange. While there is no separate clearing-house function for forward markets, all clearing operations for futures markets are handled by an exchange-clearing house, with daily mark-to-market settlements. In terms of liquidation, while most forward contracts are settled by actual delivery and only some by offset—at a cost, in contrast, most futures contracts are settled by offset and only very few by delivery. Furthermore, the price of a futures contract changes over time to reflect the market's anticipation of the future spot rate. If a firm holding a currency futures contract decides before the settlement date that it no longer wants to maintain such a position, it can close out its position by selling an identical futures contract. This, however, cannot be done with forward contracts.

7.1

Foreign Exchange Risk Management

FX risk is the exposure to potential financial losses due to devaluation of the foreign currency against the US dollar. •

Most foreign buyers generally prefer to trade in their local currencies to avoid FX risk exposure.

•

US SME exporters who choose to trade in foreign currencies can minimize FX exposure by using one of the widely-used FX risk management techniques available in the US.

•

The volatile nature of the FX market poses a great risk of sudden and drastic FX rate movements, which may cause significantly damaging financial losses from otherwise profitable export sales.

•

The primary objective of FX risk management is to minimize potential currency losses, not to make profit from FX rate movements, which are unpredictable and frequent.

7.2

FX Risk Management Options

The FX instruments are available in all major currencies and are offered by numerous commercial lenders. However, not all of these techniques may be available in the buyer's country or they may be too expensive to be useful.

7.3

Non-Hedging FX Risk Management Techniques

The exporter can avoid FX exposure by using the simplest non-hedging technique: pricing the sale in a foreign currency. The exporter can then demand cash in advance, and the current spot market rate will determine the US dollar value of the foreign proceeds. A spot transaction is when the exporter and the importer agree to pay using today's exchange rate and settle within two business days. Another non-hedging technique is to net out foreign currency receipts with foreign currency expenditures. For example, the US exporter who exports in pesos to a buyer in Mexico may want to purchase supplies in pesos from a different Mexican trading partner. If the company's export and © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 import transactions with Mexico are comparable in value, pesos are rarely converted into dollars, and FX risk is minimised.

7.4

FX Forward Hedges

The most direct method of hedging FX risk is a forward contract, which enables the exporter to sell a set amount of foreign currency at a pre-agreed exchange rate with a delivery date from three days to one year into the future. For example, suppose U.S. goods are sold to a Japanese company for 125 million yen on 30-day terms and that the forward rate for "30-day yen" is 125 yen to the dollar. The US exporter can eliminate FX exposure by contracting to deliver 125 million yen to his bank in 30 days in exchange for payment of $1 million dollars. Such a forward contract will ensure that the U.S. exporter can convert the 125 million yen into $1 million, regardless of what may happen to the dollar-yen exchange rate over the next 30 days. However, if the Japanese buyer fails to pay on time, the US exporter will be obligated to deliver 125 million yen in 30 days.

7.5

FX Options Hedges

If there is serious doubt about whether a foreign currency sale will actually be completed and collected by any particular date, an FX option may be worth considering. Under an FX option, the exporter or the option holder acquires the right, but not the obligation, to deliver an agreed amount of foreign currency to the lender in exchange for dollars at a specified rate on or before the expiration date of the option. As opposed to a forward contract, an FX option has an explicit fee, which is similar to a premium paid for an insurance policy.

7.6

Why Hedge Foreign Exchange Risk?

•

Minimize the effects of exchange rate movements on profit margins.

•

Increase the predictability of future cash flows.

•

Eliminate the need to accurately forecast the future direction of exchange rates.

•

Facilitate the pricing of products sold on export markets.

•

Protect, temporarily, a company's competitiveness if the value of the other currency crises (thereby buying time for the company to improve productivity).

7.7

Managing Foreign Exchange Risk

Table 6: Managing Foreign Exchange Risk Stages

STAGE

ACTIONS

One

Identifying and measuring the foreign exchange exposures that you want to manage.

Two

Once you have calculated your exposure, you need to develop your company's foreign exchange policy that should be endorsed by the company's senior management and usually provides detailed answers to questions such as: • • •

When should foreign exchange exposure be hedged? What tools and instruments can be used under what circumstances? Who is responsible for managing foreign exchange exposure?

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2017 STAGE

ACTIONS • •

How will the performance of the company's hedging actions be measured? What are the regular reporting requirements?

Three

Putting in place hedges that are consistent with your company's policy.

Four

Periodically measuring whether the hedges are effectively reducing your company's exposure.

7.8

Financial Hedging

A forward contract allows a company to set the exchange rate at which it will buy or sell a given quantity of foreign currency in the future (on either a fixed date or during a fixed period of time). Forward contracts are easy to use and carry no purchase price. However, you do have a contractual commitment to deliver to (or purchase from) a bank or foreign exchange broker a fixed quantity of foreign exchange at a future date. If you do not, then the forward contract could be terminated or extended which could carry a price tag for your company. Currency options are other tools that can be used to mitigate transaction exposure. Standard options give a company the right, but not the obligation, to buy or sell foreign exchange in the future at a predetermined exchange rate. Swaps, which involve the simultaneous selling and buying (or buying and selling) of a foreign currency, can help firms match receipts and payments in a foreign currency. For example, if a company receives a US$250,000 payment today and knows it will have to make a payment of US$250,000 in 45 days, it could enter into a swap arrangement whereby it sells US$250,000 today (in exchange for other currency) and commits to purchase the same amount of U.S. dollars in 45 days at an exchange rate that is pre-determined.

SUMMARY OF SWAP TYPES

In general, swaps can be classified as: (1)

interest rate swaps (IRS);

(2)

currency swaps;

(3)

commodity swaps;

(4)

equity swaps; and

(5)

credit swaps.

The different types of swap are summarised below. Table 7: Different Types of Swap Instrument

SWAP TYPE

DESCRIPTION

Accreting Swap

A swap in which the notional amount increases over time. This is usually a fixed interest rate swap but also occasionally a currency swap. The legs of the swap are calculated at a fixed rate, but the principal over which they are calculated goes up over time. This is most commonly used in the construction industry and other projects in which costs rise over the life of the venture. A derivative where counterparties exchange financial instrument benefits, involving a growing notional principal amount. An accreting principal swap, is an interest rate or cross-currency swap where the notional

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2017 SWAP TYPE

DESCRIPTION principal grows as it reaches maturity.

Amortizing Swap

An exchange of cash flows, one of which pays a fixed rate of interest and one of which pays a floating rate of interest, and both of which are based on a notional principal amount that decreases. In an amortizing swap, the notional principal decreases periodically because it is tied to an underlying financial instrument with a declining (amortizing) principal balance, such as a mortgage. The notional principal in an amortizing swap may decline at the same rate as the underlying or at a different rate which is based on the market interest rate of a benchmark like mortgage interest rates or the London Interbank Offered Rate. The opposite of an amortizing swap is an accreting principal swap - its notional principal increases over the life of the swap. In most swaps, the amount of notional principal remains the same over the life of the swap.

Basis Swap

A basis swap is an interest rate swap which involves the exchange of two floating rate financial instruments. A basis swap functions as a floatingfloating interest rate swap under which the floating rate payments are referenced to different bases.

Circus Swap.

A combination of an interest rate swap and a currency swap in which a fixed-rate loan in one currency is swapped for a floating-rate loan in another currency. A circus swap therefore converts not just the basis of the interest rate liability, but also the currency of this liability. The floating rate in a circus swap is generally indexed to U.S. dollar LIBOR. The term is derived from the acronym CIRCUS, which stands for Combined Interest Rate and Currency Swap. Also known as a "cross-currency swap" or "currency coupon swap". Companies and institutions use circus swaps to hedge currency and interest rate risk, and to match cash flows from assets and liabilities. They are ideal for hedging loan transactions since the swap terms can be tailored to perfectly match the underlying loan parameters.

Cross Currency Swap

There is an exchange of interest payments in one currency for interest payments in another currency (fixed rate to fixed rate, floating rate to floating rate, or fixed rate to floating rate).

Currency Swap

This is an agreement between two parties to exchange a series of cash flows denominated in one currency for those denominated in another for a pre-determined period of time. During the term of the agreement currents amounts are exchanged and there are payments of interest during that period. The currency swap requires an actual exchange of the two principal currency amounts on which the sets of cash flows are based.

Deferred Swap

A swap under which the payments are deferred for a specified period, usually for tax or accounting reasons. Not to be confused with a forward swap, where the entire swap is delayed.

Extendable Swap

An exchange of cash flows between two counterparties, one of whom pays interest at a fixed rate and one of whom pays interest at a floating rate, in which the fixed-rate payer has the right to lengthen the term of the arrangement. The fixed-rate payer might want to exercise its right to extend the swap if interest rates were rising because it would profit from continuing to pay a fixed, below-market rate of interest and receiving an increasing market rate of interest from the floating rate. The additional feature of an extendable swap makes it more expensive than a plain vanilla interest rate swap. That is, the fixed rate payer will pay a higher fixed interest rate and

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2017 SWAP TYPE

DESCRIPTION possibly an extension fee. The opposite of an extendable swap is a cancelable swap, which gives one counterparty the right to terminate the agreement early.

Fixed Swap

for

Forward Swap

Floating

In a fixed for floating interest rate swap a counterparty enters into a swap agreement with another counterparty to receive a fixed interest rate and to pay a floating interest rate over a period of years.

Starting

A swap in which payments are deferred for an initial period in order to benefit from lowered floating rate spreads. When the yield curve steepens, long-term rates move up faster than short-term rates and forward interest rates move up even faster. For example a party can commit to receive a fixed rate of 7% for 10 years starting in two years as this will lower the floating rate on the swapped debt (e.g. from LIBOR +.90% to LIBOR +.75%) The longer that the start of the swap is deferred, the lower the floating rate spread.

Inflation Rate Swap

These are swap instruments that allow a party to trade inflation over a given time horizon. At maturity one party will pay the cumulative percentage increase in the reference inflation index over the life of the swap in exchange for an annually compounded fixed rate. Under the terms of the swap the inflation payer will make periodic floating rate payments linked to inflation in exchange for pre-determined fixed rate payments from the inflation receiver.

Interest Rate Swap

The exchange of cash flows between two parties without transfer of the underlying debt.

Off-Market Swap

This involves the rates at which the two legs are closed are off market (rearrangement of income flows for tax purposes).

Overnight Index Swap

Portfolio Swap

These are swaps that are used to gain exposure to assets without physically holding them in a portfolio. The portfolio is customised to the individual's own preferences and areas of investment thereby creating a bespoke portfolio. A bespoke portfolio of assets is created and a counterparty is called for to hold the basket. The investor then enters into the a swap with the counterparty to receive the return on the basket and to pay in return a negotiated financing cost plus a preset spread. The counterparty passes on any gains or losses on the basket to the investor who pays the counterparty a financing cost for administering the basket.

Quanto Swap

This is a swap whereby one counterparty pays a non-local interest rate to the other counterparty, but the notional currency is a local currency. The second party may be paying a fixed rate or a floating rate. For example, a swap with a notional amount denominated in Peru Sol but where the floating rate is set as USD LIBOR.

Roller Coaster Swap

There is a mix of accreting and amortizing swaps, or it can be structured so that there is a switch in payer and receiver swaps.

Seasonal Swap

An interest rate swap (IRS) in which the notional principal varies according to a specified schedule. This type of swap is usually used in matching the

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2017 SWAP TYPE

DESCRIPTION financing requirements of retailing firms. The swap can be structured on a seasonal basis to match seasonal cash needs, such as those that usually arise in fourth quarters (Q4) of the calendar year.

Step-Up Swap

An interest rate swap with scheduled increases in the notional value. That is, the counterparties to the swap may agree to exchange different interest rates with a notional value of $1 million, with an increase to $1.1 million the following month, and $1.2 the month after that. Step-up swaps increases the dollar amounts of the swap, but the interest rate remains the same for the fixed rate payer and changes only according to the benchmark rate for the floating rate payer.

Swaptions

These are non-standard contracts that provide the party with the right but not the obligation to enter into an underlying swap. Widely used swaptions are based on interest rate swaps which can be preconfigured to provide upside and downside protection if an event occurs.

AN OVERVIEW OF INTEREST RATE SWAPS

IRS can be defined as the exchange of cash flows between two parties without transfer of the underlying debt. The cash flows are based on interest payments that are made on a nominal sum referred to as the 'principal' or 'notional' amount. The term 'notional principal' refers to the currency amount the interest rates apply to. In an IRS the value is derived from the current spot and forward interest rates. Interest payments can be fixed or floating, and can be made at different intervals and at different rates. A simple plain swap (vanilla) involves the exchange of fixed and floating rate payments on the same currency. Under the swap the side which receives payment is referred to as the 'receiving leg' and the side which makes payment is referred to as the 'paying leg'. The 'reset period' refers to the period over which a coupon is fixed. The traditional position is that the fixed rate payer (FRP) has sold the swap and the floating rate payer (FLRP) has purchased the swap.

9.1

Fixed for Floating Swap

In a fixed for floating interest rate swap Counterparty A enters into a swap agreement with Counterparty B to receive a fixed interest rate (FIR) and to pay a floating interest rate (FLIR) over a period of years. The swap is comprised of a series of forward contracts with specified maturities at which point cash flows will be exchanged, i.e. 6 months, 12 months, and 18 months. Figure 5: Fixed for Floating Swap Mechanics Fixed Rate Payer (FRP)

Fixed Rate Payments

Floating Rate Payer (FLRP)

Swap Counterparty

Swap Issuer Fixed Rate Payer (FRP) Floating Rate Payments

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9.1.1 Swaps Rationale General: Swaps can be used: (1)

to develop financial products;

(2)

to manage interest rate and exchange rate risks;

(3)

to overcome restrictions (e.g. foreign exchange controls);

(4)

for capital market segmentation purposes;

(5)

to manage basis risk;

(6)

to manage duration risk;

(7)

to take advantage of comparative advantage (arbitrage);

(8)

to take advantage of comparative advantage (asymmetric information).

Rising Interest Rates: If counterparty A believes that interest rates will rise in the future it would seek to enter into a swap agreement whereby it pays a fixed interest rate and will receive a floating rate in order to protect it from increased debt-service payments. Falling Interest Rates: If counterparty A believes that interest rates will fall in the future it would seek to enter into a swap agreement whereby it pays a floating interest rate and will receive a fixed interest rate in order to take advantage of decreased debt-service payments.

9.2

Basis Swap

A basis swap is a swap agreement in which two parties agreed to exchange two streams of money market floating rates of two different currencies during a set term period. The notional principle is exchange at the commencement of the swap and then exchanged back upon termination of the swap agreement. A practical example might be a basis swap of Peruvian Sol (PEN) LIBOR for U.S. Dollar (USD) LIBOR. The basis swap market will reflect foreign exchange demand and the credit rating of a country's central bank.

9.3

Overnight Index Swap

An overnight index swap (OIS) is an IRS whereby the floating leg is tied to an overnight rate that is compounded over a specified term (e.g. overnight Federal Funds rate published daily by the Federal Reserve). Counterparties that enter into OIS are typically seeking to manage their exposures to movements in the cash rate. Because there is no exchange of principal OIS have very little credit risk. In an example scenario Counterparty A might enter into an OIS with Counterparty B whereby Counterparty A is swapping a fixed short-term interest rate and Counterparty B is swapping an overnight interest rate. The general idea is that whichever Counterparty ends up paying less interest will pay out that difference to the other institution. Other overnight rates include: (1)

ÂŽ

EONIA (Euro OverNight Index Average) (EUR). This is the effective overnight reference rate for the euro. It is computed as a weighted average of all overnight unsecured lending transactions in the interbank market, undertaken in the European Union and European Free Trade Association (EFTA) countries ;

(2)

SONIA (Sterling Overnight Index Average) (GBP). This was introduced in March 1997 and reflects bank and building societies' overnight funding rates in the sterling unsecured market. SONIA is anticipated to move to a new basis by April

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2017 2018. SONIA is designated as a specified benchmark under the UK Financial Services and Markets Act 2000 (FSMA 2000). (3)

CHF LIBOR (Swiss Franc London Interbank Offered Rate) (CHF). The Swiss franc LIBOR interest rate is the average interbank interest rate at which a large number of banks on the London money market are prepared to lend one another unsecured funds denominated in Swiss francs. The Swiss franc (CHF) LIBOR interest rate is available in 7 maturities, from overnight (on a daily basis) to 12 months.

(4)

JPY LIBOR (JPY) The overnight Japanese yen (JPY) LIBOR interest rate is the average interest rate at which a selection of banks in London are prepared to lend to one another in Japanese yen with a maturity of 1 day

(5)

(Tokyo Overnight Average Rate (TONAR) (JPY).

OIS are usually executed for relatively short terms (e.g. from one week to one year, but with the majority of swaps in maturities out to three months). The main participants in the OIS market are banks which are seeking to benefit from relatively strong or relatively little expectations of movements in existing cash rates. Because of the relatively short maturities and the low level of credit risk, An Overnight Index Swap Rate (OISR) is calculated on a daily basis based on the mean interest rate institutions with loans based on the overnight rate have paid for that day. The overnight rate will constantly change throughout the day so Counterparties will pay a different interest rate at different times throughout the day.

9.3.1 OIS as Market Indicator Tools OIS are useful tools for analysing market expectations about future movements in the cash rate. •

If the fixed rate in OIS is trading above the current cash rate this would potentially indicate that market participants are expecting a rise in the cash rate over the duration of the swap.

•

When the OISR is combined with another indicator such as LIBOR, it is possible to create a LIBOR OIS spread. This is now considered to be a key measure of credit risk within the banking sector. The OIS represents the assumed Federal Funds Rate (i.e. key interest rate controlled by the U.S. Federal Reserve).

• •

During normal economic times credit risk is not a major factor in determining the OIS rate or LIBOR. LIBOR is generally higher than OIS because of liquidity risk and credit risk. However, during dynamic economic times the spread between the two rates widens (e.g. prior to the financial crisis in 2007-2008 the spread was 0.01 percentage points and at the height of the crisis rose to 3.65%).

9.4

Non-Deliverable Swap

Non-deliverable Swap (NDS) contracts are similar to cross-currency swaps, however for NDS there is no requirement to swap actual currencies as they are settled in US Dollars or other highly liquid currencies. The payable named in a maturing, controlled currency will be converted into a major currency at the spot exchange rate, with the net settlement amount being valued in a major currency on each interest payment day and also at maturity. At the outset, the principal in a controlled currency is converted into a major currency at the prevailing spot exchange rate. Typically the interest paid for in the controlled currency is fixed whilst the interest rate for the major currency can be either fixed or floating rate. The two currencies swap interest on each payment date.

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2017 NDS provide an offshore market hedge against the non-hedgeable risks brought about by local capital controls or foreign exchange market regulations. The principal is swapped at an agreed exchange rate at maturity. NDAs can be used to convert major currency loans to non-deliverable currency loan portfolios with fixed outlays. They can be used as a way of hedging to match physical assets with liabilities, to match asset-risk exposure with principal, and to match fixed exchange rate/asset rollover date with liabilities.

9.5

Forward Rate Agreements

Forward Rate Agreements (FRAs) are agreements between two parties where each party agrees to net two payments, the first payment is the fixed agreed-upon payment and the second is the market rate on the underlying at the time the contract matures. For example, if a company wishes to lock in a six-month LIBOR rate three months forward, the forward rate would be calculated on six-month LIBOR. FRAs are generally written for a single period (e.g. 6 month contract, 3 month contract) and the bid offer spread is usually quite small. A company might seek to use a FRN together with a floating-rate loan, as it could lock in the next rate resetting on the floating-rate loan through the FRN, e.g. if the company expects that rates may rise owing to political risk. A counterparty can contract to pay fixed and receive floating or to receive fixed and pay floating.

9.6

Interest Rate Options

There are generally three types of Interest Rate Option (IRO): (1) IROs traded on exchanges; IROs traded OTC; and (3) IROs embedded in another financial instrument. Exchange IROs include: (1) option on a futures contract; (2) options on 5-year US Treasury yields; (3) options on 30-year US Treasury yields. OTC IROs include: (1) OTC options on bonds; (2) OTC calls and puts on LIBOR. By 2002 OTC IROs with more than $10 trillion of notional principal were outstanding, and the OTC IRO market has witnessed a growth rate of above 30% per annum from the 1990s. Embedded IROs can be found in callable corporate option bonds and in mortgage obligations.

AN OVERVIEW OF OTHER SWAPS INSTRUMENTS

There are a huge range of swaps on the market today that reflects both the market demand for OTC swaps instruments and the innovation available on global markets. The range of IRS available highlights the innovation available (e.g. callable swaps, cancellable swaps, blended rate swaps, offmarket rate swaps, escalating rate swaps, differential swaps, zero coupon swaps, naked swaps, roller coaster swaps, participating swaps, puttable swaps, reversible swaps, contingent swaps, yield curve swaps).

10.1

Currency Swaps

Currency swaps (sometimes referred to as 'cross currency swaps') are agreements to deliver one currency against another. They are often used by firms that need to hedge a long-term liability that is denominated in a currency other than their main operating currency. The type of currency swap used must fit within the firm's existing debt management policy and risk profile. The exchange of principal under the currency swap means that the transaction will be recorded on both parties' balance sheets. The exchange rate is typically determined from the spot rate between the two currencies, i.e. the midpoint between the two currencies is used. Currency swaps typically involve the exchange and re-exchange of principals. Currency swap maturities are very often long-term (for up to 25 years) which means they are a highly flexible method of foreign exchange. In practice owing to currency risk most swaps have a term of up to seven years. ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 There is no initial fee or premium when arranging a currency swap. The pricing of currency swaps is typically expressed as LIBOR +/-bp based on interest rate curves at the onset of the swap and the credit risk of the counterparties. Cash Flow 1: Initial exchange of principals at the beginning. Cash Flow 2: The exchange of interest payments during the contract period. Cash Flow 3: The re-exchange of principals at the end. The objectives of a currency swap are: (1)

To circumvent existing exchange controls (i.e. currency restrictions in a jurisdiction).

(2)

To access cheaper capital markets.

(3)

To hedge a long-term borrowing commitment in a foreign currency.

The types of currency swap are: (1)

Fixed rate to fixed rate currency swap.

(2)

Fixed rate to floating rate currency swap.

(3)

Floating rate to floating rate currency swap.

10.1.1 Currency Swap Risks •

Legal risk.

•

Principal risk.

•

Currency risk.

•

Counterparty risk.

•

Position risk.

10.1.2 Currency Swap Benefits •

Very flexible term periods.

•

Very flexible in terms of the range of currencies available.

•

Alternative method of raising finance.

•

They can be arranged rapidly (after an ISDA Master Agreement is in place).

•

Allows firms to raise funds in domestic capital markets using beneficial rates.

•

Allows firms to exploit lower interest rates.

•

Allows firms to access more liquid capital markets.

10.1.3 Currency Swap Example Let us say that Counterparty A wishes to take out a fixed-rate loan in Columbian Pesos and Counterparty B wishes to take out a fixed rate loan in U.S. dollars. Let us assume that Counterparty A © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 is relatively more competitive in the dollar market than the Peso market, and Counterparty B is relatively more competitive in the Peso market than the Dollar market. With a currency swap Counterparty A borrows dollars and Counterparty B borrows Pesos. The Counterparties exchange principal at the beginning and the end of the swap. The swap therefore transforms Counterparty A's loan into a Peso loan and Counterparty B's loan into a Dollar loan.

10.2

Commodity Swap

A commodity swap is an agreement between two parties to exchange cash flows which are dependent on the price of an underlying commodity. Under the commodity swap a floating (or spot or market) price fixed with reference to the underlying commodity is traded for a fixed price over a specified term. The physical markets generally have shorter term periods, and commodity swaps are typically up to three years in length. No commodity is exchanged. They are valued as a series of commodities forwards with each one priced at inception with zero value. The price that is used to calculate the cash settlement amount is referred to as the 'Commodity Reference Price'. The CRP is the floating swap price for the relevant commodity based on quoted prices on a specified reference futures exchange for that commodity. CRP EXAMPLES CU means the settlement price per tonne of copper Grade A at the end of the second morning ring on the LME for cash delivery, stated in USD, as determined by the LME and displayed on page "MTLE" of the Reuters Monitor Money Rates Service. AL means the settlement price per tonne of high grade Primary Aluminium at the end of the second morning ring on the LME for cash delivery, stated in USD, as determined by the LME and displayed on page "MTLE" of the Reuters Monitor Money Rates Service GO means the morning or afternoon (as specified in the applicable Final Terms) Gold fixing price per troy ounce of Gold for delivery in London through a member of the LBMA authorised to effect such delivery, stated in USD, as determined by the London Gold Market and displayed on page "GOFO" of the Reuters Monitor Money Rates Service. The commodity swap can assist counterparties in protecting them against adverse commodity price movements. A majority of commodity swaps involve oil. For example, traders often use commodity swaps to hedge against price fluctuations in commodity prices (e.g. energy and agriculture commodities). They can also be used to hedge against fluctuations in spreads between final products and raw material prices (e.g. the cracking spread is a term used in the oil industry and futures market and refers to the differential between the crude oil price and the petroleum products that are extracted from it). Commodity swaps have been in use in the over-the-counter (OTC) markets since the 1970s, and although they can be risky, they are heavily used within the energy, chemical, and agricultural industries. The end-users are those seeking to hedge a commodity risk and the investors are those seeking to speculate on commodity markets. Two types of commodity swap are the fixed-floating swap and the commodity-for-interest swap. Figure 6: Fixed-Floating Commodity Swap Mechanics Fixed Rate Payer (FRP)

Fixed Rate Payments Based on Commodity Based Index

Floating Rate Payer (FLRP)

Commodity Swap Counterparty

Commodity Swap Issuer Floating Rate Payments Based on Commodity Based Index

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Commodity-for-interest swaps provide for a return on a commodity in exchange for a money market rate (e.g. interest rate EURIBOR +/- spread). Figure 7: Commodity-for-interest Swap Mechanics Return on Oil (NYMEX Light Crude Oil)

Oil Producer

Swap Dealer

Fixed Rate Payer (FRP) Floating Rate Payments (6 month LIBOR)

10.2.1 The Characteristics of Commodity Swaps •

Administrative costs.

•

Brokerage fees.

•

Capital costs.

•

Credit risk.

•

Hedging cost.

•

The affects of seasonality on the underlying commodity market.

•

The institutional structure of the underlying commodity market.

•

The liquidity of the underlying commodity market.

•

Variability of the futures bid/spread offer.

•

Volatility.

10.2.2 The Parameters of Commodity Swaps •

Business Days.

•

Calendar.

•

Commodity Underlying.

•

Effective Date.

•

Fixed Price.

•

Fixing.

•

Floating Price.

•

Frequency.

•

Notional Per Quantity.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 •

Payment Date.

•

Termination Date.

•

Trade Date.

•

Traded Notional.

SWAP SPECIFICATIONS

Swap contract specifications typically include items such as: (1)

Definitions;

(2)

Underlying asset;

(3)

Trading information (e.g. initial value (contract size) transaction date, expiration date, basis date, guarantees, nature of a transaction (long, short), settlement alternative, early settlement option);

(4)

contract size;

(5)

expiration date;

(6)

settlement alternative;

(7)

collateral;

(8)

assets eligible to meet margin requirements;

(9)

trading costs (e.g. commission rate by commodity brokerage house, clearing fees, exchange fees);

(10)

special provisions.

Swap leg conventions are: Fixed Leg (1)

Reset Frequency Annual;

(2)

Day Count Convention /360;

(3)

Currency (EUR/$);

(4)

Holiday Calendar TARGET;

(5)

Business Day Convention Modified Following with adjustment to period end dates.

Floating Leg (1)

Reset Frequency Semi-Annual;

(2)

Day Count Convention Actual/360;

(3)

Currency (EUR/$);

(4)

Holiday Calendar TARGET;

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 (5)

Business Day Convention Modified Following with adjustment to period end dates.

11.1

Example Fixed for Floating IRS (ICAP, 2013, pp.3-5)

Trading Conventions •

Buyer (Payer) pays fixed interest rate and receives floating interest rate.

•

Seller (Receiver) receives fixed interest rate and pays floating interest rate.

Swap Leg Conventions •

The terms of Fixed versus Floating Interest Rate Swaps are based on a number of combinations of the criteria below.

Fixed Leg •

Payment Frequency o

•

Day Count Convention o

•

Actual/360, actual/365, 360/360, 30/360, 30E/360, Actual Fixed/365, actual /366, actual / actual

Holiday Calendar o

•

Monthly, Quarterly, Semi-Annually, or Annually

Applied in accordance for the country currency denoted for the instrument

Business Day Convention o

Modified following with adjustment to period end dates.

Business days in this convention must be valid

business days for the countries denoted by the

currency. If not, it will be the next day that is a business

day on both calendars.

Fixed Rate o

The traded interest rate yield or basis points on Trade Date

Floating Leg •

Reset Frequency o

•

Day Count Convention o

•

Monthly, Quarterly, Semi-Annual

Actual/360, actual/365, 360/360, 30/360, 30E/360, Actual Fixed/365, actual /366, actual / actual

Holiday Calendar

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2017

•

Applied in accordance for the country currency denoted

for the instrument

• Business Day Convention o

•

Fixed Rate o

•

EBOR, BBSW, LIBOR, EURIBOR, CIDOR, PRIBOR, CIBOR2, BUBOR, TELBOR, NIBOR, BKBM, WIBOR, STIBOR, JIBAR, SAIBOR, TIBOR, CZEONIA, TRLIBOR, MOSPRIME

Effective Date o

•

The traded interest rate yield or basis points on Trade Date

Interest Rate Benchmark o

•

Modified Following with adjustment to period end dates. Business days in this convention must be valid business days for the countries denoted by the currency. If not, it will be the next day that is a business day on both calendars.

The first date from which fixed and floating interest amounts accrue. It is also referred to as the Start Date or the Value Date. The Effective Date of the Swap must be a business day subject to the appropriate Business Day Convention.

Trade Start Type o

Spot Starting A swap whose Effective Date is 2 business days from the Trade Date (T+2).

Forward Starting A swap whose Effective Date is anything after the Effective Date for a Spot Starting swap.

Same Day Starting A swap whose Effective Date is the same as the Trade Date (T+0)

•

Maturity Date o

•

The final date until which Fixed and Floating amounts accrue

Tenor o

The duration of time from the Effective Date to the Maturity Date. Tenors of any duration greater than 0 years to 50 years. Listed Tenors, also known as On-the-Run, are whole calendar year Spot Starting Contracts with a Tenor of 1 through 60 years. Other Tenors, also known as Off-the-Run, means any partial year Tenor (Months, Weeks, Days).

•

Roll Day Convention

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2017

•

The date used for determining all fixed and floating Reset Dates. Roll Days define the beginning and end of Fixed and Floating interest accrual periods.

For On-the-Run Contracts, the Roll Day is the same date of the month as the Effective Date. For Off-the-Run Contracts, it can be any date of the month, subject to the provisions of the Business Day Convention. Roll Day marks the start of a new interest accrual period, and is the date on which a Reset Rate takes effect.

Floating Reset Dates o

•

First Period Fixing Date o

For Spot Starting swaps, the Interest Rate for the first interest period is fixed on the Trade Date, for both Floating and Fixed Rates.

For Forward Starting swaps, the Fixed Rate for the first interest period is fixed on the Trade Date, and the Floating Rate for the first interest period is fixed 2 business days prior to the first floating payment date, taking into account agreed non working days

Stub Period Rate o

•

Dates utilized to determine the Floating Rate amounts for each interest accrual period during the Tenor of the contract. Except in the case of a Stub Period, the Reset Date is aligned with the floating rate frequency as determined.

For swaps with partial year Tenors, an interest period that is shorter than the standard underlying Floating index interest periods may occur between the Effective Date and the first or last Roll Date (knows as a Stub Period). In these cases, the Interest Rate for such Stub Period is determined using linear interpolation based on the two index rates that surround the Stub Period this can be applied either at the start or end of that period: Front or Back

Trade Types o

The Platform may support the following trade types: Outrights An Outright swap is where one party is the payer of the fixed rate and receiver of the floating rate and the other party is the receiver of the fixed fate and payer of the floating rate. Switches or Spreads Is the simultaneous purchase and sale of two different Tenors of the yield curve (e.g. 2 year by 10 year). Butterflies Butterflies are a combination of two spreads/switches (e.g. 2 year by 5 year by 10 year).

•

Contract Size o

•

Minimum notional size is dependent on currency and tenor

Minimum Price Fluctuation

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 o

Outrights The interest rate yield is quoted in increments of a minimum of .000025 (1/40th of a basis point).

o â&#x20AC;˘

Spreads and Butterflies will be quoted in basis points dependent in multiples of the increments of the underlying Outrights

Final Settlement Price o

Multiple payments take place during the term of the swap. Settlement price used for the periodic exchange of fixed and floating payments is based on the following factors: Fixed Leg Payment amount on the fixed leg is based on the traded price and notional amounts of the swap on Trade Date. Payment timing on the fixed leg is based on the Payment Frequency, Day Count Convention, Business Day Convention, and Roll Day.

Floating Leg

Payment on the floating leg is based on the Interest Rate and notional amounts of the swap. Payments on the floating leg are based on the Payment Frequency, Day Count Convention, Business Day Convention, Roll Day Convention and Floating Reset Dates.

11.1.1 Types of Commodity Swaps Commodities are physical assets, energy stores, and food. Commodities include: corn; oats, rough rice; soybeans; rapeseed; soybean meal; soybean oil; wheat; milk' cocoa; coffee; cotton; sugar; lean hogs; live cattle; feeder cattle; WTI Crude Oil; Brent Crude; ethanol; natural gas; heating oil; Gulf Coast Gasoline; RBOB Gasoline (reformulated gasoline blendstock for oxygen blending); propane; Purified Terephthalic Acid (PTA); Copper; Lead; Tin; Zinc; Aluminium; Aluminium alloy; Nickel; Cobalt; Molybdenium; Recycled Steel; Gold; Platinum; Palladium; Silver; Palm Oil; Rubber; Wool; and Amber. EXAMPLE Counterparty A enters into a commodity swap in order to secure a maximum price for the commodity and pays Counterparty B a fixed sum. In return Counterparty A will receive payments based on the current market price of the commodity.

11.2

Credit Default Swap

Credit derivatives are OTC financial contracts that are designed to replicate credit exposure by exhibiting a payoff profile that is linked to the occurrence of credit events. A credit event associated with the credit derivative's reference asset or reference entity will trigger a payout under the credit derivative. Credit derivatives allow market participants to buy or short credit exposure synthetically, independently of whether a cash market position can be established, e.g. they can be used to manage risk exposure in a corporate or non-AAA sovereign bond portfolio, or to manage the credit risk of commercial bank loan books. A credit derivative will isolate the credit risk from the underlying loan or bond and transfer them to another entity, and can therefore be used to separate the ownership and management of credit risk from other features of asset ownership.

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2017 When specified credit event occur, they will trigger the termination of the credit derivative contract and the protection seller will be obliged to transfer the default payment to the protection buyer. Credit events include: (1)

downgrades in credit ratings (e.g. Standard and Poor, Moody's) below specified minimum levels;

(2)

financial or debt restructuring (e.g. US bankruptcy restructuring);

(3)

bankruptcy or insolvency of the reference asset obligor;

(4)

default on payment obligations (e.g. bond coupons);

(5)

technical default (e.g. non-payment of interest due on a loan);

(6)

a change in credit spread that is payable by the obligor above a specified minimum level.

The 1999 ISDA credit default swap documentation specified bankruptcy, failure to pay, obligation default, debt moratorium, and restructuring as credit events. It did not specify a ratings downgrade as a credit event. In a funded credit derivative the insurance protection payment is made to the protection buyer at the start of the transaction and the payment is returned to the protection seller if there is no credit event. In an unfunded credit derivative contract the protection payment is made on termination of the contract on occurrence of a triggering credit event, and if no credit event occurs, the payment is not made. Figure 8: Credit Default Swap Fee or Premium

Counterparty A

Counterparty B

Protection Buyer

Protection Seller Default Payment on Triggering Event

Reference Asset

The Credit Default Swap (CDS) (otherwise referred to as a credit swap or default swap) is a bilateral contract that provides protection on the par value of a specified reference asset, with a protection buyer that pays a periodic fixed fee or a one-off premium to a protection seller, in return for which the seller will make a payment on the occurrence of a specified credit event. The swap can refer to a reference asset, the underlying asset, a basket of assets, or a reference entity.

11.3

Inflation Rate Swap

Inflation Rate Swaps can be used to reduce inflation risk. An inflation swap involves the exchange of Floating Rate Payments that are dependent upon changes in an inflation rate that is calculated on a nominal amount. If inflation rises then the Pension Fund will pay a fixed rate amount but will receive more as a variable payment. If inflation falls then the Pension Fund will pay a fixed rate amount but will receive less as variable payment. The net position (in terms of assets and liabilities) is therefore balanced for both outcomes,

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 resulting in a funding ratio that remains the same. The largest market for inflation rate swaps at present is the Retail Price Index (RPI) (although the Consumer Price Index (CPI) is also referenced). Figure 9: Inflation Rate Swap Mechanics

Fixed Rate Payments

Pension Fund Fixed Rate Payer (FRP)

Swap Counterparty

Floating Rate Payments (Dependent upon changes in an inflation rate calculated on a nominal amount.)

Figure 10: Zero Coupon Inflation Swap Fixed Leg = (1 + fixed rate)T x Nominal Value

Counterparty A

Counterparty B

Inflation Receiver

Inflation Payer

Inflation Leg = (Final price index/Starting price index) x Nominal Value

This transaction demonstrates the cash-flow structure of zero-coupon inflation swap of maturity T years. These are the standard inflation swap that dominates the market. A fixed zero-coupon inflation swap is a bilateral contract that enables an investor or hedger to secure an inflation-protected return with respect to an inflation index. The inflation buyer pays a predetermined fixed rate in return for an inflation-linked payment from the inflation seller. The inflation payer and the inflation receiver agree to exchange the change in the inflation index value from a base month (e.g. November 2016) to an end month (e.g. November 2020) versus a compounded fixed rate. Where the value of the index in the base month is known at the time of inception the inflation swap is referred to as 'swap starting', where it is not know the swap is referred to as 'forward starting'. Inflation payers include sovereigns; utilities; agencies; project finance; real estate; retailers; asset swap funds; and other market participants. Inflation receives include pension funds; insurance companies; inflation mutual funds; general mutual funds; retail banks; corporates; and other market participants. Payers and receivers include investment banks; proprietary desks; hedge funds; relative value funds; and other market particpants.

11.4

Total Return Swap

A total return swap (TRS) is where two counterparties swap the total return of a single asset or basket of assets in exchange for periodic cash flows (e.g. floating rate such as LIBOR +/- spread) and a guarantee against any capital losses. It is similar in nature to a plain vanilla swap but the total return (cash flows plus capital appreciation or depreciation) is exchanged by the counterparties, not simply the cash flows. In recent times TRS have received a great deal more attention owing to their potential involvement in a number of issues that have arisen around the world (e.g. LIBOR manipulation, ISDA fix rate manipulation, manipulation of CDS, IRS investigations into TRS used to avoid taxes on dividends paid to foreign investors). ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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The reference obligation may consist of bond, loan pool, commodity index, etc. The Total Return Receiver is paid the cash flows from the underlying obligation as well as any appreciation in the value of the obligation. The Total Return Receiver must pay the Total Return Payer any depreciation in the value and compensate the payer for any default losses. The Total Return Receiver must also pay periodic interest that is equivalent to a money market rate (e.g. LIBOR) plus a pre-negotiated spread. The TRS transfers the credit risk from the Total Return Payer to the Total Return Receiver for the duration of the swap. The TRS also exposes the Total Return Payer to interest rate risk as they are accepting LIBOR in exchange for the reference obligation's total return. TRS originally was used by commercial banks to change the risk profile of their loan portfolios (i.e. concentrated in specific industries and/or geographic regions). The TRS allowed a bank to reduce its risk exposure without having to sell its customers' loans, i.e. Total Return Payer. Alternatively, it could obtain exposure to other industries or geographic regions where it acted as a Total Return Receiver. TRS can also be used as a means of diversifying an investor's portfolio. The investors can obtain exposure to the returns of commercial loans or other illiquid asset classes (e.g. untraded commodity index), and so long as the returns are not correlated to the returns on the investor's existing portfolio the diversification reduces the risk level. A TRS can also lock in profits when a Total Return Payer has a funding cost that is less than the payment they receive in the TRS (LIBOR plus a spread).

11.5

Currency Forward

A currency forward contract is an agreement whereby an exchange rate in the foreign exchange market is locked for the purchase or sale of a currency on a future date. Foreign currency forward contracts can be used as a foreign currency hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future. If the date of the foreign currency payment and the last trading date of the foreign currency forwards contract are matched up then the investor has "locked in" the exchange rate payment amount. Currency forward arrangements typically protect the party should a currency depreciate below the contract level, however the party gives up all benefits if the currency appreciates throughout the life of the contract. Forward contracts are risky contracts because they require the buyer to accurately estimate the future value of the exposure amount. Foreign currency contracts may have standard contract sizes, time periods, settlement procedures and are often traded on regulated exchanges. Parties can deliver the currency or settle the difference in rates with cash. An outright forward contract is a binding obligation for a physical exchange of funds at a future date at an agreed on rate, with no payment upfront. A non-deliverable forward contract is a binding obligation for a non-physical exchange of funds at a future date at an agreed on rate. They are settled against a fixed rate at maturity, with the net amount paid in US Dollars (or another fully convertible currency), which is either paid or received. They facilitate the hedging of currencies where government regulations restrict foreign access to local currency or the parties seek to compensate for risk without a physical exchange of funds. At the maturity of a non-deliverable forward contract the forward exchange rate agreed initially is set against the prevailing market 'spot exchange rate' on the fixing date (i.e. two days before the value (delivery) date). The reference for the spot exchange rate (the fixing basis varies from currency to currency) can refer to Reuters or Bloomberg pages. On the fixing date the difference between the forward rate and the prevailing spot rate are subtracted which results in the net amount that has to be paid by one counterparty to the other as settlement on the value (delivery) date. ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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The 'forward rate' (price of an outright forward contract) is based on the spot rate at the time the deal is booked with an adjustment for 'forward points' (i.e. the interest rate differential between the two currencies). The higher yielding currency is discounted going forward. Each forward contract carries a specific delivery or fixing date, and therefore they are more suited to hedging the foreign exchange risk on a bullet principal repayment, as opposed to a stream of interest and principal payments which can be hedged using cross-currency swaps. They can sometimes be used as a more affordable (yet less effective) hedging mechanism than swaps when used to hedge the foreign exchange risk of the principal of a loan, leaving interest payments uncovered. A party to a currency forward is exposed to credit risk, exchange rate risk, and interest rate risk (i.e. since the price is dependent on the differential between the interest rates that can be earned with the two currencies, rate variations can change the price of the contract and so the party forgoes the opportunity to sign a contract at a lower rate if there is a favourable change in interest rates). Figure 11: Forward Contract used to Exchange ÂŁ100,000 into Euros

11.6

Commodity Forward

Commodity derivatives (e.g. options, futures, swaps) enable increasing, reducing, or completely avoiding the commodity price risk. A commodity forward is an agreement between two parties by which the buyer and the seller commit to buying or selling the underlying commodity at a predetermined price after maturity, or cash settlement on the expiry date. The value of a commodity forward is derived from the spot value of the particular commodity. An average contract is a customised commodity forward which may be suitable for parties who regularly buy or sell commodities at average prices. By using an average contract, the risk of an undesired price change can be avoided. With an average contract the closing transaction is not carried out based on the price of a commodity on the expiry date, but on the average price for a predetermined period.

11.7

Valuation Principles

The Initial swap valuation price must be equal for the fixed and floating. Since the floating rate is at par the rate on fixed must equal the rate on the three-year Treasury. If the rates increase the counterparty receiving the floating rate is better off

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 If the rates decline a counterparty will prefer to receive a fixed rate If there is no change in the yield curve and upward sloping curve a payer of a floating rate has a positive value over its early life. The firm is then required to obtain relevant spot rates. The firm must treat the fixed rate as the fixed rate coupon minus any floating spread. The firm may then discount at the spot rate to obtain the present value. Since the floating rate is par when reset, the firm needs to treat the floating rate as if it is a bond maturing at the reset date and discount cash flows at the appropriate spot rate to obtain the present value. If firms use the London Interbank Offer Rate (LIBOR) they should note that there is credit risk on LIBOR â&#x20AC;&#x201C; spread over T-bill rates, approximately 1-2% (AA Risk). If the initial value of the swap is to be zero, the fixed rate must also exceed the rate on default-free Treasures. Fair Value The fair value of an IRS can be calculated by determining the future cash flows for the receiving leg and the paying leg, and then discounting these cash flows using a relevant discount factor curve. Table 8: Example Swap Terms

Value Date: Notional: Pay Leg: Receive Leg: Floating Rate Spread: Trade Date: Effective Date: Maturity:

31st December 2016 $200 million Fixed 3% 3 million LIBOR 0% 30th June 2016 30th June 2016 st 31 December 2019

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017

CHAPTER 2: OPERATIONAL AND LEGAL RISKS AFFECTING SWAPS OUTLINE ■ ■ ■

Risk Management and Key Operational (Counterparty Credit, Currency, and Liquidity Risks) and Legal Risks affecting Swaps. Legal Opinion Analysis (by jurisdiction and by counterparty). Case Law Analysis (English and U.S. common law approaches to interpreting Swaps Agreements) and Risk Case Studies.

CHAPTER 2 ABBREVIATIONS

Table 9: Chapter 2 Abbreviations Abbreviation

Term

BCBS

Basel Committee on Banking Supervision

CEA

Commodities and Exchange Act

CFTC

Commodity Futures Trading Commission

DCOs

Derivatives Clearing Organizations

ETD

Early Termination Date

FCMs

Futures Commission Merchants

LSOC

Legally Segregated Operationally Commingled

NAV

Net Asset Value

P2P

Principal to Principal Model

SRM

Swap Risk Manager

SWAPS RISKS AND SWAPS RISK MANAGEMENT

Effective swap administration plays a crucial and fundamental role in any swaps risk management framework. Any swap administration framework should, at a minimum, include monitoring the efficacy of the swaps in matching asset and liability duration, management of collateral, management of market events that might significantly affect the existing swaps portfolio, and restructuring swaps if required. A swaps risk manager (SRM) must: (1)

comprehensively understand the range of risks that may affect the range of swaps that exist in the portfolio;

(2)

comprehensively understand the range of risk that may affect relevant swap counterparties;

(3)

comprehensively understand the swaps documentation framework;

(4)

comprehensively understand the collateral documentation framework;

(5)

put in place an effective swap administration framework; and

(6)

put in place an effective market and economic indicator monitoring system.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 Some governmental institutions (e.g. federal agencies) are restricted or prohibited from trading in futures contracts.

13.1

Duration Risk

Duration risk is a measure of the sensitivity of the price of a fixed income investment (e.g. bond, loan) to a change in interest rates (e.g. duration risk is high for longer-dated bonds). Cash has zero duration risk. Duration is a measure of time but it also measures how much the price of a financial instrument (e.g. bond) is likely to fluctuate when there is an up or down movement in interest rates. The higher the duration number, the more sensitive the investment will be to changes in interest rates. This means that fluctuations in price (negative or positive) will be more pronounced. For long-term bonds with high duration numbers there may be a higher level of loss in value. For a bond, duration is the number of years it will take a bond's cash flow to repay an investor the bond's purchase price, the longer the repayment period (duration), the longer the chances that the bond will be exposed to interest rate risk. Generally, a 1% rise in interest rates would cause about a 1% fall in a bond's price for every year of duration. All else being equal, bonds with shorter maturities have lower duration and bonds with higher coupon rates have lower duration. Variables such as how much interest a bond pays during its lifespan, maturity (i.e. the length of time before the bond's principal is repaid) and the bond's call features and yield (which may be affected by credit quality) play a role in the computation of the duration. The practice of interest rate risk management is called duration matching. The aim of duration matching is to decrease the duration gap to zero, at which point the net worth of the balance sheet will be immune to changes in interest rate. Portfolio managers typically use swaps to reduce the duration gap and immunize the portfolio from interest rate risk. Figure 12: Duration Gap Equation

Duration Gap = DA â&#x20AC;&#x201C; (Total Liabilities/Total Assets) * DL 13.2

Counterparty Credit Risk

Credit risk refers to the risk of loss arising from a counterparty default. There are five ways that credit risk can be addressed in relation to swaps: (1)

the first is to put in place a robust counterparty due diligence and selection process;

(2)

the second is to use credit risk technologies to quantify the credit risk of a swap for current replacements costs and potential replacement costs;

(3)

the third is to mitigate credit risk through the use of legal documentation governing credit risk in the swap transaction;

(4)

the fourth is to mitigate credit risk through implementation of effective collateral agreements, i.e. similar to a security deposit;

(5)

the fifth is to seek to put in place netting procedures in place (e.g. via Master Agreements) that can net counterparty exposures under multiple OTC derivatives agreements.

13.2.1 Counterparty Risk Methodologies These types of counterparty risk methodologies focus on the mark-to-market component of replacement risk. The types of metrics used to measure and monitor counterparty exposure are: ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017

(1)

notional of contracts; This methodology covers information with respect to the total size of a product with a particular counterparty. Decisions must also be taken with respect to the netting of short and long positions that are entered into with a counterparty, with different coupons, maturities, specifications, collateral arrangements, etc.

(2)

current mark-to-market; This methodology seeks to measure the current exposure of a counterparty. This may or may not be adjusted to take into account the benefit of netting arrangements and/or collateral arrangements.

(3)

expected exposure; This methodology portrays the expected positive mark-to-market profile of a swap and incorporates netting and collateral arrangements at different specified points in the future (i.e. normally calculated as the mean potential mark-to-market paths which are in-the-money)

(4)

stressed future potential exposure or peak exposure measure; This methodology is represented by a high percentile of the distribution of potential in-themoney paths for a portfolio of derivatives.

Counterparty risk can be managed via the construction of counterparty risk limits based on: (1)

financial product type (interest rate, foreign exchange, equities, inflation);

(2)

counterparty rating, incorporation jurisdiction, market capitalisation;

(3)

exposure metrics (with reference to collateral and risk mitigation techniques);

(4)

maturity bucket (1 day, 1 week, 30 days, 1-50 years).

13.3

Operational Risk

Operational risk is defined as the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people, and systems, or from external events (including legal risk), differ from the expected losses. For OTC derivatives minimising operational risk relates to minimising the amount of manual handling and interference in derivatives trading and clearing processes, i.e. tending towards a reliance on electronic processes. Manual handling can often result in delays and risks of errors.

13.4

Replacement Risk

The risk that a derivative contract holder will know that a counterparty will be unable to meet the terms of a contract, thereby creating the need for a replacement contract. The counterparty will then have to replace the counterparty's delivery obligations (e.g. interest rate payment, commodity) and the likelihood is that the replacement price will be higher than the original price because the market has moved since the contract was originally entered into.

13.5

Market Risk

Market risk refers to the sensitivity of an asset or portfolio to overall market price movements (e.g. currency, property, inflation, equities, interest rates). Market risk can be defined as the risk of losses in all on-balance sheet and off-balance sheet positions arising from adverse movements in market

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 prices. Market risk is typically addressed by diversification of a portfolio as well as hedging through the use of interest swaps and inflation swaps to produce offsetting positions. From a regulatory perspective, market risk stems from all the positions included in banks' trading book as well as from commodity and foreign exchange risk positions in the whole balance sheet. Traditionally, trading book portfolios consisted of liquid positions easy to trade or hedge. However, developments in banks' portfolios have led to an increase in the presence of credit risk and illiquid positions not suited to the original market capital framework. To address these flaws, material changes in market risk frameworks have been introduced via the Basel capital adequacy frameworks.

13.6

Currency Risk

Currency risk (or exchange rate risk) is the risk that arises from the change in price of one currency in relation to another currency (owing to relative valuation of currencies). Such changes can lead to unpredictable gains and losses when profits or dividends from an investment are converted from one currency to another. Alternatively, investors or companies that are operating across multiple jurisdictions will be exposed to currency risk, thereby creating unpredictable profits and losses. Currency risks can be reduced through effective hedging which will offset currency fluctuations.

13.7

Liquidity Risk

Because swaps are traded on an OTC basis, it is often wrongly assumed that swaps are illiquid. However, the sheer notional volume of swaps around the world (i.e. $Trillions) means that swaps are highly liquid instruments. Nevertheless, it should still be remembered that under certain circumstances liquidity risk might affect a bank's ability to replace a swap that has defaulted, or the bank's ability to synthetically hedge swaps through other market instruments. Moreover, in the event of a swap default, liquidity in the market could become drastically reduced, thereby preventing a bank from acquiring a new swap or making it highly costly for the bank to do so. In practice because different financial instruments have been used to synthetically hedge and replicate swaps, and taking into consideration the sheer notional size of the global swaps markets, liquidity risks are more limited. Guideline 4 (Liquidity Risk) specifies: A bank should properly identify, measure, monitor and control its liquidity needs and risks in each currency when settling FX transactions. A bank's liquidity needs and risks should be appropriately represented in a bank's liquidity risk management framework. The framework should address how the bank's liquidity needs and risks in each currency will vary based on the chosen method of settlement. In addition, the framework should incorporate stress tests using various severe, but plausible, scenarios. (BCBS Supervisory Guidance 1993, p.17). A bank may face a significant liquidity shortfall if a counterparty fails to deliver a leg of an FX transaction (the purchased currency) on time. This situation may be exacerbated in a non-PVP settlement process, whereby the bank has already paid away the sold currency and cannot use those funds as collateral or to swap outright to obtain the needed counter-currency. A bank should accounts for those risks in its liquidity risk management framework and develop contingency plans to address possible liquidity shortfalls. A bank may settle its FX payment obligations based on a bilateral or multilateral net position in each currency (position netting) even though the underlying obligations remain gross from a legal perspective. When this is the case, a bank should understand and address the risk that its liquidity needs could change materially following a settlement disruption. In particular, the failure of a counterparty or a settlement disruption in an FMI could lead to a scenario where a bank's net liquidity needs increase significantly by reverting to gross liquidity needs.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 (BCBS Supervisory Guidance 1993, p.18).

13.8

Rehypothecation Risk

Rehypothecation is the reuse of customer collateral by a bank or counterparty which has provided by the customer under an OTC derivative or swap agreement. In the case of Lehman Brothers in the U.S., customers had deposited billions of dollars in collateral with the bank and prior to its bankruptcy Lehman Brothers had entered into swaps with a net value in excess of $15 billion. Lehman Brothers had rehypothecated the collateral used to support swap contracts taken out and the collateral had often not resided in a separate account held for the customer's benefit, i.e. co-mingling. At law this meant that legal ownership of the collateral did not reside exclusively with the customer. Once Lehman Brothers entered Chapter 11 Proceedings they found it difficult to try to recoup such collateral owing to the convoluted Chapter 11 process in the U.S., i.e. they were left with an unsecured claim against the bankruptcy estate.

13.9

Legally Segregated Operationally Commingled (LSOC)

This refers to a new customer protection model that is different from the traditional futures segregation model used by US Futures Commission Merchants (FCMs). The Legally Segregated Operationally Commingled (LSOC) model is a requirement that has been established by the Commodity Futures Trading Commission (CFTC) rules under the Dodd-Frank reforms. LSOC applies only to customer positions in cleared products that are in the US swaps regulatory class (e.g. interest-rate swaps, credit-default swaps, FX and commodity swaps and forwards). It is not applicable to futures contracts unless futures clear in the customer cleared swaps origin pursuant to Derivatives Clearing Organizations (DCOs) rules for portfolio margining of futures versus swaps. The main aim of LSOC is to protect cleared swap customers from 'fellow customer risk'. This is the risk that FCM customers could sustain losses if other customers of that same firm fail to satisfy payment obligations to the firm. In the US futures model an FCM must hold customer funds physically separate from its 'house' funds. This separate pool of assets is called the 'segregated funds pool'. The firm must at all times ensure that it maintains at least as much value in the segregated funds pool as is required to cover its liabilities to customers. The bank accounts or custody accounts that hold client assets (whether at the FCM or clearinghouse) are often referred to as 'client omnibus accounts' because they hold assets of many individual customers pooled together. Under the LSOC rules the firm must perform a daily segregation calculation in the same way as it does for futures, and the client assets are still pooled together. However, the FCM must also assure the clearinghouse that when it meets its margin call to a clearinghouse for customer positions, it never uses value provided by one customer to meet an obligation of another customer. This requires FCMs to perform a more precise calculation of each customer's obligations to the clearinghouse. So, if any customers default to the FCM, and the FCM in turn defaults to the clearinghouse, the clearinghouse can use value attributable to a particular customer only to cure losses of that customer, and not for any other customer. In practice this requires: (1)

the identification of clients to each clearinghouse to which they hold positions;

(2)

the clearinghouse must know the specific positions of each client; and

(3)

the collateral value for each client on deposit with the clearinghouse must be reported by the FCM to that clearinghouse at least daily.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017

13.9.1 LSOC without Excess and LSOC with Excess Owing to the complex operational requirements LSCO has been phased in via two phases: (1) LSOC without Excess; and (2) LSOC with Excess. LSOC without Excess is the current industry standard and requires a DCO to accept, and segregate on its books and records, only the minimum collateral required to meet initial margin requirements of customer cleared swaps. The FCM holds any excess collateral. There are no FCM reporting requirements to the DCO under this model. Any amount of collateral that the FCM gives to a clearinghouse in excess of the minimum margin requirements is deemed to be unallocated client excess. In a default the clearinghouse cannot use any of that excess to cover any client's losses. LSOC with Excess allows clients to take advantage of the ability to pledge excess collateral to the DCO. This benefits clients by allowing a lower likelihood of liquidation and therefore a higher probability of portability, and speedier asset recovery, in the event of an FCM default. Under LSOC with Excess FCMs will be required to provide a collateral value report to each clearinghouse at least once per day. This report will break down the ownership interest in the collateral assets provided by the FCM and the clearinghouse. This will include an amount for each customer and an amount provided by the FCM itself or the 'firm-contributed assets'. In the event of a FCM default the FCM will file for Chapter 11 Bankruptcy Protection. All of the estate assets including customer collateral will be frozen by the bankruptcy court, and only a court-ordered distribution can result in the collateral being transferred to a transferee FCM or returned to the customer. The court will typically instruct the DCO to distribute collateral as part of a bulk transfer of customers to one or more transferee FCMs. Normally only customers whose positions can be ported are included in the first round distribution of collateral. The amount the court will allow the DCO to transfer is typically conservative in nature to ensure that collateral is not overly distributed to any single group of customers. For any amounts that are not distributed as part of a bulk distribution, customers will need to file a claim with the trustee and court for the amount still owed by the estate of the defaulted FCM.

13.10 Close Out Risk ®

Swap contracts are typically documented using the ISDA Master Agreement architecture. Under this framework the Master Agreements typically contain numerous different close out provisions that allow swap counterparties to close out their positions under the Master Agreement by calculating a final payment upon the default of the bank. However, this calculation can differ depending on the Master Agreement (1992 or 2002) used and on the close out methodology adopted (i.e. First Method and Market Quotation, First Method and Loss, Second Method and Market Quotation, Second Method and Loss, 1992 Master Agreement). ®

Figure 13: Definition of Market Quotation (1992 ISDA Master Agreement, Multicurrency, Cross-Border)

"Market Quotation" means, with respect to one or more Terminated Transactions and a party making the determination, an amount determined on the basis of quotations from Reference Market-makers. Each quotation will be for an amount, if any, that would be paid to such party (expressed as a negative number) or by such party (expressed as a positive number) in consideration of an agreement between such party (taking into account any existing Credit Support Document with respect to the obligations of such party) and the quoting Reference Market-maker to enter into a transaction (the "Replacement Transaction") that would have the effect of preserving for such party the economic equivalent of any payment or delivery (whether the underlying obligation was absolute or contingent and assuming the satisfaction of each applicable condition precedent) by the parties under Section 2(a)(i) in respect of such Terminated Transaction or group of Terminated Transactions that would, but for the occurrence of the relevant Early Termination Date, have been required after that date. For this purpose, Unpaid Amounts in respect of the Terminated Transaction or group of Terminated Transactions are to be excluded but, without limitation, any payment or deliver that would, but for the relevant Early Termination Date, have been required (assuming satisfaction of each © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 applicable condition precedent) after that Early Termination Date is to be included. The Replacement Transaction would be subject to such documentation as such party and the Reference Market-maker may, in good faith, agree. The party making the determination (or its agent) will request each Reference Market-maker to provide its quotation to the extent reasonably practicable as of the same day and time (without regard to different time zones) on or as soon as reasonably practicable after the relevant Early Termination Date. The day and time as of which those quotations are to be obtained will be selected in good faith by the party obliged to make a determination under Section 6(e), and, if each party is so obliged, after consultation with each other. If more than three quotations are provided, the Market Quotation will be the arithmetic mean of the quotations, without regard to the quotations having the highest and lowest values. If exactly three such quotations are provided, the Market Quotation will be the quotation remaining after disregarding the highest and lowest quotations. For this purpose, if more than one quotation has the same highest value or lowest value, then one of such quotations shall be disregarded. If fewer than three quotations are provided, it will be deemed that the Market Quotation in respect of such Terminated Transactions or group of Terminated Transactions cannot be determined. During the financial crisis, these market quotations were not made available for many different types of transactions. Therefore, instead of an ex ante valuation methodology agreed by the swap counterparties, the valuation of thousands of complex swaps has now become a complex ex post calculation not agreed by the swap counterparties. If a Counterparty contests such claims then the other swaps counterparty will be left to undertake protracted litigation. ÂŽ

Figure 14: Definition of Loss (1992 ISDA Master Agreement, Multicurrency, Cross-Border)

"Loss" means, with respect to this Agreement or one or more Terminated Transactions, as the case may be, and a party, the Termination Currency Equivalent of an amount that party reasonably determines in good faith to be its total losses and costs (or gain, in which case expressed as a negative number) in connection with this Agreement or that Terminated Transaction or group of Terminated Transactions, as the case may be, including any loss of bargain, cost of funding or, at the election of such party but without duplication, loss or cost incurred as a result of its terminating, liquidating, obtaining or reestablishing any hedge or related trading position (or any gain resulting from any of them). Loss includes losses and costs (or gains) in respect of any payment or delivery required to have been made (assuming satisfaction of each applicable condition precedent) on or before the relevant Early Termination Date and not made, except, so as to avoid duplication, if Section 6(e)(i)(1) or (3) or 6(e)(ii)(2)(A) applies. Loss does not include a party's legal fees and out-of-pocket expenses referred to under Section 11. A party will determine its Loss as of the relevant Early Termination Date, or, if that is not reasonably practicable, as of the earliest date thereafter as is reasonably practicable. A party may (but need not) determine its Loss by reference to quotations of relevant rates or prices from one or more leading dealers in the relevant markets. Those counterparties option for the Loss valuation methodology would have legal fees and out-ofpocket expenses excluded from any subsequent claim against another counterparty that has defaulted. In addition, a counterparty that has opted for the Loss valuation methodology might also run into the same problems as those Lehman counterparties that opted for the Market Quotation methodology where loss could only be calculated by way of quotations of relevant rates or prices from one or more leading dealers in the relevant markets. Counterparties should therefore be aware of the need for segregated collateral accounts or for collateral to be held with a third party custodian or via a standalone bankruptcy-remote vehicle.

13.11 Legal Risk Legal risk refers to the risk of loss arising from a swap contract that is subsequently proved to be unenforceable. Some areas pertaining to legal risk include:

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 (1)

lack of authority for a counterparty to enter into the contract (i.e. ultra vires);

(2)

contract held to be illegal according to applicable legislation, a court judgement, or a regulatory body (i.e. void or voidable);

(3)

problems associated with any relevant and applicable bankruptcy procedures.

In practice, swaps counterparties should ensure that organizational documents legally authorise firms to enter into all types of swaps transactions that are required by the firm, and that the firm falls under the definition of an 'Eligible Contract Participant' under the US Commodities and Exchange Act (CEA) when dealing with US regulated counterparties. An entity, such as a financial institution, insurance company, or commodity pool, that is classified by the Commodity Exchange Act as an eligible contract participant based upon its regulated status or amount of assets. This classification permits these persons to engage in transactions (such as trading on a derivatives transaction execution facility) not generally available to non-eligible contract participants, i.e., retail customers. (18)

Eligible contract participant

The term "eligible contract participant" means— (A) (i)

acting for its own account— a financial institution;

(ii)

an insurance company that is regulated by a State, or that is regulated by a foreign government and is subject to comparable regulation as determined by the Commission, including a regulated subsidiary or affiliate of such an insurance company;

(iii)

an investment company subject to regulation under the Investment Company Act of 1940 (15 U.S.C. 80a–1 et seq.) or a foreign person performing a similar role or function subject as such to foreign regulation (regardless of whether each investor in the investment company or the foreign person is itself an eligible contract participant);

(iv)

a commodity pool that—

(I)

has total assets exceeding $5,000,000; and

(II)

is formed and operated by a person subject to regulation under this chapter or a foreign person performing a similar role or function subject as such to foreign regulation (regardless of whether each investor in the commodity pool or the foreign person is itself an eligible contract participant) provided, however, that for purposes of section 2(c)(2)(B)(vi) of this title and section 2(c)(2)(C)(vii) of this title, the term "eligible contract participant" shall not include a commodity pool in which any participant is not otherwise an eligible contract participant;

(v)

a corporation, partnership, proprietorship, organization, trust, or other entity—

(I)

that has total assets exceeding $10,000,000;

(II)

the obligations of which under an agreement, contract, or transaction are guaranteed or otherwise supported by a letter of credit or keepwell, support, or other agreement by an entity described in subclause (I), in clause (i), (ii), (iii), (iv), or (vii), or in subparagraph (C); or

(III)

that—

(aa)

has a net worth exceeding $1,000,000; and

(bb)

enters into an agreement, contract, or transaction in connection with the conduct of the entity's business or to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the entity in the conduct of the entity's business;

(vi)

an employee benefit plan subject to the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1001 et seq.), a governmental employee benefit plan, or a foreign person performing a similar role or function subject as such to foreign regulation—

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 (I)

that has total assets exceeding $5,000,000; or

(II)

the investment decisions of which are made by—

(aa)

an investment adviser or commodity trading advisor subject to regulation under the Investment Advisers Act of 1940 (15 U.S.C. 80b–1 et seq.) or this chapter;

(bb)

a foreign person performing a similar role or function subject as such to foreign regulation;

(cc)

a financial institution; or

(dd)

an insurance company described in clause (ii), or a regulated subsidiary or affiliate of such an insurance company;

(vii) (I)

a governmental entity (including the United States, a State, or a foreign government) or political subdivision of a governmental entity;

(II)

a multinational or supranational government entity; or

(III)

an instrumentality, agency, or department of an entity described in subclause (I) or (II); except that such term does not include an entity, instrumentality, agency, or department referred to in subclause (I) or (III) of this clause unless (aa) the entity, instrumentality, agency, or department is a person described in clause (i), (ii), or (iii) of paragraph (17)(A); (bb) the entity, instrumentality, agency, or department owns and invests on a discretionary basis $50,000,000 or more in investments; or (cc) the agreement, contract, or transaction is offered by, and entered into with, an entity that is listed in any of subclauses (I) through (VI) of section 2(c)(2)(B)(ii) of this title;

(viii) (I)

a broker or dealer subject to regulation under the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) or a foreign person performing a similar role or function subject as such to foreign regulation, except that, if the broker or dealer or foreign person is a natural person or proprietorship, the broker or dealer or foreign person shall not be considered to be an eligible contract participant unless the broker or dealer or foreign person also meets the requirements of clause (v) or (xi);

(II)

an associated person of a registered broker or dealer concerning the financial or securities activities of which the registered person makes and keeps records under section 15C(b) or 17(h) of the Securities Exchange Act of 1934 (15 U.S.C. 78o–5(b), 78q(h));

(III)

an investment bank holding company (as defined in section 17(i) [2] of the Securities Exchange Act of 1934 (15 U.S.C. 78q(i)); [3]

(ix)

a futures commission merchant subject to regulation under this chapter or a foreign person performing a similar role or function subject as such to foreign regulation, except that, if the futures commission merchant or foreign person is a natural person or proprietorship, the futures commission merchant or foreign person shall not be considered to be an eligible contract participant unless the futures commission merchant or foreign person also meets the requirements of clause (v) or (xi);

(x)

a floor broker or floor trader subject to regulation under this chapter in connection with any transaction that takes place on or through the facilities of a registered entity (other than an electronic trading facility with respect to a significant price discovery contract) or an exempt board of trade, or any affiliate thereof, on which such person regularly trades; or

(xi)

an individual who has amounts invested on a discretionary basis, the aggregate of which is in excess of—

(I)

$10,000,000; or

(II)

$5,000,000 and who enters into the agreement, contract, or transaction in order to manage the risk associated with an asset owned or liability incurred, or reasonably likely to be owned or incurred, by the individual;

(B)

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 (i)

a person described in clause (i), (ii), (iv), (v), (viii), (ix), or (x) of subparagraph (A) or in subparagraph (C), acting as broker or performing an equivalent agency function on behalf of another person described in subparagraph (A) or (C); or

(ii)

an investment adviser subject to regulation under the Investment Advisers Act of 1940 [15 U.S.C. 80bâ&#x20AC;&#x201C;1 et seq.], a commodity trading advisor subject to regulation under this chapter, a foreign person performing a similar role or function subject as such to foreign regulation, or a person described in clause (i), (ii), (iv), (v), (viii), (ix), or (x) of subparagraph (A) or in subparagraph (C), in any such case acting as investment manager or fiduciary (but excluding a person acting as broker or performing an equivalent agency function) for another person described in subparagraph (A) or (C) and who is authorized by such person to commit such person to the transaction; or

(C)

any other person that the Commission determines to be eligible in light of the financial or other qualifications of the person.

The Global Derivatives Study Group (Group of 30) set out guidance practice and principles relating to derivatives. Recommendation 15 (Promoting Enforceability) states: Dealers and end-users should work together on a continuing basis to identify and recommend solutions for issues of legal enforceability, both within and across jurisdictions, as activities evolve and new types of transactions are developed (Group of 30, p.16). Enforceability of netting provisions is considered a serious concern by 43% of dealer senior management responding to the Survey, and another 45% consider it to be of some concern. It is also considered a serious issue by management of many end-users (Group of 30, p.17).

The Global Derivatives Study Group (1993). Derivatives: Practice and Principles, July, The Group of Thirty, Washington. The Basel Committee on Banking Supervision has provided Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions (BCBS Supervisory Guidance, 1993). Guideline 6 (Legal Risk) specifies: A bank should ensure that agreements and contracts are legally enforceable for each aspect of its activities in all relevant jurisdictions (BCBS Supervisory Guidance 1993, p.23).

It stipulates that key considerations include ensuring that netting and collateral agreements (including provisions for close-out netting) are legally enforceable in all relevant jurisdictions, and that banks should identify when settlement finally occurs so that it can understand when key financial risks are irrevocably and unconditionally transferred as a matter of law (BCBS Supervisory Guidance, 1993, p.23).

13.12 Legal Risk and Netting The effect of close-out netting is to consolidate all obligations of the parties by substituting the multiple payment and/or delivery obligations under the several transactions between the parties by a single net payment obligation of one party for all transactions that are being terminated. It is very important that any netting agreements that are in place work in the event of default of a counterparty, and that they are not impaired by insolvency procedures and other creditors' claims. More specifically firms need to identify the legal enforceability of the close-out netting provisions under the ISDA Master Agreement. Enforceability means: (1)

enforceability as a matter of contract law under the governing law of the contract (e.g. English law or New York law); and

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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(2)

consistency with the bankruptcy laws of the jurisdiction where the counterparty is located. Regardless of the law that is selected to govern the contract local insolvency law in an insolvent party's jurisdiction will always override in the event of an insolvency.

Close-out netting under the ISDA Master Agreement consists of: (1)

early termination;

(2)

valuation of the terminated transactions; and

(3)

an accounting of those values, together with amounts previously due but unpaid, to arrive at a single net sum owing by one party to the other.

In order for close-out netting to be enforceable against a party in a particular jurisdiction each of these areas must be able to stand up to the bankruptcy of that counterparty.

LEGAL OPINION ANALYSIS

Guideline 6 (Legal Risk) in relation to enforceability states: A bank should understand whether there is a high degree of certainty that contracts, and actions taken under such contracts, will not be subject to a stay beyond a de minimis period, voided or reversed. In jurisdictions where close-out netting may not be legally enforceable, banks should ensure that they have compensating risk management controls in place. A bank conducting business in multiple jurisdictions should identify, measure, monitor and control for the risks arising from conflicts of laws across jurisdictions. The identification of legal risk in various jurisdictions can be accomplished through (i) legal opinions upon which a bank is entitled to rely that are commissioned by, and addressed to, a trade organisation or an FMI of which a bank is a member; or (ii) legal opinions provided by the bank's in-house or external counsel who are licensed to practice law in the jurisdictions for which they are providing such opinions. All opinions should be reviewed for legal sufficiency by bank counsel, and be updated, on a regular basis (BCBS Supervisory Guidance, 1993, p.23).

A legal opinion is a legal document in which a solicitor, barrister, lawyer, or qualified legal professional provides his or her opinion on, or his or her understanding of, the law of a legal jurisdiction as applied ® to certain assumed facts. Within the ISDA Master Agreement framework, legal opinions refer to: (1)

netting opinions;

(2)

collateral opinions;

(3)

Addendum Principal to Principal Model (P2P) Clearing Member Reliance;

(4)

Addendum P2P Client Reliance;

(5)

Futures Commission Merchant (FCM) Reliance.

14.1

ISDA® Opinions ®

Close-out netting opinions that have been commissioned by ISDA are generally concerned with the ® efficacy of close-out netting provisions across multiple derivative transaction types. ISDA has obtained netting opinions from lawyers from multiple jurisdictions around the world. In netting opinions ® lawyers opine on whether close-out provisions contained in the ISDA Master Agreement framework would be enforceable by a party against a range of entities organised or incorporated in that lawyer's jurisdiction. For example, counsel in the UK might provide a netting opinion on whether the close-out ® provisions contained in the ISDA Master Agreement where enforceable under English law.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 ®

ISDA has also obtained opinions from lawyers from multiple jurisdictions around the world in relation ® to whether or not the lawyer opines that the provisions contained in ISDA credit support documents would be enforceable by a party against a range of types of entities organised or incorporated in the jurisdiction in which the lawyer resides. ®

The reason why these ISDA opinions matter is that although ISDA Master Agreements are typically governed by English law and New York law, insolvency laws of the jurisdiction in which a counterparty is organised or incorporated will normally apply in the event of an insolvency event. ®

ISDA opinions relating to client clearing include the Addendum P2P Clearing Member Reliance ® opinion and the Addendum P2P Client Reliance opinion. ISDA explains: ISDA has addressed the enforceability of the close-out, set-off and default provisions of the ISDA/FIA Client Cleared OTC Derivatives Addendum (the "P2P Addendum") when used in conjunction with the form of the Master Agreement. The P2P Addendum works in conjunction with an existing master agreement to facilitate the standardised documentation of client clearing and to support delivery of the client protections used by central counterparties on the default of a clearing member. The P2P Addendum operates on the principal-to-principal client clearing model and is designed to operate on a cross CCP basis in conjunction with any non-US CCP that adopts a client clearing structure capable of being used with the P2P Addendum. ISDA opinions are produced either for reliance by a Clearing Member (CM) entering into a P2P Addendum with a Client located in a particular jurisdiction or for reliance by a Client entering into a P2P Addendum with a CM located in a particular jurisdiction. ®

There is also an ISDA opinion relating to FCM reliance. ISDA states: ISDA and FIA jointly commission and publish, for the benefit of their members, legal reviews addressing the enforceability of a US registered FCM's close out and netting rights vis-à-vis its customers in various jurisdictions under the FIA-ISDA Cleared Derivatives Addendum. These legal reviews are based on assumptions regarding the content of the underlying futures and options agreement that is supplemented by the FIA-ISDA Cleared Derivatives Addendum between an FCM and a customer. ISDA and FIA also commission and publish for the benefit of their members, legal reviews addressing the ability of customers to net against their respective FCMs when using the FIA-ISDA Cleared Derivatives Addendum and against three CCPs that support the FCM model of clearing (CME, ICE and LCH).

14.2

ISDA® Opinion Library

Jurisdiction

Netting

Collateral

Addendum Reliance

Anguilla

Yes

Australia

Yes

Commissioned

Yes

Austria

Yes

Bahamas

Yes

Barbados

Yes

Belgium

Yes

Bermuda

Yes

Brazil

Yes

British Virgin Islands

Yes

Commissioned

Yes

Canada

Yes

Commissioned

Yes

Cayman Islands

Yes

- Yes

Yes

Channel Islands - Jersey Yes

Yes

Chile

Yes

Colombia

Yes

Channel Guernsey

Curacao, Maarten

Islands

Aruba,

St Yes

P2P

CM Addendum Reliance

P2P

Client FCM Reliance

Cyprus

Yes

Commissioned

Czech Republic

Yes

Commissioned

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017

Jurisdiction

Netting

Collateral

Addendum Reliance

Denmark

Yes

England & Wales

Yes

Finland

Yes

France

Yes

Germany

Yes

Greece

Yes

Hong Kong

Yes

Commissioned

Yes

Hungary

Yes

Commissioned

Iceland

Yes

India

Yes

Indonesia

Yes

Commissioned

Ireland

Yes

Israel

Yes

Italy

Yes

Japan

Yes

Commissioned

Yes

Luxembourg

Yes

Malaysia

Yes

Commissioned

Malta

Yes

Commissioned No

Mauritius

Yes

Mexico

Yes

Netherlands

Yes

New Zealand

Yes

Norway

Yes

Peru

Yes

Commissioned No

Philippines

Yes

Poland

Yes

Portugal

Yes

Romania

Commissioned No

Russia

Yes

Scotland

Yes

Commissioned

Yes

Singapore

Yes

Commissioned

Yes

Slovakia

Yes

Slovenia

Yes

Commissioned No

South Africa

Yes

Commissioned

South Korea

Yes

Spain

Yes

Sweden

Yes

Switzerland

Yes

Taiwan

Yes

Commissioned

Thailand

Yes

Commissioned

Turkey

Yes

UAE (DIFC Free Zone)

Commissioned No

USA

Yes

Commissioned

Yes

P2P

CM Addendum Reliance

P2P

Client FCM Reliance

CASE LAW ANALYSIS AND RISK CASE STUDIES

An analysis of case law and case studies around the world helps to provide a perspective into what defences have been used by counterparties to get out of their swap obligations. In practice there is a very broad range of defences that have been used and which risk managers should be aware of when negotiating and documenting swap agreements. Briefly these relate to: (1)

Ultra Vires;

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 (2)

Breach of bank's duty of care;

(3)

Termination for error;

(4)

Misinformation about overhedges;

(5)

Undisclosed fees;

(6)

Early payment;

(7)

Negligent advice;

(8)

Invalidity or unenforceability by reason of mandatory rules of national law;

(9)

Misrepresentation.

15.1

Hazell v The Council of the London Borough of Hammersmith and Fulham and Others

Hazell v The Council of the London Borough of Hammersmith and Fulham and Others In the early 1980s a number of local authorities in the UK began to use IRS to hedge their exposure to interest rate fluctuations in relation to their borrowing. Hammersmith entered into IRS on a very large scale. It was estimated that Hammersmith was a counterparty to 0.5% of global trade in swaps. All of Hammersmith's swap positions were betting on falling interest rates. Thereafter interest rates climbed from the 8% mark to 15% within one year. At that point Hammersmith's position was extremely bad. Hammersmith had been entering into swaps on a massive scale simply to collect a premium which they would then use to spend on services. When they ran into huge financial problems because of the rise in interest rates they then went on to embark on more frantic trading in derivatives trying to solve their problems. Total borrowings of Hammersmith were approximately £390 million but it had entered into swap transactions with a total aggregate notional principal of over £6 billion. The House of Lords ruled that a local authority had now power to enter into a swap transaction and so all swaps that Hammersmith had entered into were void. Thereafter this sparked a huge amount of further litigation which was highly instrumental in developing the modern law of restitution in England. This included cases such as Westdeutsche Landesbank Girozentrale v Islington LBC, Kleinwort Benson v Glasgow CC (No 2), Kleinwort Benson Ltd v Lincoln CC, Kleinwort Benson Ltd v Birmingham CC, Kleinwort Benson Ltd v South Tynside MBC, Morgan Greenfell & Co Ltd v Welwyn Hatfield DC.

15.2

IMPORTANT POINTS TO REMEMBER

For all swaps counterparties it is important that a review is made to confirm the capacity and authority of the swaps counterparty to enter into the trade. A firm must ascertain whether prior authorisation is sufficient or new authorisation will be required. For novation of swaps a firm must ascertain whether the new swap counterparty and the swap agreement are subject to consents, approvals, or other requirements imposed by statutory contractual, resolution, or swap policy provisions. If a new trade is off-market a firm should also determine whether the payment from a replacement swap counterparty is subject to any legal or contractual restrictions (e.g. indenture waterfall) or may be used to make the termination payment. If a new trade is on-market a firm will need a source of payment for any termination payment that is to be paid under the swap agreement.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017

15.3

Jefferson County Bankruptcy

15.3.1 Overview Jefferson County is the most populous county in the state of Alabama, in the United States (US), and of the 2010 census the population was 658,466.In 2011 Jefferson County was $4 billion in debt and declared bankruptcy. The financial problems were related to costs of a huge sewer project. Corruption was found among six county commissioners and 15 other officials who were convicted of accepting bribes. This was the largest Chapter 9 (municipal) bankruptcy in the US, (until it was surpassed by that of Detroit, Michigan in 2013),and Jefferson County emerged from bankruptcy in December 2013, following the approval of a bankruptcy plan by the United States bankruptcy court for the Northern District of Alabama.

15.3.2 Background The case can be traced to an aging sewage system that federal regulators ordered fixed in the 1990s. To pay for the repairs, Jefferson County began borrowing money and refinancing old debt, issuing more than $3 billion in warrants and interest-rate swaps by 2003.In early 2008 the county's $3.2 billion of variable-rate and auction-rate sewer warrants collapsed along with associated interest-rate swaps when liquidity in the bond market dried up amid the global financial crisis. The county subsequently lost its legal battles to retain a state-approved occupational license that provided major support for the county's general fund. When state lawmakers refused to help by approving a replacement revenue stream, the county ran out of liquidity in late 2011 and was forced into bankruptcy with a total of $4.23 billion of long-term debt.

15.3.3 Controversy With Jefferson County, it has been said that various financial firms, but primarily JP Morgan, exploited an existing culture of corruption and made taxpayers the victims of one of the largest frauds in the history of the financial markets. Back in 1996, Jefferson County entered into a consent decree with the federal Environmental Protection Agency to make extensive improvements to its sewer system. The county financed the improvements through several bond offerings. The project was originally estimated to cost around $1.5 billion, but its scope eventually climbed to $3 billion. (Sewer rates quadrupled over four years in order to pay for the project.)In 2002, the FBI launched an investigation into the county's construction program, which resulted in the conviction of 21 people, including contractors, county commissioners, and county employees. The convictions were mainly related to construction firms bribing local officials to obtain business. The practice of bribery continued. According to the SEC, in March 2002, Charles LeCroy, then managing director for JP Morgan Securities' southeast regional office in Orlando, Florida, sent a series of emails to his superiors discussing how one of the firm's competitors had successfully scored new municipal underwriting and swap business by enlisting the paid support of the politically connected principals and employees of local broker-dealers. In their first experiment with Jefferson County, LeCroy and Douglas MacFaddin, managing director of JP Morgan's municipal derivatives unit, focused their efforts on two commissioners, and mostly on Commissioner Jeff Germany. These commissioners had not been re-elected and wanted to execute a $1.8 billion debt refinancing before they left office in November in order to direct payments to people who had supported their campaigns â&#x20AC;&#x201C; specifically through Gardnyr Michael and ABI Capital, two local broker-dealers. The county ended up issuing the bonds in three series: 2002-B, 2002-C, and 2002-D. The 2002-C series was the largest component of the transaction, and was the only series that involved auction rate securities and (theoretically offsetting) interest rate swaps. Although the county had selected Gardnyr Michael and ABI Capital to serve as co-underwriters on the 2002-B and 2002-D series, they were not eligible to work on 2002-C because Alabama state law imposes net capital requirements on counterparties to swap contracts, which the two firms did not meet. The state's capital requirements for swap counterparties are significant because JP Morgan's strategy for producing the funds to pay off these firms (in exchange for the firms persuading county commissioners to hire JP Morgan) was to incorporate the cost of the payments into the interest rates on the county's swap agreements. JP Morgan essentially structured the transaction so that county taxpayers would be the ones paying to ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 bribe their own officials. To pass the funds on to Gardnyr Michael and ABI Capital, JP Morgan had to devise some role for the firms in a transaction that it would have been illegal for them to participate in. JP Morgan ended up wiring $250,000 each to the local firms, who provided no actual services to the county, equivalent to one-third of JP Morgan's $1.5 million underwriting fee on the deal. (Because the cost was being passed on to the county, the JP Morgan bankers were mostly indifferent to how much the firms were being paid.) Those firms turned around and wired a large portion of the fees to some of Germany's campaign contributors. Securing a second transaction through the same means proved to be a little more complicated for JP Morgan's bankers because Goldman Sachs had already beat them to establishing a relationship with the new crop of county commissioners. In November 2002, a fellow named Larry Langford took over as president of the Jefferson County Commission. Both JP Morgan and Goldman Sachs had been pitching new bond offerings and swap arrangements to the county. Blount Parrish had wanted to participate in any new offering, but like Gardnyr Michael and ABI Capital, did not meet the state's net capital requirements for that kind of transaction. Blount suggested that Langford hire Goldman Sachs to underwrite a new 2003-B deal because Blount already had a "consulting" agreement with Goldman. Another broker-dealer, Rice Financial Products, had likewise been pitching offerings to the county through a local "consultant" that was also good friends with Blount. To ensure that JP Morgan won the county's business, LeCroy and MacFaddin cut a deal with Langford to pay them all off. Pursuant to their negotiations, LeCroy and MacFaddin paid Goldman Sachs $3 million and Rice Financial $1.4 million. Goldman Sachs turned around and paid Blount Parrish $300,000.JP Morgan entered into a swap with the county (at an inflated cost to the county), and Goldman and Rice entered into separate corresponding swaps with JP Morgan. In the end, the fraudulent payments LeCroy and MacFaddin made to secure the county's business from 2002 to 2003 totalled $8.2 million. Before the refinancing transactions with JP Morgan, over 95% of the county's debt was in traditional, fixed rate bonds. After the refinancings, 93% was variable rate debt, including $2.1 billion of auction rate securities. The debt was synthetically fixed through $5.6 billion notional of swaps.

15.3.4 Bankruptcy Filing Jefferson County filed for bankruptcy on November 9, 2011. This action was valued at $4.2 billion, with debts of $3.14 billion relating to sewer work; it was then the most costly municipal bankruptcy ever in the US. The County requested Chapter 9 relief under federal statute 11 U.S.C. Â§921. The case was filed in the Northern District of Alabama Bankruptcy Court as case number 11-05736.As of May 2012, Jefferson County had slashed expenses and reduced employment of county government workers by more than 700. The challenges facing the county's finances and its sewer system won't end with bankruptcy. Because the new bond issue pushes debt service payments into the future, rising 67 percent in 2024, the county is facing a projected $1.2 billion gap in money available to maintain the sewer system.

15.3.5 Bankruptcy Settlement Jefferson County emerged from bankruptcy after closing on about $1.8 billion in new sewer warrants used to pay creditors. The exit came approximately two years after filing a $4.23 billion bankruptcy in Nov. 2011, which was the largest by a U.S. city or county at that time. It was argued by a group of ratepayers that the deal heavily favored Wall Street bankers and rate increases scheduled for the next 40 years to repay sewer creditors are onerous. County officials countered that the settlement with J.P. Morgan Chase & Co.; hedge funds and bond insurers reduced the county's $3.2 billion sewer debt by $1.4 billion, a huge savings.

15.3.6 Settlement Details The county sold all of the new warrants needed to raise $1.84 billion to refinance about $3 billion in sewer debt. The plan called for selling $500 million in senior bonds and $1.2 billion in subordinated debt. As part of that deal, JPMorgan Chase & Co. agreed to forgive about $842 million of the $1.22

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 billion the county owed. Jefferson County reached a settlement with JPMorgan and other creditors after battling in court for 20 months.

15.3.7 Impact The residential sewer rates increase 7.89 percent annually for four years and 3.49 percent afterward for the foreseeable future. The first of four increases went into effect. Also, an additional $5 base charge began for all sewer customers. Non-residential users absorbed a $5 base charge last year also and a 3.49 percent increase in the first year, under the plan. In years 2-4, those users' rates would match the residential users' increases and decrease to 3.49 percent afterward for the foreseeable future. It was estimated that Jefferson County would spend about $14.7 billion on sewer debt service, operations and system maintenance over the 40-year life of the debt. The amount is based on the fees ratepayers are to pay over the 40-year sewer revenue restructuring financing plan that the county provided as part of its plan to exit bankruptcy. It was also sent to sewer warrant holders in a material event notice on the Municipal Securities Rulemaking Board's Electronic Municipal Market Access (EMMA) service. According to Calvin Grigsby, a lawyer for ratepayers, "The financing plan includes the $6.6 billion in debt service and the $4.4 billion in operating expenses, and the $3.7 billion in additional annual charges for extra coverage and, if not needed, pay-as-you-go capital improvements" over the 40-year plan, he said.

15.3.8 Corruption and Legal Costs Almost twenty four elected officials, contractors, county employees, and bankers involved in the sewer bond deals went to jail for bribery and fraud. Those included Larry Langford, the former mayor of Birmingham. Before becoming mayor, Langford was president of the county commission when he orchestrated refinancing of the sewer debt to avoid large rate increases on sewer system customers. Langford was convicted on 61 federal charges in October 2009 for bribery, money laundering, mail and wire fraud, conspiracy, and filing a false tax return and is serving a 15-year prison sentence in Kentucky. Since the November 2011 filing, the county has spent nearly $30 million on attorneys and other advisers.

15.3.9 The Future The settlement does not solve all of the county's problems relating to the sewer system. By 2024, when they reach the revenues the county has projected, even after annual sewer rate increases, it will not be enough to fund all the capital costs. For now, the county has decided to underfund capital expenditures, and not just for 2024. For the life of the plan, the county projects it will fall $1.2 billion short of what it will need to maintain the sewer system. Options are that the county could raise sewer rates even higher than it has already agreed to do. However, state law says sewer rates must be reasonable, and the county says that its current plan already raises sewer rates as high as that state law allows. It could borrow more money, but if the county is already having trouble, the markets might not allow it to borrow more. If the county can neither borrow more money nor raise new revenues, there is a last option of another bankruptcy. The impact of Jefferson County's bankruptcy will reverberate for decades in Alabama and in the $3.7 trillion U.S. municipal bond market.

15.4

Marme Inversiones 2007 S.L. v The Royal Bank of Scotland Plc

Marme Inversiones 2007 S.L. v. The Royal Bank of Scotland Plc and others, High Court of Justice, Queen's Bench Division Commercial Court, CL-2014-000348. The owner of Banco Santander SA's Madrid headquarters asked the court to delay a dispute with Royal Bank of Scotland Group Plc and other lenders who were seeking about 700 million euros ($798 million) from IRS linked to the 1.9 billion-euro acquisition of the Ciudad Financiera complex. Marme borrowed 1.6 billion euros from a group of banks to buy Santander's 250-hectare office complex in September 2008, the week before Lehman Brothers Holdings Inc. filed for bankruptcy protection. The long-term IRS were 'snowball' swaps which meant that the spread was cumulative at each payment date and subject to leverage, once benchmark interest rates fell below certain thresholds. ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 The complex derivative led to an €89 million loan spiralling into a debt of almost €500 million. This has been referred to as 'the worst trade ever'. Marme went into voluntary administration in 2014 after missing loan repayment deadlines and is subject to insolvency applications in Spain. The revelation that banks tried to rig benchmark interest rates underpinning trillions of dollars in contracts has led to lawsuits by clients who say they were misled, as well as criminal prosecutions and regulatory fines. Marme's case is the largest of a number of London lawsuits seeking to rescind unprofitable swap contracts because they were linked to Libor. Marme wanted to rescind swap agreements it had entered on based on "false representations" by RBS. An English court declined to delay four banks from trying to enforce swaps contracts against Spanish property investor Marme Group, pending its ongoing insolvency proceedings in Spain – despite claims by the group that the contracts are invalid due to Euribor rigging.

15.5

IMPORTANT POINTS TO REMEMBER

Part of the appeal to England's Court of Appeal rested on the interpretation of Article 3(3) of the Rome Convention, which if engaged could bring into issue mandatory provisions of Portuguese law that would have made the swaps liable to be terminated. Banco Santander Totta SA v. Companhia Carris De Ferro De Lisboa SA (Carris), Banco Santander Totta SA v. Sociedade Transportes Colectivos Do Porto SA (STCP), Banco Santander Totta SA v. Metro Do Porto SA (MDP), and Banco Santander Totta SA v. Metropolitano De Lisboa EPE (MDL), case numbers A3/2016/1781, A3/2016/1782, A3/2016/1783 and A3/2016/1785, in the Court of Appeal (Civil Division) of England and Wales.

15.6

Dexia Crediop S.p.A (Dexia) v Comune di Prato

Dexia Crediop S.p.A (Dexia) v Comune di Prato [2016] EWHC 2824 (Comm), 10 November 2016 Between 2002 and 2006, the Italian bank Dexia CrediopS.p.A. (Dexia) entered into a number of IRS with an Italian local public administration called Prato. The swap that was used was set out under an ISDA Master Agreement which specified a choice of English law and jurisdiction. After the financial crisis of 2008 Prato took on board massive losses on the swaps and sought to have them set aside in the English Commercial Court. Prato's defence and counterclaim were based primarily on arguments relating to capacity and mandatory provisions of Italian law. Article 3(3) of the Rome Convention provides that the choice of English law as the governing law of a contract shall not prejudice the application of the "mandatory rules" of the law of the one country with which "all the other elements relevant to the situation at the time of the choice are connected". Prato was therefore able to rely and prevail on Italian law "mandatory rules" defences although their relevance to swap contracts is limited. In 2002 an Italian bank, began advising an Italian local authority known as Comune du Prato (Prato) on debt restructuring and interest rate swaps. The two parties entered into a Master Agreement govern by English law. Six swaps took place between December 2002 and June 2006. All obligations under swaps 1 to 5 were performed by each side. However, Prato defaulted under swap 6. Dexia brought proceedings against Prato for the recovery of sums it said should have been paid by Prato under swap 6. Prato defended those proceedings on the basis that: (1)

the swaps were void as a matter of English law because of Prato's lack of capacity; and

(1)

Prato was entitled to treat the swaps as null and void, because of breaches by Dexia of mandatory rules of Italian law.

Specifically, Dexia argued that its obligations under the swaps were unenforceable as they contravened general principles of Italian law and local government law, which, in accordance with © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 article 3(3) of the Convention 80/934/ECC on the law application to contractual obligations (Rome Convention), could not be derogated from. Prato relied upon article 30.6 of the Italian financial services law known as Testo UnicodellaFinanza (TUF), which required a 7 day cooling off period to be given for contracts made off-site, to argue that all the swaps were null and void. Prato was founded to be entitled to rely on article 30.6 TUF. This provision was considered by the High Court to be a mandatory provision under article 3(3) of the Rome Convention that could not be derogated from. Accordingly, Dexia's failure to notify Prato of its right of withdrawal within seven days of entering into each swap meant each of the swaps was null and void and Dexia's claim failed.

15.7

Italian Administrative Supreme Court (Decision No 5962 Judgement of the Consiglio di Stato, 27 November 2012)

In this case the court held that certain IRS could not be executed at mid-market prices and price components such as credit charges, hedging charges, and profits could be legitimately charged by banks in their roles as investment services providers. The court held that these components were not regarded as "implicit costs" but rather as legitimate charges and therefore the banks were under no obligation to disclose the various components of the final price of the swaps to the Italian local authority, Pisa. It was Pisa that had a duty of due diligence to seek the information that it deemed necessary to properly evaluate and undertake its decision to enter into the swaps.

15.8

Lehman Brothers Holdings Inc.

Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy protection in the U.S. on 15 September 2008.

•

Lehman had argued that the amount due upon the early termination of an IRS is the "midmarket" value, i.e. the present value of the difference between the two cash flows being exchanged.

•

However this was incorrect as other factors impacted the market value of a derivative such as credit charges, hedging costs, and dealer profit margins.

•

The mid-market value is preferable because it excludes market discounts and therefore maximises the amount that the provider can claim is due to it.

•

Be highly wary of any concessions that are offered by a distressed swap provider.

•

The termination of derivative instruments is "safe harbored" under the U.S. Bankruptcy Code, i.e. a counterparty may terminate the swap based on the bankruptcy filing of its swap provider without running into difficulties relating to the Bankruptcy Code's automatic stay provisions. However the judge in the Lehman bankruptcy noted that this safe harbour has a limited duration and ruled that one year is too long to wait.

Upon the occurrence of a Bankruptcy Event of Default under the applicable swap documentation, a Municipal Counterparty had the right (but not the obligation), so long as the Event of Default is continuing, to designate an Early Termination Date (ETD) by not more than 20 days' notice to the Defaulting Party. If it is out-of-the-money under its agreement after netting all transactions and does not want to make a payment to the Defaulting Party at a given time, the Municipal Counterparty can defer designating an ETD. It cannot selectively terminate transactions governed by the same agreement on the basis of the Event of Default (unless the relevant provision has been modified), and there may be limits under state law and bankruptcy law as to how long it can wait to designate an ETD as the result of a bankruptcy. Some bankruptcy courts have held that the right to designate an ETD as the result of a bankruptcy filing under a safe-harbored swap agreement may become stale. A Municipal Counterparty should have at least several months under the Bankruptcy Code to decide whether to terminate the swap agreement. © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 A bankruptcy trustee or debtor in possession is allowed to assume and assign a swap agreement to a new counterparty curing all existing monetary defaults and demonstrating 'adequate assurance of future performance' by the new counterparty. The bankruptcy court may base its finding of adequate assurance of future performance upon the rating of the new counterparty or other criteria that it deems to be relevant. The Municipal Counterparty may oppose the assignment but it does not have the right to terminate the swap solely on the basis of the assignment or defaults that preceded the assignment. •

Have parties assessed the impact that recent redemptions or a drop in the market value of assets under management have had on their Net Asset Value (NAV)? The parties may consider requesting a waiver or other modification to the Additional Termination Events or Events of Defaults in the Master Agreement.

•

Parties should consider placing a time limit on how long a non-defaulting party can withhold its payment obligations following a default but prior to declaring an early termination date under the agreement.

•

Parties should confirm that any existing Master Agreements have a set-off clause and whether the right of set-off should be extended to affiliates of the non-defaulting party.

•

A standard CSA contains an election that allows the secured party to sell, pledge or rehypothecate posted collateral, and parties may want to consider not permitting such election.

15.9

1994 Procter and Gamble

From a high level overview Procter and Gamble lost $157 million in swaps transactions with Bankers Trust. The transaction was speculative from the perspective of Procter and Gamble, essentially a bet that interest rates would fall and make the swap profitable for them. Bankers Trust deal may not have been speculative if they hedged their position with other swaps written with other counterparties. Throughout history, there have been large and significant losses within the financial markets, especially during the mid 1990's when a string of various losses occurred in that time period. Since then, a considerable effort has been devoted to the development of risk measures to warn against the potential of such losses. One such loss occurred in March 1994, when Procter and Gamble Inc. (P&G) charged $157m against pre-tax earnings, representing the losses on 2 interest rate swaps. The contract, initially worth about $6.65m, experienced an extreme change in value over a short period of time between 1993-1994, leading to a loss of over $100m. This was only one of the major interest rate based losses experienced by various firms during this time period. The contract was initiated in November 1993 and terminated in March 1994, with a loss of approximately $100m. It was a 5 year semi-annual swap in which the company received a fixed rate and paid a floating rate. The floating rate was based on 30-day commercial paper, a discount of 75 basis points, and a spread. The spread would be set in May 1994, and its magnitude depended on the yield on the 5-year constant maturity Treasury and the price of a particular Treasury bond. Once set, the spread would apply to the remaining term of the contract, and so represented a onetime bet on interest rates. However, interest rates spiked. The contract was negotiated in January 1994, yields had risen by 25 BP. P&G terminated the contract, yields had risen to 100 BP. Only 6months in, locked-in contract at 1412 BP (14.12%) above the CP rate. The loss was $157 million. In the end, the resulting $157 million loss produced a suit filed against Bankers Trust in 1994, as they blamed them for the losses because they had suggested the contracts, and fraudulently informed them about the contract. Two years later, and finally the settlement favored P&G, whereby they only needed to pay Bankers Trust $35m, not $157m. This was to serve of great importance to derivative transactions, and the first lawsuit ruled by a judge in 1996.

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15.10 Enron and Prepaid Commodity Swaps In January 1992 Enron was given a full discretion by the U.S. Securities and Exchange Commission to estimate the market values of its contracts and reported the changes in these values as a steady increase in profits without disclosing the source, i.e. it was authorised to use mark-to-market for energy contracts. Subsequent to this Enron executed more than 24 contracts of prepaid commodity swaps and prepaid commodity forward contracts via special purpose entities that were established by JPMorgan Chase and Citigroup. Enron borrowed a total of $8.7 billion between 1992 and 2000 using these structured finance contracts disguised as commodity swaps. Since there was no accounting guidance for prepaid commodity swaps Enron was able to manipulate its financial statements to satisfy its management goals at the expense of investors.

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CHAPTER 3: NEGOTIATING AND DOCUMENTING SWAPS AGREEMENTS OUTLINE ■ ■ ■

Pre-Trade Legal (ISDA Master Agreement, CSA, Credit Lines) and Counterparty Requirements, Execution (Structuring, Valuation, Negotiation, and Execution), and PostTrade Processes (Settlement, Booking, Margining). ® Documenting and negotiating key ISDA Master Agreement provisions for Swaps (Terms and Conditions, Payment Procedures, Procedures for Cancellation, Applicable Law, Competent Legal Authority in the Event of Dispute). Events of Default (Standard and Protective), Termination Risk, Termination Events, and Termination Value, Mismatch Risk, Cancellation Clauses, Credit Ratings Downgrades, Cure Periods, Political Risk, Force Majeure.

CHAPTER 3 ABBREVIATIONS

Table 10: CHAPTER 3 Abbreviations Abbreviation

Term

ABS

Asset-backed securities

ADR

Arbitration and Dispute Resolution

AET

Automatic Early Termination

BAPCPA

Bankruptcy Abuse Prevention and Consumer Protection Act

CDO

A collateralized debt obligation

CEREP

The central repository (CEREP) for publishing the rating activity statistics and rating performance statistics of credit rating agencies set up by ESMA.

CLO

A collateralized loan obligation

CMBS

Commercial mortgage-backed securities

CPG

Credit Policy Group

CSA

Credit Support Annex

CSD

Credit Support Document

CSP

Credit Support Provider

CVA

Credit Valuation Adjustment

DMO

Debt Management Office

EBF

European Banking Federation

ECAI

Eligible Credit Assessment Institution

Emerging Markets

EMA

European Master Agreement

EOD

Events of Default

ERISA

The Employment Retirement Income Security Act

ESMA

The European Securities and Markets Authority

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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Term

FARC

Revolutionary Armed Force of Colombia

FATCA

Foreign Account Tax Compliance Act

GMRA

Global Master Repurchase Agreement

ICC

International Chamber of Commerce

IDR

Issuer Default Ratings

ISDA

International Swaps and Derivatives Association

Information Technology

MTM

Mark-to-Market

NAV

Net Asset Value

OECD

The Organisation for Economic Co-operation and Development

OTC

Over the Counter

QFC

Qualified Financial Contract

REPO

Repurchase

RMBS

Residential mortgage-backed securities

Structured Finance

SMO

Swap Management Office

START

The Strategy Arms Reduction Treaty

SWIFT

Society for Worldwide Interbank Financial Telecommunication

Termination Event

UNASUR

The Union of South American Nations

Y2K

Year 2000

SWAP PROCESS OVERVIEW

Table 11: Overview of the Swap Process

PRE-TRADE

TRADE EXECUTION

POST-TRADE

• • • • •

• • •

•

Internal Approvals. Legal Agreement (ISDA). Legal Agreement (CSA). Guarantees. Infrastructure (Swap Model, Swap Management Systems, Accounting, Swap Personnel).

Internal Modelling. Indicative Quotes (Dealers). Execution of Swap.

• • •

Booking and Settlement of Swap. Mark-to-Market (MTM) Margining. Accounting Policies. Swap Risk Management Framework.

PRE-TRADE LEGAL AND COUNTERPARTY PROCESSES

•

Put in place internal approvals for the swap management office (SMO) or debt management office (DMO) (e.g. internal authority for derivative contracts).

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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Operational infrastructure such as Information Technology (IT) systems, front office staff, back office staff for daily monitoring of swaps contracts and collateral management systems.

•

Building panels of market makers and developing relationships with market makers.

•

Put in place all relevant legal agreements (ISDA Master Agreements and Credit Support Annex (CSA) and train all relevant personnel in negotiating and documenting legal agreements.

•

Put in place a credit risk policy and independent credit personnel.

•

Put in place an effective risk management framework that covers debt management strategies, credit risk policies, and counterparty dealing policies).

•

Set up hard currency and local currency accounts in relevant banks.

•

Authorised signatories for transactions and instructions method (i.e. SWIFT) need to be effected.

•

The internal SMO or DMO must source the required systems in terms of market data feed, setting up the relevant valuation model for swaps contracts.

TRADE EXECUTION

Trade execution processes include: •

The structuring of swaps;

•

The valuation of swaps;

•

Contract details needed for trade capture and reporting;

•

The negotiation of swaps terms;

•

Execution of swaps;

•

Collateral management;

•

Margin requirements for cleared and uncleared swaps;

•

Confirmation of swaps;

•

Third party technology solutions for middle-office and back-office functions;

•

Portfolio compression and reconciliation.

POST-TRADE PROCESSES

Post-trade processes will typically consist of the following: •

Settlement; Matching and confirmation of trade details, funds transfer, transfer of ownership of underlyings and maintenance of necessary documentation, operational and technology costs, custody fees.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

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Booking; Booking (or positioning) a swap is entering into a swap normally with a swap dealer, or alternatively with a swap counterparty on a bilateral OTC basis. This is an alternative scenario to that where the swap facilitator acts as an agent in the swap transaction and does not take the swap onto its books.

•

Margining; MTM systems and methodologies, margining practices, financing costs associated with transferring, receiving and monitoring collateral.

20.1

Automated Swap Systems

Automated swap systems will allow firms to manage the full life cycle of a swap, including swap creation, booking and managing positions, rate resets, financing, corporate actions, profit and loss calculation and monitoring, collateral and margin management. These types of automated systems manage swap positions with real-time market data that provides instant profit and loss, performance, collateral and margin details. The systems can typically cater to multi-asset and multi-currency portfolios across the full trade life cycle (booking, amendments, ISDA confirmations, rate resets, undo resets, rollovers, early terminations, expirations, event diaries). Other features include a confirmations manager to track and monitor all swap trades, a futures manager (to calculate margin and funding requirements with automatic and daily positing to general ledgers) a funding manager (to manage the funding for all swaps operations in a range of currencies and internal cost allocations), and an automated systems to post all cash flows into a general ledger.

NEGOTIATING AND DOCUMENTING AGREEMENT PROVISIONS FOR SWAPS

ISDA®

MASTER

Negotiating and documenting Master Agreement provisions for swaps will reflect: (1)

the credit strength of the counterparties;

(2)

the legal Master Agreement experience of the counterparties;

(3)

whether ISDA Credit Support Documentation is required to be executed;

(4)

the volume of OTC derivatives transactions anticipated between the counterparties;

(5)

the particular OTC Master Agreement framework that is being negotiated.

In respect of the last issue, there are other Master Agreement frameworks that are sometimes easier to negotiate and document, for example the Swiss Master Agreement for OTC Derivatives. By way of further example there are other Master Agreement frameworks that have been put in place such as the European Master Agreement (EMA) sponsored by the European Banking Federation (EBF), the French National Master Agreement (i.e. Convention-cadre relative aux opérations de marché à terme), and the German National Master Agreement (i.e. Rahmenvertrag für Finanztermingeschäfte).

21.1

Terms and Conditions

The terms and conditions that are negotiated and documented for OTC derivatives transactions include any specifically tailored requirements set out in the Schedule to the ISDA Master Agreement or the relevant CSA. © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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These include for example Events of Default (Failure to pay or deliver; Breach of agreement; Credit support default; Misrepresentation; Default under specified transaction; Cross default; Bankruptcy; and Merger without assumption). They also include Termination Events (Illegality; Tax event; Tax event upon merger; Credit event upon merger; Force majeure). The ISDA Master Agreement at a minimum will seek to cover areas such as basic representations, payment mechanics, warranties and covenants, events of default, other events or circumstances that give one or both parties the right to terminate all or certain transactions applicable procedures to terminate transactions and to calculate, convert and set-off termination values. The terms and conditions also include Definitions booklets that relate to a specific type of derivative transaction and contain definitions and mechanical provisions which allow the parties not to reproduce such standard terms in each confirmation.

21.2

Payment Procedures

Interest payment bases used for swaps: (1)

Actual/Actual (actual/365 days or 366 days (leap year)).

(2)

Money Market (actual number of days/360 days (/365 for sterling).

(3)

Bond Basis (30/360 (360/360), interest is calculated on a 30-day month).

21.3

Governing Law, Jurisdiction, and Disputes

The Master Agreement framework allows counterparties to specify which substantive law will govern any disputes that arise through section 13 of the 2002 Agreement which provides that the Governing Law and Jurisdiction will be specified in the Schedule. 13.

Governing Law and Jurisdiction

(a) Governing Law. This Agreement will be governed by and construed in accordance with the law specified in the Schedule. (b) Jurisdiction. With respect to any suit, action or proceedings relating to any dispute arising out of or in connection with this Agreement ("Proceedings"), each party irrevocably:― (i)

submits:―

(1) if this Agreement is expressed to be governed by English law, to (A) the non-exclusive jurisdiction of the English courts if the Proceedings do not involve a Convention Court and (B) the exclusive jurisdiction of the English courts if the Proceedings do involve a Convention Court; or (2) if this Agreement is expressed to be governed by the laws of the State of New York, to the non-exclusive jurisdiction of the courts of the State of New York and the United States District Court located in the Borough of Manhattan in New York City; (ii) waives any objection which it may have at any time to the laying of venue of any Proceedings brought in any such court, waives any claim that such Proceedings have been brought in an inconvenient forum and further waives the right to object, with respect to such Proceedings, that such court does not have any jurisdiction over such party; and © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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(iii) agrees, to the extent permitted by applicable law, that the bringing of Proceedings in any one or more jurisdictions will not preclude the bringing of Proceedings in any other jurisdiction. (c) Service of Process. Each party irrevocably appoints the Process Agent, if any, specified opposite its name in the Schedule to receive, for it and on its behalf, service of process in any Proceedings. If for any reason any party's Process Agent is unable to act as such, such party will promptly notify the other party and within 30 days appoint a substitute process agent acceptable to the other party. The parties irrevocably consent to service of process given in the manner provided for notices in Section 12(a)(i), 12(a)(iii) or 12(a)(iv). Nothing in this Agreement will affect the right of either party to serve process in any other manner permitted by applicable law. (d) Waiver of Immunities. Each party irrevocably waives, to the extent permitted by applicable law, with respect to itself and its revenues and assets (irrespective of their use or intended use), all immunity on the grounds of sovereignty or other similar grounds from (i) suit, (ii) jurisdiction of any court, (iii) relief by way of injunction or order for specific performance or recovery of property, (iv) attachment of its assets (whether before or after judgment) and (v) execution or enforcement of any judgment to which it or its revenues or assets might otherwise be entitled in any Proceedings in the courts of any jurisdiction and irrevocably agrees, to the extent permitted by applicable law, that it will not claim any such immunity in any Proceedings. Finance One v Lehman Brothers, U.S. Court of Appeals for the Second Circuit The Court held that a provision specified in the parties' Master Agreement Schedule which specified New York law as the governing agreement law did not allow Lehman to set off amounts it owed Finance One for unrelated transactions that did not arise under the agreement. If counterparties wish to rely on extra-contractual rights or remedies that may be available under New York law, they should include a choice-of-law provision that is broadly drafted so as to cover such rights and remedies, e.g. set-off rights or assignability. New York courts will not broaden a narrow choice of law provision to cover disputes that extend beyond a dispute under the Master Agreement framework, i.e. "arising out of or relating to this Agreement". SECTION 5-1401 New York General Obligations Law 1. The parties to any contract, agreement or undertaking, contingent or otherwise, in consideration of, or relating to any obligation arising out of a transaction covering in the aggregate not less than two hundred fifty thousand dollars, including a transaction otherwise covered by subsection one of section 1105 of the uniform commercial code, may agree that the law of this state shall govern their rights and duties in whole or in part, whether or not such contract, agreement or undertaking bears a reasonable relation to this state. This section shall not apply to any contract, agreement or undertaking (a) for labor or personal services, (b) relating to any transaction for personal, family or household services, or (c) to the extent provided to the contrary in subsection two of section 1-105 of the uniform commercial code. 2. Nothing contained in this section shall be construed to limit or deny the enforcement of any provision respecting choice of law in any other contract, agreement or undertaking. A choice of law provision that specifies the application of New York law in an agreement for a transaction covering at least US$250,000 in the aggregate will be upheld regardless of whether the agreement bears any relationship to the State of New York.

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2017 Choice of forum is also critical as the forum will decide which law to apply. In a Bahraini case in 2016 swaps counterparties had entered into a Master Agreement which specified the governing law as English law. However the Bahraini court did not apply the contractually agreed choice of English law as the governing law of the contract, it determined that Bahraini law would apply instead. This resulted in the Bahraini court not being willing to order the defendant to pay the sum that was due to a bank under the Master Agreement close-out provisions. th

Allen & Overy (2013). ISDA publishes model arbitration clauses for Master Agreements, (9 September). "The model clauses are the centrepiece of the Arbitration Guide and have been designed for use with the Master Agreements. The model clauses are intended to be inserted in the Schedule to a Master Agreement, and have the effect of deleting the jurisdiction clause set out in Section 13 (b) of the Master Agreement and replacing it with an agreement to arbitrate disputes. The model clauses effect further amendments to adapt other provisions of the Master Agreement (such as appointment of process agents and waiver of sovereign immunity) so that they operate properly with the choice of arbitration. It is the specific tailoring of the clauses for use with the Master Agreement which distinguishes them from the generic model clauses published by arbitral institutions for use in other contracts. Although the governing law of the Master Agreement remains either English law or New York law, the model clauses provide a much greater variety of arbitral forums than the traditional choice between English and New York courts. The choice of seats and rules of arbitration was taken in response to member feedback, and it quickly became clear that members wished to see choices available in the clauses beyond England and New York."

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 Figure 15: Model Clause for International Chamber of Commerce Rules (New York Seat)

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21.4

Competent Legal Authority in the Event of a Dispute

The swap counterparties should agree and specify in advance the Competent Legal Authority in the event of a dispute between the parties. This can be either a legal authority relating to the jurisdiction of one of the counterparties (e.g. the national courts) or alternatively they can specify an international arbitration and dispute resolution centre (e.g. Centre for International Arbitration and Dispute Resolution, London; ICC International Court of Arbitration, ICC International Centre for ADR; P.R.I.M.E. Finance; Investment Arbitration Center in Latin America, UNASUR).

KEY SWAPS ISSUES

22.1

Events of Default

These are listed in section 5 of the 2002 Master Agreement. The Events of Default and Termination Events apply to both counterparties under the Master Agreement framework. However, some events may also be triggered by a third party (e.g. Credit Support Provider) and the counterparties can also specify Specified Entities in the Schedule to which the Events of Default will also apply. The ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 counterparty who triggers the Event of Default is referred to as the 'Defaulting Party' and the other counterparty is referred to as the 'Non-Defaulting Party', i.e. the party or parties who are affected by the Termination Event or Additional Termination Event. Any party not affected by a Termination Event or Additional Termination Event is referred to as a 'Non-Affected Party'. 5.

Events of Default and Termination Events

(a) Events of Default. The occurrence at any time with respect to a party or, if applicable, any Credit Support Provider of such party or any Specified Entity of such party of any of the following events constitutes (subject to Sections 5(c) and 6(e)(iv)) an event of default (an "Event of Default") with respect to such party:â&#x20AC;&#x2022; These Events of Default (EOD) are subject to two qualifications in Sections 5(c) and 6(e)(iv), i.e. EOD arising when Illegality and Force Majeure arise. Standard EOD under the 2002 Master Agreement refer to 7 EOD listed in section 5. These are: (1)

Failure to Pay or Deliver;

(2)

Breach of Agreement; Repudiation of Agreement;

(3)

Credit Support Default;

(4)

Misrepresentation;

(5)

Cross-Default;

(6)

Bankruptcy; and

(7)

Merger Without Assumption.

Protective EOD are those Events of Default that are required by a Counterparty and are referred to as a 'Default Under Specified Transaction'.

22.1.1 Failure to Pay or Deliver (i) Failure to Pay or Deliver. Failure by the party to make, when due, any payment under this Agreement or delivery under Section 2(a)(i) or 9(h)(i)(2) or (4) required to be made by it if such failure is not remedied on or before the first Local Business Day in the case of any such payment or the first Local Delivery Day in the case of any such delivery after, in each case, notice of such failure is given to the party; This Event of Default will apply where a party fails to make or deliver payments or fails to deliver specified property under a Transaction. The Grace Period for a failure to pay or deliver under the 1992 Agreement was three Local Business Days whereas under the 2002 Agreement this is now one Local Business Day or one Local Delivery Day in the case of deliveries. A notice of the failure can be validly given only after close on the failure date (section 12(a)(Notices)) and such notice will be deemed to be effective on the following business day. Under the 1992 Agreement this was a day on which commercial banks are open for business in the city of the defaulting party. However, the 2002 Agreement also incorporates a reference to a Local Delivery Day which covers a day on which settlement systems required to facilitate the relevant delivery are open for business. Since termination is served after close at the expiry of the relevant Grace Period, termination will be effective T+5 (1992 Master Agreement) or T+3 (2002 Master Agreement). A default under a Specified Transaction is covered under the Master Agreement architecture requiring 3 Local Business Days (1992 Master Agreement) or 1 Local Business Day (2002 Master Agreement). ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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22.1.2 Breach of Agreement; Repudiation of Agreement (ii)

Breach of Agreement; Repudiation of Agreement.

(1) Failure by the party to comply with or perform any agreement or obligation (other than an obligation to make any payment under this Agreement or delivery under Section 2(a)(i) or 9(h)(i)(2) or (4) or to give notice of a Termination Event or any agreement or obligation under Section 4(a)(i), 4(a)(iii) or 4(d)) to be complied with or performed by the party in accordance with this Agreement if such failure is not remedied within 30 days after notice of such failure is given to the party; or (2) the party disaffirms, disclaims, repudiates or rejects, in whole or in part, or challenges the validity of, this Master Agreement, any Confirmation executed and delivered by that party or any Transaction evidenced by such a Confirmation (or such action is taken by any person or entity appointed or empowered to operate it or act on its behalf); This Event of Default will be triggered where a party breaches a covenant or breaches an agreement. This section stipulates a 30-day grace period following notice in which a counterparty can cure the breach. This 30-day grace period can be shortened by specification in the Schedule, e.g. 15-day grace period. (1)

Failure to maintain authorisations.

(2)

Failure to provide accounting information within specified timeframe.

(3)

Failure to provide a legal opinion within specified timeframe.

There is no grace period specified for the repudiation provisions. Therefore where there is clear evidence that Counterparty A has repudiated the provisions of the Master Agreement (or a Confirmation or Transaction), Counterparty B need not wait until actual default of obligations (e.g. payment default, delivery default, failure to perform an obligation). Table 12: ISDA 2002 Master Agreement Breach of Agreement Excluded Events

Failure to Pay or Deliver (EOD)

Failure to give Notice (TE)

Failure to Comply with Tax Related Agreements

Any obligations that are covered by the Failure to Pay or Deliver Event of Default.

Any failure to give notice of a Termination Event.

Any failure to comply with certain tax related agreements or obligations that are contained in Section 4.

22.1.3 Credit Support Default (iii)

Credit Support Default.

(1) Failure by the party or any Credit Support Provider of such party to comply with or perform any agreement or obligation to be complied with or performed by it in accordance with any Credit Support Document if such failure is continuing after any applicable grace period has elapsed; (2) the expiration or termination of such Credit Support Document or the failing or ceasing of such Credit Support Document, or any security interest granted by such party or such Credit Support Provider to the other party pursuant to any such Credit Support Document, to be in full force and effect for the purpose ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 of this Agreement (in each case other than in accordance with its terms) prior to the satisfaction of all obligations of such party under each Transaction to which such Credit Support Document relates without the written consent of the other party; or (3) the party or such Credit Support Provider disaffirms, disclaims, repudiates or rejects, in whole or in part, or challenges the validity of, such Credit Support Document (or such action is taken by any person or entity appointed or empowered to operate it or act on its behalf); This Event of Default is triggered where there is a default under any Credit Support Document (CSD) (e.g. guarantee or security agreement). It is also applicable to any earlier-than-agreed-upon expiration, termination, or repudiation of a CSD (including any action undertaken by a Credit Support Provider (CSP). The CSP must be identified in Part 4(g) of the Schedule or in the CSD itself. A counterparty's guarantor should be identified in the Schedule. Any other document which takes the form of a pledge or creates a security interest is a CSD and should be referred to in the Schedule, i.e. New York Law ISDA CSA and English Law ISDA CSD. Where there is complete title transfer and ownership is transferred to another counterparty under an English Law ISD CSA then such party should not be identified in the Schedule as title transfer is completed under a separate document which does not form part of the ISDA architecture. There will be a default if a party or its CSP breach any term of the CSD and the breach continues on after the applicable grace period. If the CSD or any security interest granted by a counterparty becomes ineffective prior to discharge of all obligations under related Transactions there will be a default in the absence of the other counterparty's written consent. If a CSP (or a third party entitled to act on its behalf such as a national regulator, a liquidator, a done acting under a power of attorney) repudiates, disowns, or challenges the validity of the CSP this will trigger the Event of Default.

22.1.4 Misrepresentation (iv) Misrepresentation. A representation (other than a representation under Section 3(e) or 3(f)) made or repeated or deemed to have been made or repeated by the party or any Credit Support Provider of such party in this Agreement or any Credit Support Document proves to have been incorrect or misleading in any material respect when made or repeated or deemed to have been made or repeated; This will apply where representations (other than payer and payee tax representations) that are set out in the ISDA Master Agreement or CSD are breached by either party of a CSP. This will be where representations that are made are materially misleading or incorrect. Representations in the ISDA Master Agreement are deemed to be repeated for each new transaction. There is no cure period for a misrepresentation Event of Default.

22.1.5 Default under Specified Transaction (v) Default Under Specified Transaction. The party, any Credit Support Provider of such party or any applicable Specified Entity of such party:â&#x20AC;&#x2022; (l) defaults (other than by failing to make a delivery) under a Specified Transaction or any credit support arrangement relating to a Specified Transaction and, after giving effect to any applicable notice requirement or grace period, such default results in a liquidation of, an acceleration of obligations under, or an early termination of, that Specified Transaction; (2) defaults, after giving effect to any applicable notice requirement or grace period, in making any payment due on the last payment or exchange date of, or any payment on early termination of, a Specified Transaction (or, if there is no

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 applicable notice requirement or grace period, such default continues for at least one Local Business Day); (3) defaults in making any delivery due under (including any delivery due on the last delivery or exchange date of) a Specified Transaction or any credit support arrangement relating to a Specified Transaction and, after giving effect to any applicable notice requirement or grace period, such default results in a liquidation of, an acceleration of obligations under, or an early termination of, all transactions outstanding under the documentation applicable to that Specified Transaction; or (4) disaffirms, disclaims, repudiates or rejects, in whole or in part, or challenges the validity of, a Specified Transaction or any credit support arrangement relating to a Specified Transaction that is, in either case, confirmed or evidenced by a document or other confirming evidence executed and delivered by that party, Credit Support Provider or Specified Entity (or such action is taken by any person or entity appointed or empowered to operate it or act on its behalf); This Event of Default is triggered by a default by a party, a CSP, or a Specified Entity under a Specified Transaction. Specified Transactions are OTC derivatives that are not entered into or governed under the relevant ISDA Master Agreement. The definition of Specified Transaction is set out in Section 14 (Definitions): "Specified Transaction" means, subject to the Schedule, (a) any transaction (including an agreement with respect to any such transaction) now existing or hereafter entered into between one party to this Agreement (or any Credit Support Provider of such party or any applicable Specified Entity of such party) and the other party to this Agreement (or any Credit Support Provider of such other party or any applicable Specified Entity of such other party) which is not a Transaction under this Agreement but (i) which is a rate swap transaction, swap option, basis swap, forward rate transaction, commodity swap, commodity option, equity or equity index swap, equity or equity index option, bond option, interest rate option, foreign exchange transaction, cap transaction, floor transaction, collar transaction, currency swap transaction, cross-currency rate swap transaction, currency option, credit protection transaction, credit swap, credit default swap, credit default option, total return swap, credit spread transaction, repurchase transaction, reverse repurchase transaction, buy/sell-back transaction, securities lending transaction, weather index transaction or forward purchase or sale of a security, commodity or other financial instrument or interest (including any option with respect to any of these transactions) or (ii) which is a type of transaction that is similar to any transaction referred to in clause (i) above that is currently, or in the future becomes, recurrently entered into in the financial markets (including terms and conditions incorporated by reference in such agreement) and which is a forward, swap, future, option or other derivative on one or more rates, currencies, commodities, equity securities or other equity instruments, debt securities or other debt instruments, economic indices or measures of economic risk or value, or other benchmarks against which payments or deliveries are to be made, (b) any combination of these transactions and (c) any other transaction identified as a Specified Transaction in this Agreement or the relevant confirmation. Table 13: Transaction and Specified Transaction

ISDA Master Agreement Transaction

ISDA Master Agreement Specified Transaction

This is an OTC derivatives transaction that is made between two counterparties and is subject to the provisions of the ISDA Master Agreement.

This is an OTC derivatives transaction that is made between the same two counterparties but is not subject to the provisions of the ISDA Master Agreement.

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It is defined in very broad terms and covers most transactions which may be entered into under an ISDA Master Agreement. Counterparties negotiating the Schedule may specifically amend the definition to broaden or narrow the types of transactions that are caught by the definition. The 2002 Agreement has extended the definition to cover stock lending and repurchase (repo) agreements. However, this will only apply where there has been an actual acceleration by a counterparty. The provision does not apply to any Transactions between a party (or any CSP or any Specified Entity of it) and any third party or to Transactions under the Master Agreement between the parties. The Transactions are intended to cover transactions that have been concluded under other agreements or long form confirmations. Counterparties must take care when including repurchase agreements within the definition as these are typically subject to different close-out regimes under Global Master Repurchase Agreement (GMRA) frameworks. The right to terminate must be exercised in relation to all Transactions and therefore a 'mini-close out' (i.e. a close out of Affected Transactions) will not result in a Default Under Specified Transaction.

22.2

1992 Agreement

Three Local Business Days as a fallback grace period for any failure to pay or deliver at the maturity of a Specified Transaction (if no grace period is specified in the Specified Transaction documentation).

22.3

2002 Agreement

One Local Business Day as a fallback grace period for any failure to pay at the maturity of a Specified Transaction (if no grace period is specified in the Specified Transaction documentation). Failure to deliver is excluded from fallback grace periods. Table 14: 1992 ISDA Master Agreement Default under Specified Transaction Defaults

1992 ISDA Master Agreement Liquidation, Acceleration, Early Termination Default

Payment or Delivery Default

Repudiation

A default which results in the liquidation, acceleration, or early termination of the Transaction.

A default in making any payment or delivery due on the final payment date or any early termination date of any Specified Transaction after giving effect to any applicable grace period.

Repudiation of a Specified Transaction in whole or in part.

Default Under Specified Transaction in the 2002 Agreement includes any credit support arrangement for a Specified Transaction. A failure to deliver must result in the acceleration or early termination of all (not some) Transactions under the documentation relating to the Special Transaction before an Event of Default due to a failure to deliver is triggered. Table 15: 2002 ISDA Master Agreement Default under Specified Transaction Defaults

2002 ISDA Master Agreement Acceleration or Early Termination Default

Payment Default

Delivery Default

Repudiation

Acceleration or early termination of the Specified Transaction or any related Credit

Payment default on the final payment date, or with any early termination settlement

Delivery default under a Specified Transaction (or any related Credit Support Arrangement

Repudiation of a Specified Transaction by the party itself or third parties (e.g.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 2002 ISDA Master Agreement Acceleration or Early Termination Default

Payment Default

Delivery Default

Repudiation

Support Arrangement supporting the Specified Transaction.

payment after the notice of a minimum one Local Business Day grace period has lapsed.

supporting the Specified Transaction), resulting in the liquidation of all transactions under the Specified Transaction documentation (after the giving of notice or the expiry of the grace period).

Specified Entities, CSPs, liquidators, national regulators).

Specified Transactions can be brought with the ISDA framework (e.g. for termination purposes) by including a 'Scope of Agreement' clause in Section 5 of the Schedule. Scope of Agreement. Notwithstanding anything contained in this Agreement to the contrary, if the parties enter or have entered into a Specified Transaction, such Specified Transaction shall be subject to, governed by, and construed in accordance with the terms of this Agreement, unless the Confirmation relating thereto shall specifically express to the contrary. Each such Specified Transaction shall be a Transaction for the purposes of this Agreement.

22.3.1 Cross-Default (vi) Cross-Default. If "Cross-Default" is specified in the Schedule as applying to the party, the occurrence or existence of:â&#x20AC;&#x2022; (l) a default, event of default or other similar condition or event (however described) in respect of such party, any Credit Support Provider of such party or any applicable Specified Entity of such party under one or more agreements or instruments relating to Specified Indebtedness of any of them (individually or collectively) where the aggregate principal amount of such agreements or instruments, either alone or together with the amount, if any, referred to in clause (2) below, is not less than the applicable Threshold Amount (as specified in the Schedule) which has resulted in such Specified Indebtedness becoming, OR BECOMING CAPABLE AT SUCH TIME OF BEING DECLARED, due and payable under such agreements or instruments before it would otherwise have been due and payable; or (2) a default by such party, such Credit Support Provider or such Specified Entity (individually or collectively) in making one or more payments under such agreements or instruments on the due date for payment (after giving effect to any applicable notice requirement or grace period) in an aggregate amount, either alone or together with the amount, if any, referred to in clause (1) above, of not less than the applicable Threshold Amount; The parties must expressly specify to which party the Cross-Default provisions will apply, i.e. Party A, Party B. Specified Indebtedness (i.e. borrowed money) Specified Indebtedness is defined to mean any obligation (whether present or future, contingent or otherwise, as principal or surety or otherwise) in respect of borrowed money. It is made expressly subject to the Schedule and the Schedule provides for the term to have the meaning specified in ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 Section 14 of the 2002 Master Agreement, or alternatively a different definition can be used by the parties. Specified indebtedness can be widened to include other types of indebtedness such as commercial paper, acceptances, OTC derivatives transactions with third parties, or lease purchase obligations (e.g. capitalised payments). Specified indebtedness can be narrowed in order to exclude certain types of obligations such as banking deposits taken by a bank in the ordinary course of its business. The Cross-Default provision will be triggered by: (1)

a default or similar event under such agreement which has resulted in the Specified Indebtedness becoming, or becoming capable of being declared, due and payable;

(2)

a default in making any payment on its due date under such agreement after giving effect to any applicable grace period.

If the Cross-Default provision applies a Threshold Amount should be specified in order to provide a monetary figure above which a Non-Defaulting Party may exercise its rights. The Threshold Amount can be either a fixed monetary figure or it can be a percentage (e.g. percentage of shareholders' equity). The Cross-Default provision will automatically apply to a party's CSP (unless otherwise agreed). The Cross-Default provision will not apply to any Specified Entity unless it is specified in Part 1(a) of the Schedule. If Specified Entity is included then all Specified Indebtedness owed by all relevant parties can be added together when determining the Threshold Amount. Parties can also include a provision in the Schedule that excludes Cross-Default from being triggered in the event of operational or administrative errors that are corrected within a specified grace period.

22.4

1992 Master Agreement

These two provisions are viewed separately in relation to the determination of the Threshold Amount, i.e. each has to be above the Threshold Amount to be triggered.

22.5

2002 Master Agreement

These two provisions are viewed cumulatively in relation to the determination of the Threshold Amount. This provision can be varied in the Schedule in order to change the size of the Threshold Amount, or to apply these two provisions separately as in the 1992 Agreement. Any Threshold Amount should specify the equivalent amount in any other currency that is relevant to the parties.

22.6

Cross-Acceleration

The Cross-Default provision can be changed to a Cross-Acceleration provision by deleting "or becoming capable at such time of being declared". The parties can also include a grace period before the failure to pay will trigger an Event of Default. This is particularly useful in situations that involve attendant loans as grace periods can match grace periods contained in the loan documentation and this will not trigger a cross-default under such loan documentation.

22.7

Specified Entity

A Specified Entity is any other member or members in a counterparty's group who is specified as joined in the Master Agreement via the Schedule and are relevant to ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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three Events of Default: (1)

Default under Specified Transaction;

(2)

Cross-Default;

(3)

Bankruptcy;

and one Termination Event: (1)

Credit Event Upon Merger.

These members are those members of a counterparty's group (e.g. parent or fellow subsidiaries) whose relationship is so close to that of the counterparty that if an Event of Default happened to them, it would be likely to significantly affect the counterparty. Specified Entities can be specifically referred to or they can be generalised as 'Affiliates'. The reference to Affiliates may be a general one, or it may be tailored to include 'Material Affiliates', e.g. those who account for 15-25% of group pre-tax profits or assets. Specified Entities can be specified as applicable to all such events or simply a specific Default under Specified Transaction. The overall effect of adding Specified Entities is to extend a Non-Defaulting Party's rights in certain circumstances to third parties who are not part of the ISDA Master Agreement. If a bank agrees to including a smaller subsidiary as a Specified Entity then it runs the risk that that Specified Entity could trigger an Event of Default which could in turn lead to a termination of all Transactions under the ISDA Master Agreement.

22.7.1 Bankruptcy (vii) Bankruptcy. The party, any Credit Support Provider of such party or any applicable Specified Entity of such party:â&#x20AC;&#x2022; (l) is dissolved (other than pursuant to a consolidation, amalgamation or merger); (2) becomes insolvent or is unable to pay its debts or fails or admits in writing its inability generally to pay its debts as they become due; (3) makes a general assignment, arrangement or composition with or for the benefit of its creditors; (4)(A) institutes or has instituted against it, by a regulator, supervisor or any similar official with primary insolvency, rehabilitative or regulatory jurisdiction over it in the jurisdiction of its incorporation or organisation or the jurisdiction of its head or home office, a proceeding seeking a judgment of insolvency or bankruptcy or any other relief under any bankruptcy or insolvency law or other similar law affecting creditors' rights, or a petition is presented for its winding-up or liquidation by it or such regulator, supervisor or similar official, or (B) has instituted against it a proceeding seeking a judgment of insolvency or bankruptcy or any other relief under any bankruptcy or insolvency law or other similar law affecting creditors' rights, or a petition is presented for its winding-up or liquidation, and such proceeding or petition is instituted or presented by a person or entity not described in clause (A) above and either (I) results in a judgment of insolvency or bankruptcy or the entry of an order for relief or the making of an order for its winding-up or liquidation or (II) is not dismissed, discharged, stayed or restrained in each case within 15 days of the institution or presentation thereof; (5) has a resolution passed for its winding-up, official management or liquidation (other than pursuant to a consolidation, amalgamation or merger); (6) seeks or becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee, custodian or other similar official for it or for all or substantially all its assets; (7) has a secured party take possession of all or ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 substantially all its assets or has a distress, execution, attachment, sequestration or other legal process levied, enforced or sued on or against all or substantially all its assets and such secured party maintains possession, or any such process is not dismissed, discharged, stayed or restrained, in each case within 15 days thereafter; (8) causes or is subject to any event with respect to it which, under the applicable laws of any jurisdiction, has an analogous effect to any of the events specified in clause (l) to (7) above (inclusive); or (9) takes any action in furtherance of, or indicating its consent to, approval of, or acquiescence in, any of the foregoing acts; or This Event of Default is triggered if a party, a CSP, or any Specified Entity is subject to any bankruptcy or insolvency proceedings. It is very broadly drafted in order to capture nearly all types of bankruptcy or insolvency proceedings by any type of entity (e.g. dissolution, insolvency, inability to pay debts, compositions, insolvency proceedings, a winding-up or similar resolution, enforcement of security or execution of judgments, analogous proceedings, any action to further or consent to any of such proceedings). The 1992 Master Agreement provides for a 30 day grace period before an Event of Default is triggered. This provides the party with 30 days to have an involuntary bankruptcy dismissed, discharged, stayed, or restrained. The 2002 Master Agreement provides for a 15 day grace period where proceedings are initiated by a third party. The 2002 Master Agreement provides for the Event of Default to be triggered immediately in the event that proceedings are initiated by the principal regulator or other primary insolvency official of a party (or any CSP or any Specified Entity of it). The Schedule can be amended to reference bankruptcy or insolvency proceedings brought within a specific jurisdiction.

22.7.2 Merger Without Assumption (viii) Merger Without Assumption. The party or any Credit Support Provider of such party consolidates or amalgamates with, or merges with or into, or transfers all or substantially all its assets to, or reorganises, reincorporates or reconstitutes into or as, another entity and, at the time of such consolidation, amalgamation, merger, transfer, reorganisation, reincorporation or reconstitution:â&#x20AC;&#x2022; (l) the resulting, surviving or transferee entity fails to assume all the obligations of such party or such Credit Support Provider under this Agreement or any Credit Support Document to which it or its predecessor was a party; or (2) the benefits of any Credit Support Document fail to extend (without the consent of the other party) to the performance by such resulting, surviving or transferee entity of its obligations under this Agreement. This Event of Default is triggered when a merger (or similar transaction) involving a party or CSP, where the surviving entity does not assume the obligations of either party or its CSP. It also covers the situation where any CSD fails to fully extend to the performance by the resulting entity of its obligations under the Master Agreement. This provision does not apply to Specified Entities.

22.8

Set-Off Rights

Bilateral set-off rights can be applied to amounts owed between the ISDA parties and these are enforceable under the Master Agreement architecture. Triangular set-off rights (including affiliates of a counterparty) and rectangular set-off rights (including parties and affiliates of both parties) are not enforceable.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 The 1992 Master Agreement did not include any provision for set-off, and therefore if a counterparty wished to have it included then they had to draft a specific set-off clause in the Schedule in Part 5. The 2002 Master Agreement provides for set-off in section 6(f).

22.9

Safe Harbor Rights

Under the US Bankruptcy Code IRS receive special treatment. Under the US Chapter 11 bankruptcy framework there is an automatic stay of proceedings which prevents creditors from seizing the assets of the debtor. Executory contracts can be rejected or assumed and the trustee's avoidance powers are significant. However, notwithstanding this automatic stay ISDA parties can terminate the ISDA Master Agreement, liquidate all transactions, and exercise set-off rights and make termination payments. Such rights must be specified in the underlying OTC derivatives contract. These rights are therefore a very effective way to avoid dealing with US bankruptcy proceedings and being exposed to market risk which the insolvency proceedings are heard in court. Sections 362 and 560 of the Bankruptcy Code provide that a non-debtor swap counterparty is permitted to terminate the swap and seize its collateral notwithstanding the automatic stay. The automatic stay remains in relation to all other actions relating to the swap, so a debtor cannot be compelled to make payments or provide reports to a swap counterparty. In the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), a new counter party called 'financial participant' is clearly defined as a new entity which needs to meet financial requirements. The aim of this is to reduce systemic risk allowing these entities to close out and net derivatives contracts and repurchase agreements and reduce systemic risk allowing the 'clearing organisations' among the 'financial participants'. The BAPCPA also modified section 553 concerning automatic stay, in fact, this automatic stay and the avoidance and liquidation expectations for the contracts mentioned before are structured to allow creditors to deal directly with debtors (without the intervention of the Bankruptcy Court). The new framework allows a Qualified Financial Contract (QFC) to be terminated by a debtor's counterparty which will collect the obligations, without the limitation of the automatic stay. The cause of the termination can be any financial condition (bankruptcy or insolvency) under the ipso facto clauses (which give the right to a party to terminate a QFC following the financial difficulties of the debtor, without any limitation). The other purpose of this new Safe Harbor provision is to providing protections against avoidance for transfers related to QFCs and generally made before the beginning of a case from or to, among others, a swap participant or a participant related to swap. The right to terminate a QFC is protected and cannot be avoided. If a counterparty uses a New York CSA then it will provide New York law as the governing law and collateral will be located in New York. New York law will therefore govern the perfection and the priority of competing security interests in the collateral. This is important to note because commercial agreements often contain an 'IPSO FACTO CLAUSE' which vests a right of termination in a party upon the bankruptcy or insolvency of a counterparty to a contract. Under the Bankruptcy Code such clauses are generally not enforceable and a trustee can assume and enforce a contract notwithstanding the Non-Defaulting Party's right to terminate a contract pursuant to such a clause. However, under the Bankruptcy Code ipso facto clauses are enforceable when they relate to swap agreements. Section 560 permits swap participants to exercise the contractual right to terminate a swap agreement in the event of insolvency or bankruptcy.

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2017 Where a swap counterparty files for bankruptcy protection this will trigger the ipso facto clause and relieve the non-debtor swap counterparty from performance of the terms of the swap. The counterparty will be entitled to termination damages caused by the Event of Default. Swap counterparties have the right to set-off mutual obligations that arise when the counterparties net out upon a Termination Event or an Event of Default under the Bankruptcy Code. However, set-off is not absolute and set-off obligations must all be PRE-PETITION DEBTS, so a counterparty cannot set-off a PRE-PETITION obligation with an obligation that arises POST-PETITION. It should be noted that the one-way settlement provisions under the 1992 Master Agreement conflict with the commercial reasonableness requirements of the Bankruptcy Code, i.e. a creditor must establish that its damage claims are commercially reasonable. As it would not prima facie seem to be commercially reasonable that one counterparty is able to receive a payment and the other counterparty is not. If a creditor's claim is secured under the Safe Harbor rules creditors may have a right to adequate protection. It is therefore necessary to determine the priority, perfection, and classification of swap obligations separate to any attendant loan. The underlying loan agreement is likely to have clauses that state whether the swap is subordinate to the loan or pari passu. If the swap is pari passu the swap obligations will be added to the loan obligations to determine if they are fully secured or undersecured under section 506 based on collateral value. This will affect adequate protection requirements, plan classification, impairment, relief under section 362, and plan treatment.

22.9.1 Forward Contract under 11 U.S.C. §101(25) (25) The term "forward contract" means— (A)

a contract (other than a commodity contract, as defined in section 761) for the purchase, sale, or transfer of a commodity, as defined in section 761(8) of this title, or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade, or product or byproduct thereof, with a maturity date more than two days after the date the contract is entered into, including, but not limited to, a repurchase or reverse repurchase transaction (whether or not such repurchase or reverse repurchase transaction is a "repurchase agreement", as defined in this section) [1] consignment, lease, swap, hedge transaction, deposit, loan, option, allocated transaction, unallocated transaction, or any other similar agreement;

(B) any combination of agreements or transactions referred to in subparagraphs (A) and (C); (C) any option to enter into an agreement or transaction referred to in subparagraph (A) or (B); (D) a master agreement that provides for an agreement or transaction referred to in subparagraph (A), (B), or (C), together with all supplements to any such master agreement, without regard to whether such master agreement provides for an agreement or transaction that is not a forward contract under this paragraph, except that such master agreement shall be considered to be a forward contract under this paragraph only with respect to each agreement or transaction under such master agreement that is referred to in subparagraph (A), (B), or (C); or (E)

any security agreement or arrangement, or other credit enhancement related to any agreement or transaction referred to in subparagraph (A), (B), (C), or (D), including any guarantee or reimbursement obligation by or to a forward contract merchant or financial participant in connection with any agreement or transaction referred to in any such subparagraph, but not to exceed the damages in connection with any such agreement or transaction, measured in accordance with section 562.

22.9.2 Swap Agreement under 11.U.S.C. §101(53B) (53B) The term "swap agreement"—

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2017 (A)

means— (i)

(ii)

any agreement, including the terms and conditions incorporated by reference in such agreement, which is— (I)

an interest rate swap, option, future, or forward agreement, including a rate floor, rate cap, rate collar, cross-currency rate swap, and basis swap;

(II)

a spot, same day-tomorrow, tomorrow-next, forward, or other foreign exchange, precious metals, or other commodity agreement;

(III)

a currency swap, option, future, or forward agreement;

(IV)

an equity index or equity swap, option, future, or forward agreement;

(V)

a debt index or debt swap, option, future, or forward agreement;

(VI)

a total return, credit spread or credit swap, option, future, or forward agreement;

(VII)

a commodity index or a commodity swap, option, future, or forward agreement;

(VIII)

a weather swap, option, future, or forward agreement;

(IX)

an emissions swap, option, future, or forward agreement; or

(X)

an inflation swap, option, future, or forward agreement;

any agreement or transaction that is similar to any other agreement or transaction referred to in this paragraph and that— (I)

is of a type that has been, is presently, or in the future becomes, the subject of recurrent dealings in the swap or other derivatives markets (including terms and conditions incorporated by reference therein); and

(II)

is a forward, swap, future, option, or spot transaction on one or more rates, currencies, commodities, equity securities, or other equity instruments, debt securities or other debt instruments, quantitative measures associated with an occurrence, extent of an occurrence, or contingency associated with a financial, commercial, or economic consequence, or economic or financial indices or measures of economic or financial risk or value;

(iii) any combination of agreements or transactions referred to in this subparagraph; (iv) any option to enter into an agreement or transaction referred to in this subparagraph; (v)

a master agreement that provides for an agreement or transaction referred to in clause (i), (ii), (iii), or (iv), together with all supplements to any such master agreement, and without regard to whether the master agreement contains an agreement or transaction that is not a swap agreement under this paragraph, except that the master agreement shall be considered to be a swap agreement under this paragraph only with respect to each agreement or transaction under the master agreement that is referred to in clause (i), (ii), (iii), or (iv); or

(vi)

any security agreement or arrangement or other credit enhancement related to any agreements or transactions referred to in clause (i) through (v), including any guarantee or reimbursement obligation by or to a swap participant or financial participant in connection with any agreement or transaction referred to in any such clause, but not to exceed the damages in connection with any such agreement or transaction, measured in accordance with section 562; and

(B) is applicable for purposes of this title only, and shall not be construed or applied so as to challenge or affect the characterization, definition, or treatment of any swap agreement under any other statute, regulation, or rule, including the Gramm-Leach-Bliley Act, the Legal Certainty for Bank Products Act of 2000, the securities laws (as such term is defined in section 3(a)(47) of the Securities Exchange Act of 1934) and the Commodity Exchange Act.

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22.10 Termination Risk Termination Risk refers to the following consequences of swap termination: (1)

reversion of swapped debt to its original variable or fixed-rate form; and

(2)

liability for potentially large payments if termination occurs during adverse market conditions.

Although termination risk may affect a swap counterparty's asset and liability management strategy, it is the interim costs of termination risk that need to be addressed. A firm should therefore aim to create projections of potential liability for termination payments under a range of interest rate scenarios. Such projections can then be reviewed by analysts from ratings agencies to evaluate the availability, liquidity, and adequacy of proposed sources of funds. Events of automatic termination can be strictly limited to credit-related events (e.g. ratings downgrades, counterparty bankruptcy or insolvency, and non-payment of debt), or extended to noncredit-related events (e.g. default under separate agreements).

TERMINATION EVENTS

Termination Events are set out in section 5(b) of the 2002 ISDA Master Agreement and include: (1)

Illegality;

(2)

Force Majeure Event;

(3)

Tax Event;

(4)

Tax Event Upon Merger;

(5)

Credit Event Upon Merger;

(6)

Additional Termination Event (if any, which are specified in the Schedule or a Confirmation).

If a Termination Event has occurred, a party has the right to terminate following a Termination Event under section 6(b) of the ISDA Master Agreement. The Affected Party must notify the other party promptly as soon as it becomes aware of the Termination Event (unless it is a Force Majeure event in which case either party must use all reasonable efforts to notify the other party promptly upon becoming aware of it). The notification must include details about the Termination Event, its nature, and each affected Transaction. If a party fails to give notice of the Termination Event this may lead to the Termination Event becoming an Event of Default.

23.1

Illegality (i) Illegality. After giving effect to any applicable provision, disruption fallback or remedy specified in, or pursuant to, the relevant Confirmation or elsewhere in this Agreement, due to an event or circumstance (other than any action taken by a party or, if applicable, any Credit Support Provider of such party) occurring after a Transaction is entered into, it becomes unlawful under any applicable law (including without limitation the laws of any country in which payment, delivery or compliance is required by either party or any Credit Support Provider, as the case may be), on any day, or it would be unlawful if the relevant payment, delivery or compliance were required on that day (in each case, other than as a result of a breach

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 by the party of Section 4(b)):― (1) for the Office through which such party (which will be the Affected Party) makes and receives payments or deliveries with respect to such Transaction to perform any absolute or contingent obligation to make a payment or delivery in respect of such Transaction, to receive a payment or delivery in respect of such Transaction or to comply with any other material provision of this Agreement relating to such Transaction; or (2) for such party or any Credit Support Provider of such party (which will be the Affected Party) to perform any absolute or contingent obligation to make a payment or delivery which such party or Credit Support Provider has under any Credit Support Document relating to such Transaction, to receive a payment or delivery under such Credit Support Document or to comply with any other material provision of such Credit Support Document; This Termination Event covers events which mean that a party (The Affected Party) (or its CSP) cannot legally perform its payment or delivery or other material obligations under Transactions or any obligation under a CSD. This excludes any failure to maintain relevant authorisations under its constitutional documents. Illegality under the 2002 Master Agreement simply refers to the occurrence of an event or circumstance occurring after a Transaction has been entered into. The illegality must affect the Office through which payments and deliveries are effected in respect of a Transaction (this includes the ability to take receipts of payments and deliveries). The Affected Party has the right to declare an Early Termination Date although both parties must first make an effort to transfer the Affected Transactions to a party not subject to the illegality in order to cure the Illegality Termination Event under the 1992 ISDA Master Agreement. Illegality in respect of CSD covers only obligations to make or receive payments or deliveries in compliance with any other material provision of the affected CSD. The 1992 Master Agreement makes an express reference to a change in law or interpretation.

23.2

Force Majeure Event (ii) Force Majeure Event. After giving effect to any applicable provision, disruption fallback or remedy specified in, or pursuant to, the relevant Confirmation or elsewhere in this Agreement, by reason of force majeure or act of state occurring after a Transaction is entered into, on any day:― (1) the Office through which such party (which will be the Affected Party) makes and receives payments or deliveries with respect to such Transaction is prevented from performing any absolute or contingent obligation to make a payment or delivery in respect of such Transaction, from receiving a payment or delivery in respect of such Transaction or from complying with any other material provision of this Agreement relating to such Transaction (or would be so prevented if such payment, delivery or compliance were required on that day), or it becomes impossible or impracticable for such Office so to perform, receive or comply (or it would be impossible or impracticable for such Office so to perform, receive or comply if such payment, delivery or compliance were required on that day); or (2) such party or any Credit Support Provider of such party (which will be the Affected Party) is prevented from performing any absolute or contingent obligation to make a payment or delivery which such party or Credit Support Provider has under any Credit Support Document relating to such Transaction, from receiving a payment or delivery under such Credit Support Document or from complying with any other material provision of such Credit Support Document (or would be so

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 prevented if such payment, delivery or compliance were required on that day), or it becomes impossible or impracticable for such party or Credit Support Provider so to perform, receive or comply (or it would be impossible or impracticable for such party or Credit Support Provider so to perform, receive or comply if such payment, delivery or compliance were required on that day), so long as the force majeure or act of state is beyond the control of such Office, such party or such Credit Support Provider, as appropriate, and such Office, party or Credit Support Provider could not, after using all reasonable efforts (which will not require such party or Credit Support Provider to incur a loss, other than immaterial, incidental expenses), overcome such prevention, impossibility or impracticability; This is not specified in the 1992 Master Agreement but is included within the 2002 Master Agreement. This Termination Event applies where a force majeure or act of state occurs after the date on which a Transaction is entered into, and this prevents a party from performing its obligations under the agreement. It is possible for the Schedule to be amended to define force majeure more specifically, and if required to broaden the circumstances to those in which the affected Office is prevented from performance or where performance is impracticable. Force majeure may apply to a Transaction or to a CSD. Force majeure requires the relevant cause to be out of the control of the affected Office, party, or CSP, and only applies if such Office, party, or CSP is not able to overcome the prevention, impossibility, or impracticability having used reasonable efforts such as would not require such party to incur more than incidental losses.

23.2.1 Deferral of Payments Under the 2002 ISDA Master Agreement there are deferral provisions which become effect upon the triggering of an Illegality or Force Majeure Termination Event (similar to the Market Disruption deferral provisions set out in the ISDA 1996 Equity Definitions). These require the deferral of any payment or delivery obligations under a Transaction affected by Illegality or Force Majeure so that the obligation does not become due until the earlier of: (1)

the first Local Business Day (or Local Delivery Day for deliveries) after the applicable Waiting Period;

(2)

the date on which the event or circumstance giving rise to the Illegality or Force Majeure ceases to exist.

The Waiting Period is 3 Local Business Days (Illegality) and 8 Local Business Days (Force Majeure). The Waiting Period is reduced to zero for Illegality or Force Majeure affecting CSD where delivery or payment is actually required on the relevant day. Force majeure is Office specific and includes the ability to take receipt of deliveries and payments and the ability to make them.

23.3

Tax Event (iii) Tax Event. Due to (1) any action taken by a taxing authority, or brought in a court of competent jurisdiction, after a Transaction is entered into (regardless of whether such action is taken or brought with respect to a party to this Agreement) or (2) a Change in Tax Law, the party (which will be the Affected Party) will, or there is a substantial likelihood that it will, on the next succeeding Scheduled Settlement Date (A) be required to pay to the other party an additional amount in respect of an Indemnifiable Tax under Section 2(d)(i)(4) (except in respect of interest under Section 9(h)) or (B) receive a payment from which an amount is required to be deducted or withheld for or on account of a Tax (except in respect of interest underSection 9(h)) and no additional amount is required to be paid in respect of such Tax under Section 2(d)(i)(4) (other than by reason of Section 2(d)(i)(4)(A) or (B));

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This section essentially requires tax withholding with respect to payments made under a Transaction. This Termination Event covers any action or proceeding that is brought by a tax authority, or a Change in Tax Law (defined in Section 14) which has the effect that the Affected Party will, or there is a substantial likelihood that it will, be required to make a gross-up in respect of Indemnifiable Tax (other than in respect of default interest), or will receive a net payment in circumstances where no gross-up is required and it has not breached its own tax agreements or representations.

23.4

Tax Event Upon Merger (iv) Tax Event Upon Merger. The party (the "Burdened Party") on the next succeeding Scheduled Settlement Date will either (1) be required to pay an additional amount in respect of an Indemnifiable Tax under Section 2(d)(i)(4) (except in respect of interest under Section 9(h)) or (2) receive a payment from which an amount has been deducted or withheld for or on account of any Tax in respect of which the other party is not required to pay an additional amount (other than by reason of Section 2(d)(i)(4)(A) or (B)), in either case as a result of a party consolidating or amalgamating with, or merging with or into, or transferring all or substantially all its assets (or any substantial part of the assets comprising the business conducted by it as of the date of this Master Agreement) to, or reorganising, reincorporating or reconstituting into or as, another entity (which will be the Affected Party) where such action does not constitute a Merger Without Assumption;

This Termination Event occurs where there is a merger (or a similar reorganisation) of one of the parties and such reorganisation (which is not a Merger Without Assumption) results in a deduction on account of tax for which one party is required to pay gross-up payments to the other party. Alternatively the party may be required to receive payments net in circumstances where no gross-up is required (other than by reason of its own failure to comply with tax covenants or representations).

23.5

Credit Event Upon Merger (v) Credit Event Upon Merger. If "Credit Event Upon Merger" is specified in the Schedule as applying to the party, a Designated Event (as defined below) occurs with respect to such party, any Credit Support Provider of such party or any applicable Specified Entity of such party (in each case, "X") and such Designated Event does not constitute a Merger Without Assumption, and the creditworthiness of X or, if applicable, the successor, surviving or transferee entity of X, after taking into account any applicable Credit Support Document, is materially weaker immediately after the occurrence of such Designated Event than that of X immediately prior to the occurrence of such Designated Event (and, in any such event, such party or its successor, surviving or transferee entity, as appropriate, will be the Affected Party). A "Designated Event" with respect to X means that:â&#x20AC;&#x2022; (1) X consolidates or amalgamates with, or merges with or into, or transfers all or substantially all its assets (or any substantial part of the assets comprising the business conducted by X as of the date of this Master Agreement) to, or reorganises, reincorporates or reconstitutes into or as, another entity; (2) any person, related group of persons or entity acquires directly or indirectly the beneficial ownership of (A) equity securities having the power to elect a majority of the board of directors (or its equivalent) of X or (B) any other ownership interest enabling it to exercise control of X; or (3) X effects any substantial change in its capital structure by means of the issuance, incurrence or guarantee of debt or the issuance of (A) preferred stock or other securities convertible into or exchangeable for debt or preferred stock or (B)

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 in the case of entities other than corporations, any other form of ownership interest; or This Termination Event is only applicable if specified in the Schedule. It will apply when the Affected Party merges with or transfers all or substantially all of its assets into another entity, and the resulting, surviving, or transferee entity is materially less creditworthy that the Affected Party immediately before the action. The ISDA Master Agreement Schedule is usually amended to include a definition of materially weaker, e.g. credit ratings downgrades, a minimum level of credit ratings, loss of a credit rating. The ISDA Master Agreement Schedule can also be amended to include other change of control transactions or capital restructurings that result in the creditworthiness of a party being materially weaker than it was immediately prior to such action.

23.6

Additional Termination Event (vi) Additional Termination Event. If any "Additional Termination Event" is specified in the Schedule or any Confirmation as applying, the occurrence of such event (and, in such event, the Affected Party or Affected Parties will be as specified for such Additional Termination Event in the Schedule or such Confirmation).

This Termination Event allows additional provisions to be specified in the Schedule that allows the parties to terminate the Master Agreement early for other reasons. The Affected Party should be specified in the Schedule. Example Additional Termination Events (1)

a fixed or percentage decrease in assets under management;

(2)

failure to report the Net Asset Value (NAV) of the counterparty;

(3)

a fixed or percentage decrease in the NAV over a fixed (e.g. 1, 3, 6, 12 month) period;

(4)

key person event (e.g. persons that are key to the business or operations of a firm);

(5)

breach of investment restrictions;

(6)

failure to deliver stipulated financial statements;

(7)

the commencement of official regulatory, civil, criminal investigations;

(8)

prohibited transactions under national laws (e.g. ERISA);

(9)

a fixed or percentage increase or decrease in relevant interest rates (i.e. inbuilt floor or cap);

(10)

other representations and warranties in relation to authority to act or in relation to FATCA or the OECD Common Reporting Standard.

23.7

Termination Notices

Section 12(a) of the ISDA Master Agreement sets out details regarding the procedure for giving effective notices. The Non-Defaulting Party must send the Defaulting Party a notice where a potential Event of Default or Event of Default has occurred.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 The Non-Defaulting Party has a discretion as to whether or not to call such an event an Event of Default. If an event has occurred and it is not in its interests to send out a notice (e.g. the swap is substantially out-of-the-money) it may choose to ignore the event and not send out a notice. Where a Termination Event has occurred (other than a Force Majeure) occurs, an Affected Party should promptly after becoming aware of it send out a notice terminating the Transactions. Where a Force Majeure Event has occurred, either party may send out a notice promptly after becoming aware of it. As soon as possible after the triggering of an Event of Default, notice should be delivered to the counterparty that all Transactions under the Master Agreement will be terminated. The notice should provide a maximum of 20 days between the date of notice and the early termination date. Parties must specify the relevant Event of Default and must designate a date (not earlier than the date on which such notice is effective) as the Early Termination Date in respect of all outstanding Transactions (if Automatic Early Termination applies, the Early Termination Date will be set immediately upon the occurrence of the event). Parties must also ensure that the notice is addressed correctly and served in writing (notices by email or by fax in the case of the 1992 Master Agreement) will be invalid unless there is a specific amendment to the Master Agreement Schedule.

EARLY TERMINATION

24.1

Event of Default Termination

Where an Event of Default has occurred the Non-Defaulting Party has the right to terminate the Agreement and to trigger the close-out provisions by choosing to designate an Early Termination Date by not more than 20 days' notice to the Defaulting Party.

24.2

Termination Event Termination

Any Affected Party must give notice to the other promptly on realising that a Termination Event has occurred. Under the 1992 ISDA Master Agreement where any of these events occurs: (1)

Illegality and one Affected Party;

(2)

Tax Event and one Affected Party;

(3)

Tax Event Upon Merger where the Affected Party is the party required to make a gross-up or to receive a net payment;

the Affected Party must use all reasonable endeavours to transfer its rights and obligations in respect of Affected Transactions to another of its offices or affiliates so that the Termination Event will not occur. The Affected Party has 20 days from giving notice to the other party of the relevant event. If the Affected Party is not able to make such transfer the Non-Affected Party then has 30 days within which to attempt such a transfer. In both cases the prior written consent of the other party is required. The 2002 ISDA Master Agreement excludes illegality and only includes: (1)

Tax Event and one Affected Party;

(2)

Tax Event Upon Merger where the Affected Party is the party required to make a gross-up or to receive a net payment.

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 Where any of these events occurs: (1)

other cases of illegality;

(2)

Tax Event and two Affected Parties;

the parties are required to use reasonable efforts to reach agreement on avoiding action within 30 days after notice has been given. If no solutions are reached, or in any other event, an Early Termination Date may be designated by not more than 20 days' notice.

24.3

Automatic Early Termination

If Automatic Early Termination (AET) is specified as being applicable in the Schedule, the parties elect that upon the occurrence of certain insolvency events, the agreement will automatically terminate and the close-out netting provisions will apply. Under the 2002 ISDA Master Agreement where a relevant event occurs an Early Termination Date is deemed to have occurred immediately before that event. The aim is to ensure that where an insolvency event occurs for Counterparty A, Counterparty B protects its position by automatically terminating all Transactions under the Agreement prior to the insolvency framework taking hold. This is desirable in jurisdictions where the insolvency framework might otherwise override the close-out netting provisions of the ISDA Master Agreement. However, parties choosing to opt for AET should carefully review their operations as the automatic termination of all Transactions might lead to unfavourable winding-up of Transactions.

TERMINATION VALUE

The termination value of the OTC derivatives can be calculated using four different methods under the 1992 Master Agreement: (1)

First Method and Market Quotation;

(2)

First Method and Loss;

(3)

Second Method and Market Quotation; The unpaid amount due is the net amount (i.e. a party's gain or loss) that results from the termination of the transaction calculated on the basis of quotations obtained from reference market makers for the terminated transactions. The Defaulting Party and the Non-Defaulting Party must indemnity the losses suffered.

(4)

Second Method and Loss. Loss is the total losses under the Master Agreement (including loss of bargain, cost of funding, unpaid amounts, but excluding legal fees and other out-of-pocket expenses). The Defaulting Party pays the amount lost by the Non-Defaulting Party and the Non-Defaulting Party will pay the amount lost by the Defaulting Party.

The termination value of the OTC derivatives can be calculated using one method under the 2002 Master Agreement: (1)

The Close-Out Amount. This is a more flexible method that combines elements of market quotation and loss methods. It includes losses or gains to the Determining Party in order to replace the transaction with its economic equivalent. The amount is to be determined by the Determining Party, which will act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result.

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25.1

The Loss Method

This method allows a party a great deal of flexibility when determining its losses and costs (or gains) incurred as a result of the termination or the replacement of related hedging positions (e.g. based on internal models, or quotation of dealers in relevant markets (if the party decides to elect this method and to the extent the party acts reasonably and in good faith).

25.2

The Market Quotation Method

This method provides a more stringent framework in which the determining party must seek quotations from three or more leading dealers in the relevant market, in order to obtain a quote for the amount that would be payable upon entering into replacement transactions that are economically equivalent to the terminated transactions. The determining party must then determine the arithmetic average of these quotes (but must first disregard the highest and lowest quote).

25.3

The Close-Out Method

This method requires a reasonable determination of losses or gains that would be realised upon entering into replacement transactions that are economically equivalent to the transactions entered into by the parties now terminated. The determining party must act in good faith, and must in general use commercially reasonable procedures to produce a commercially reasonable result. This method is flexible in that the determining party is allowed to consider any relevant information, including relevant market data from dealers, end-users, information vendors, and any other sources. The determining party is also allowed to use information from internal models and third-party quotations, and there is no absolute requirement to obtain a set number of quotations in order to determine their arithmetic average.

25.4

Cancellation or Break Clauses

Break clauses can be inserted into swap agreements to allow Counterparty A (e.g. a bank) the right to terminate the swap after a number of years (e.g. 10 years), so that on termination no cash is exchanged. Because Counterparty B (e.g. a company) has effectively written an option for the bank Counterparty B may be duly recompensed by receiving a favourable leg on one of the legs of the swap. Banks have the potential to offer borrowers longer dated hedging (longer than the term of the loan) but to insert a credit break clause in the Master Agreement documentation. A credit break allows the bank to take a credit decision and choose not to continue with the hedging post the credit break date. The key areas to negotiate with credit breaks include the notice periods given on the break decision, and will two-way break clauses apply (i.e. will the borrower be paid for an in-the-money position). A discretionary credit break allows the bank to allocate capital to the date of the credit break and not to the full life of the swap. The presence of a mandatory break in a swap contract should reduce the Credit Valuation Adjustment (CVA) charge. The CVA calculation models the models the default probability swap market value while the swap is alive, so the calculation stops at the break date. The mandatory break clause should specify calculation of the value of the swap at market value and the Valuation Agent (e.g. bank or panel of banks). This needs to be specified in either the Schedule to the Master Agreement or within a specific confirmation. Optional break clauses granted to a bank should in theory reduce the CVA charge but this may be dependent on the view that the CVA desk takes on whether or not requires a further CVA charge to continue the swap.

25.5

Cure Periods

If an Event of Default has occurred the Defaulting Party is often provided with a given period of time in which to 'cure' the default. Until the cure period has ended, the derivative transaction cannot be terminated on the grounds of an Event of Default. The 1992 Master Agreement and the 2002 Master ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

NEGOTIATING AND DOCUMENTING SWAPS, OTC DERIVATIVES, AND CREDIT AND COLLATERAL SUPPORT AGREEMENTS

2017 Agreement have different cure periods, and different Events of Default have different cure periods. In general the 2002 Master Agreement cure periods are shorter. Table 16: Master Agreement Events of Default and Cure Periods

Events of Default Failure to pay.

Action

Cure Period

The Non-Defaulting Party must serve notice and allow the Defaulting Party three Local Business Days (1992 Agreement) or one Local Business Day (2002 Agreement to remedy the payment.

Three Local Business Days 1992 Master Agreement

The Non-Defaulting Party must serve notice and allow a 30 day Cure Period before termination.

30-Days

support

The applicable cure period in the relevant CSD applies.

Relevant CSD.

under

The applicable cure period for the specific transaction applies, if no cure period is stated, the Non-Defaulting Party must serve notice and allow 30-days to remedy this default.

Applicable cure period or 30days (if no cure period stated).

Cross-default.

This has immediate effect with no cure period.

No cure period.

Bankruptcy.

Clause 5(a)(vii) lists a number of grounds for bankruptcy. A 30-day cure period applies where insolvency proceedings are instituted or where a secured party takes possession of assets.

30-day cure period (third party insolvency proceedings) or no cure period (official insolvency proceedings).

Breach agreement.

Credit default. Default specified transactions.

One Local Business Day 2002 Master Agreement

For other grounds (e.g. party is dissolved or becomes insolvent) no cure period applies.

25.6

Mismatch Risk

Mismatch risk refers to the risk that two sides of a transaction (or a series of transactions) will not be able to be exactly matched. This is a significant risk if the transaction is illiquid in nature or very complex, requiring rapid execution. It can also refer to the risk to a dealer from failing to precisely match the provisions of the various transactions in the book. A swap dealer might enter into a pair of nearly matched swaps. On one swap the dealer may be a fixed rate payer and on the other swap the dealer may be a fixed rate receiver. In this scenario one or more of the terms may be mismatched (e.g. the reference rate on the floating rate leg, the payment frequency, the payment dates, the reset dates). This term mismatching gives rise to mismatch risk which may tend to diversify away or may have to be hedged. Another example of mismatch risk is interest-rate mismatch risk. An interest-rate mismatch will occur where a bank lends for six months at a fixed rate and finances this lending with a three-month deposit (i.e. in three months time the rate of interest payable on the deposit may be substantially higher than the cost of three or six months' deposit when the loan was first made.

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25.7

Political Risk

Political risk is generally referred to as the risk an investment's returns could suffer as a result of political changes or instability in a particular jurisdiction. Instability may affect investment returns and this instability could stem from a change in government, legislative bodies, other foreign policy makers or military control. Political risk is also known as "geopolitical risk" and becomes more of a factor as the time horizon of an investment gets longer. Political or other events can destabilise existing financial systems and/or economies. Political risks also have an influence on economic growth. Indeed, the investor will be more or less interested to invest their money according to their risk aversion and the degree of political risk suffered by a country. Political risk is difficult to quantify in practice but it is something that should be addressed in risk management policies are the number of political risk events have been significantly increasing in recent times. In 2016, some notable political risks were: (1) the vote of confidence in Spain; (2) the British Brexit vote; (3) the referendum of Constitutional Reform in Italy; and (4) the presidential election of Donald Trump in the US. The interval period of political risks highlighted here is 2000 to 2015. These events are listed in order to show some of the large number of political risk events that have transpired in practice. •

The Bug of 2000 or Year 2000 (Y2K) The bug of 2000 or Y2K (Year 2000) was one of world anxiety. Indeed, the Y2K represented a computer problem due to the fact that the programmer did not anticipate the changing of number 1999 into 2000. And the problem is that the computer would not be able to register or to code a number with zero like 2000. That is to say that the computer would not recognize this number then this effect would lead to a reset or bug in the system. Or if we say bug or reset of the computer that means all the information will disappear and cause a disaster for all companies using computer but also governments, customers, and the financial market. The problem was not just in United States but all around the world. Thus, all governments and companies took it seriously and invest thousand of billions to find a solution for this problem. The fear came from the fact that years before engineers made computer's tests and included number with three zeros and the result was that computer failed these tests and engineers did not find the way to resolve the problem. In the common thought, the computer problem would cause a disaster as well as economic, military, technological, etc. To protect the industry against this supposed but real disaster, many companies invest billions and billions to avoid their companies failing.

•

Vladimir Putin elected as President of Russia Federation, March 26, 2000 Vladimir Putin was elected as the President of the Russia Federation. The new President came with a different strategy from his predecessor. Russia's economy was in a dramatic situation since the crisis of 1998. This crisis was cause by multiple effects. First of all, it was caused by the voluntary commitment of the Russia government to reduce inflation. Therefore, this idea was follow by the political risk due to the election scheduled of June 1996 which opposed Boris Yeltsin to Gennady Zyuganov. Finally, by the monopoly power of the Moscow Bank. These different events but linked each other had led to Russia economic meltdown. In 1995, Russia government had to voluntarily reduction the inflation inside their country and to obtain an inflation rate with a single digit by 1997. Therefore, the government planned to reduce also the fiscal deficit to less to 3 percent by 1998. But this approach led to increase the interest rate linked to exchange. Indeed, the exchange rate went up and appreciated by 55 percent against US dollar. Moreover, the privatisation of private sector and the Gross Domestic Product did not increase. Hence, the market started to speculate against the ruble. Thus, in 1998, the Rouble was aborted by investors and conduced to decline of the Rouble which impacted the economic and led to the crisis.

•

President George W. Bush and September 11, 2001 In December 12, 2000 George W. Bush was elected as the President of the United of State. The new President had a policy based on the increase of defence spending, opposition at the

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2017 abortion, reorganisation of school etc. However, before he started to work, on September 11, 2001 the country was victim of terrorist attacks. The aim of these attacks was to attack the heart of United States by destroying their symbol that is to say the World Trade Center Towers and the Pentagon. Unfortunately, the terrorist reached to their goal, destroying the towers of the World Trade Center in New York and hit the Pentagon The attack had brought the chaos in the country, killed thousands of people and led to fall down of the economy. The Dow Jones fell down to 7.1% when it opened on September 17, 2001. All markets were affected by these attacks and dropped due to the terrorist attack. In this context, the President of the United States George W. Bush declared "We will make no distinction between the terrorists who committed these acts and those who harbor them". Thus, started the involvement of the United States in the War against Osama Ben Laden and all form of terrorism. This war against terrorism cost billions of US dollars to the country and had had an impact on their economy. •

Euro as a fiduciary monetary, January 1, 2002 The Euro became a fiduciary monetary. Indeed, after the Euro zone had adopted the principle of unique money, that one was followed by the creation of paper money. According to the paper written by a financial analyst who analysed data and aggregated between the period ex-ante euro and post-euro with Germany as example. The result of the paper concluded that the introduction of the single currency had led to an overall increase of equity and bond inside the market.

•

Colombia Presidential, February 23, 2002 Ingrid Betancourt candidate at the Colombia presidential was kidnapped by The Revolutionary Armed Force of Colombia (FARC). The conflict from Colombia is related to the fact most Colombians denounced the higher inequality which exists in the country. This problem of inequality led to the creation of a rebellion that fought against the elite. The kidnapping of Ingrid Betancourt had an international impact and permitted the intervention of others country such as France in the combat against the FARC to release Ingrid Betancourt.

•

Presidential election in France, May 5, 2002 Jacques Chirac began the French president with 82% of vote against Jean Marie Le pen.

•

The Strategy arms Reduction Treaty (the START), May 24 2002 United States of America and Russia signed the Strategy arms Reduction Treaty (the START).

•

Saddam Hussein, December 1, 2002 Saddam Hussein apologized to Kuwait for invading the country. His apology was rejected by Kuwait. The apology came from the fact that in 1990 Iraq decided to invade Kuwait with the aim of taking oil. Indeed, in few hours the Iraq's army had captured the city and established it as a provincial government. At this time, Iraqis controlled 20 percent of the world's oil reserves. That caused in impact on the oil price.

•

French Referendum, May 29, 2005 French people said no to the European Constitution through a referendum.

•

Lehman Brothers, September 15, 2008 Lehman Brothers collapsed and announced also the beginning of the financial crisis. This crisis would conduce to the European zone debt.

•

The rising of Boko Haram, July 2009

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Launch of military operation of Boko Haram group which is the Nigeria's militant Islamic group. This operation had been launched to support their cause that is to say create in independent Islamic state. To achieve its goal, Boro has killed number of people in the north of Nigeria and set up an Islamic state. The word was chocked when Boko Haram had kidnapped hundred of children during their school's study. This terrorist's group dives the country in instability situation and had conducted the Nigeria president to declare the state of emergency Indeed, Nigeria remains the largest Africa's economy thanks to the massive oil reserves that it possesses. These reserves are exploited by international corporations. •

European Zone Debt October 18, 2000 Agreement to solve the debt crisis inside the European Zone.

•

The Arab Spring January 1, 2011. The Arab Spring which started in 2011 was a series of popular movement began in Tunisia, Egypt, Lybia, Yemen, Syria. If we focus on Egypt stock market we will see that at this period, the profit of public companies had declined by 36% during the period from January to march 2011. That shows that the political instability impacts economic growth and financial market.

•

The death of Nelson Mandela, December 5, 2013.

25.7.1 Political Risk in the ISDA Master Agreement Political risk is covered in section 10 of the 2002 ISDA Master Agreement. Figure 16: Section 10 of the 2002 ISDA Master Agreement 10.

Offices; Multibranch Parties

(a)

If Section 10(a) is specified in the Schedule as applying, each party that enters into a Transaction through an Office other than its head or home office represents to and agrees with the other party that, notwithstanding the place of booking or its jurisdiction of incorporation or organisation, its obligations are the same in terms of recourse against it as if it had entered into the Transaction through its head or home office, except that a party will not have recourse to the head or home office of the other party in respect of any payment or delivered deferred pursuant to Section 5(d) for so long as the payment or delivery is so deferred. This representation and agreement will be deemed to be repeated by each party on each date on which the parties enter into a Transaction.

This clause therefore represents an implied payment or guarantee of performance. If Section 10(a) is not specified in the Schedule as applying then a counterparty is seeking to shift the political risk of its branch on to the other counterparty. If this clause is disapplied then a counterparty must evaluate each branch in terms of relevant credit and legal risks applying (e.g. is close-out netting enforceable, existing political risks in the branch's jurisdiction).

25.8

Force Majeure

There are generally two aspects to the operation of force majeure clauses: (1)

the definition of force majeure events;

(2)

the operative clause that sets out the effect on the parties' rights and obligations if a force majeure event occurs.

The common law meaning of force majeure may be uncertain and open to interpretation by the courts of the counterparty's jurisdiction, which means that it is in the interests of both parties to clearly define © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 the term. The process of negotiating the list of events will identify the risk allocation between the parties. When dealing with force majeure clauses it is appropriate to deal with other issues that will arise if the force majeure clause is triggered. For example, counterparties may wish to deal with extensions of time or what is to happen to existing payment schedules or collateral calls. When drafting force majeure clauses counterparties need to expect the unexpected in advance, to allocate the risk between the parties, to change obligations, and to offer an out or suspension (of the swap). A force majeure clause can include the requirement for reasonable diligence to avoid or mitigate the event. Areas where parties may seek to include or exclude, include an inability to immediately comply with a law, order, rule, or regulation or a governmental action or delay in granting necessary permits or permit approvals. Parties should be wary of catch-all clauses, e.g. "any other cause whatsoever that is not within the reasonable control of either party which, through the exercise of due diligence said party is unable to foresee or overcome." More narrow language might limit circumstances excusing performance to when it would be inadvisable, commercially impracticable, illegal, or impossible to perform.

25.8.1 World Bank Group Sample Force Majeure Clause 1 Public-Private Partnership in Infrastructure Resource Center EXAMPLE 1 - simple example This is a simple example, with no distinction between political and natural events. It requires that payment obligations continue even in the case of Force Majeure. It relates to a BOT project and so there is a Construction Period as well as an operating phase: 1.1

Definition of Force Majeure

In this Clause [ ], "Event of Force Majeure" means an event beyond the control of the Authority and the Operator, which prevents a Party from complying with any of its obligations under this Contract, including but not limited to: 1.1.1

act of God (such as, but not limited to, fires, explosions, earthquakes, drought, tidal waves and floods);

1.1.2

war, hostilities (whether war be declared or not), invasion, act of foreign enemies, mobilisation, requisition, or embargo;

1.1.3

rebellion, revolution, insurrection, or military or usurped power, or civil war;

1.1.4

contamination by radio-activity from any nuclear fuel, or from any nuclear waste from the combustion of nuclear fuel, radio-active toxic explosive, or other hazardous properties of any explosive nuclear assembly or nuclear component of such assembly;

1.1.5

riot, commotion, strikes, go slows, lock outs or disorder, unless solely restricted to employees of the Supplier or of his Subcontractors; or

1.1.6

acts or threats of terrorism.

1.2

Consequences of Force Majeure Event

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1.2.1

Neither the Authority nor the Operator shall be considered in breach of this Contract to the extent that performance of their respective obligations (excluding payment obligations) is prevented by an Event of Force Majeure that arises after the Effective Date.

1.2.2

The Party (the "Affected Party") prevented from carrying out its obligations hereunder shall give notice to the other Party of an Event of Force Majeure upon it being foreseen by, or becoming known to, the Affected Party.

1.2.3

If and to the extent that the Operator is prevented from executing the Services by the Event of Force Majeure, while the Operator is so prevented the Operator shall be relieved of its obligations to provide the Services but shall endeavour to continue to perform its obligations under the Contract so far as reasonably practicable [and in accordance with Good Operating Practices], [PROVIDED that if and to the extent that the Operator incurs additional Cost in so doing, the Operator shall be entitled to the amount of such Cost [COST BEING DEFINED AS HAVING NO PROFIT COMPONENT] (the Operator having taken reasonable steps to mitigate the Cost)].

1.2.4

If and to the extent that the Operator suffers a delay during the Construction Period as a result of the Event of Force Majeure then it shall be entitled to an extension for the Time for Completion in accordance with Sub-Clause [ ].

1.2.5

If an Event of Force Majeure results in a loss or damage to the Facility, then Operator shall rectify such loss or damage to the extent required by the Authority, PROVIDED that any Cost of rectification (less any insurance proceeds received by the Operator for the loss or damage) is borne by the Authority (the Operator having taken reasonable steps to mitigate the Cost).

1.2.6

[The Operator shall be entitled to payment of the Base Monthly Charge during the period of interruption caused by the Event of Force Majeure.]

1.2.7

[The Contract Period shall be extended by a period of time equal to the period of interruption caused by an Event of Force Majeure.] [1.2.6 OR 1.2.7]

1.3

Optional Termination, Payment and Release

Irrespective of any extension of time, if an Event of Force Majeure occurs and its effect continues for a period of [180] days, either the Authority or the Operator may give to the other a notice of termination. [If Authority is paying fee during Force Majeure, then Operator should not have a termination right, he is being paid.], which shall take effect [28] days after the giving of the notice. If, at the end of the [28]-day period, the effect of the Force Majeure continues, the Contract shall terminate. After termination under this Sub-Clause [1.3], the Operator shall comply with Sub-Clause [termination provisions] and the Authority shall pay the Supplier an amount calculated and certified in accordance with [ ].

25.8.2 World Bank Group Sample Force Majeure Clause 2 In this example there is no distinction drawn between political and natural force majeure events: "Force Majeure Event" means the occurrence of: (a)

an act of war (whether declared or not), hostilities, invasion, act of foreign enemies, terrorism or civil disorder;

(b)

ionising radiations, or contamination by radioactivity from any nuclear fuel, or from any nuclear waste from the combustion of nuclear fuel, radioactive toxic explosive or other hazardous properties of any explosive nuclear assembly or nuclear component thereof;

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2017 (c)

pressure waves from devices travelling at supersonic speeds or damage caused by any aircraft or similar device;

(d)

a strike or strikes or other industrial action or blockade or embargo or any other form of civil disturbance (whether lawful or not), in each case affecting on a general basis the industry related to the affected Services and which is not attributable to any unreasonable action or inaction on the part of the Company or any of its Subcontractors or suppliers and the settlement of which is beyond the reasonable control of all such persons;

(d)

specific incidents of exceptional adverse weather conditions in excess of those required to be designed for in this Agreement which are materially worse than those encountered in the relevant places at the relevant time of year during the twenty (20) years prior to the Effective Date;

(e)

tempest, earthquake or any other natural disaster of overwhelming proportions; pollution of water sources resulting from any plane crashing into [ ];

(f)

discontinuation of electricity supply, not covered by the agreement concluded with the [utility company]; or

(g)

other unforeseeable circumstances beyond the control of the Parties against which it would have been unreasonable for the affected party to take precautions and which the affected party cannot avoid even by using its best efforts,

which in each case directly causes either party to be unable to comply with all or a material part of its obligations under this Agreement; (1)

Neither Party shall be in breach of its obligations under this Agreement (other than payment obligations) or incur any liability to the other Party for any losses or damages of any nature whatsoever incurred or suffered by that other (otherwise than under any express indemnity in this Agreement) if and to the extent that it is prevented from carrying out those obligations by, or such losses or damages are caused by, a Force Majeure Event except to the extent that the relevant breach of its obligations would have occurred, or the relevant losses or damages would have arisen, even if the Force Majeure Event had not occurred (in which case this Clause 20 shall not apply to that extent).

(2)

As soon as reasonably practicable following the date of commencement of a Force Majeure Event, and within a reasonable time following the date of termination of a Force Majeure Event, any Party invoking it shall submit to the other Party reasonable proof of the nature of the Force Majeure Event and of its effect upon the performance of the Party's obligations under this Agreement.

(3)

The Company shall, and shall procure that its Subcontractors shall, at all times take all reasonable steps within their respective powers and consistent with Good Operating Practices (but without incurring unreasonable additional costs) to:

(a)

prevent Force Majeure Events affecting the performance of the Company's obligations under this Agreement;

(b)

mitigate the effect of any Force Majeure Event; and

(c)

comply with its obligations under this Agreement.

The Parties shall consult together in relation to the above matters following the occurrence of a Force Majeure Event. (4)

Should paragraph (1) apply as a result of a single Force Majeure Event for a continuous period of more than [180] days then the parties shall endeavor to agree any modifications to this Agreement (including without limitation, determination of new tariffs (if appropriate) in

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2017 accordance with the provisions of Clause 7(4)(e)) which may be equitable having regard to the nature of the Force Majeure Event and which is consistent with the Statutory Requirements.

25.8.3 World Bank Group Sample Force Majeure Clause 3 EXAMPLE 3 - distinction between political and other force majeure events. Here is a relatively simple clause, with a distinction between political and other force majeure, and the consequences thereof: Force Majeure Events of Force Majeure For the purpose of this Agreement, an "Event of Force Majeure" means any circumstance not within the reasonable control of the Party affected, but only if and to the extent that (i) such circumstance, despite the exercise of reasonable diligence and the observance of Good Utility Practice, cannot be, or be caused to be, prevented, avoided or removed by such Party, and (ii) such circumstance materially and adversely affects the ability of the Party to perform its obligations under this Agreement, and such Party has taken all reasonable precautions, due care and reasonable alternative measures in order to avoid the effect of such event on the Party's ability to perform its obligations under this Agreement and to mitigate the consequences thereof. Instances of Force Majeure Subject to the provisions of clause 1.1, Events of Force Majeure shall include, but not be limited to: (a)

the following Natural Force Majeure Events:

•

fire, chemical or radioactive contamination or ionising radiation, earthquakes, lightning, cyclones, hurricanes, floods, droughts or such other extreme weather or environmental conditions, unanticipated geological or ground conditions, epidemic, famine, plague or other natural calamities and acts of God;

•

explosion, accident, breakage of a plant or equipment, structural collapse, or chemical contamination (other than resulting from an act of war, terrorism or sabotage), caused by a person not being the affected Party or one of its contractors or subcontractors or any of their respective employees or agents;

•

to the extent that they do not involve [country] or take place outside of [country], acts of war (whether declared or undeclared), invasion, acts of terrorists, blockade, embargo, riot, public disorder, violent demonstrations, insurrection, rebellion, civil commotion and sabotage;

•

strikes, lockouts, work stoppage, labour disputes, and such other industrial action by workers related to or in response to the terms and conditions of employment of those workers or others with whom they are affiliated save, when such event is directly related to, or in direct response to any employment policy or practice (with respect to wages or otherwise) of the party whose workers resort to such action;

•

in relation to the Concessionaire, non-performance by a counter-party to a contract relating to the Concessionaire's Business by reason of an event or circumstance that would constitute a Natural Force Majeure Event under this Agreement; and

(b)

the following Political Force Majeure Events:

•

to the extent they take place in [country], acts of terrorists, blockade, embargo, riot, public disorder, violent demonstrations, insurrection, rebellion, civil commotion and sabotage;

•

to the extent that they are politically motivated, strikes, lockouts, work stoppages, labour disputes, or such other industrial action by workers, save in relation to the Concessionaire,

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2017 when such event is directly related to, or in direct response to any employment policy or practice (with respect to wages or otherwise) of the Concessionaire; •

failure or inability of the Concessionaire to obtain or renew any Consent, on terms and conditions as favourable in all material respects as those contained in the original Consent relating to the Concessionaire's Business (other than due to a breach by the Concessionaire of any of such terms and conditions);

•

any action or failure to act without justifiable cause by any Competent Authority, other than a court or tribunal(including any action or failure to act without justifiable cause by any duly authorised agent of any Competent Authority, other than a court or tribunal);

•

expropriation or compulsory acquisition of the whole or any material part of the Concessionaire's System or Investor's shares in the Concessionaire, except where such appropriation or compulsory acquisition is on account of contravention of law by the Concessionaire or by the Investor; •any legal prohibition on the Concessionaire's ability to conduct the Concessionaire's Business, including passing of a statute, decree, regulation or order by a Competent Authority prohibiting the Concessionaire from conducting the Concessionaire's Business, other than as a result of the Concessionaire's failure to comply with the law or any order, Consent, rule, regulation or other legislative or judicial instrument passed by a Competent Authority;

•

in relation to the Concessionaire, non-performance by a counter-party under a contract relating to the Concessionaire's Business by reason of an event or circumstance that would constitute a Political Force Majeure Event under this Agreement,

provided that breakdown of plant or equipment (unless itself caused by an Event of Force Majeure), or unavailability of funds, shall not constitute an Event of Force Majeure. Effects of an Event of Force Majeure Either Party shall be excused from performance and shall not be in default in respect of any obligation hereunder to the extent that the failure to perform such obligation is due to a Natural Force Majeure Event. Additionally, the Concessionaire, [but not [ ] in respect of [ ]], shall be excused from performance and shall not be in default in respect of any obligation under this Agreement to the extent that the failure to perform such obligation is due to a Political Force Majeure Event. Notice of an Event of Force Majeure If a Party wishes to claim protection in respect of an Event of Force Majeure, it shall, subject to clause [ ], as soon as possible following the occurrence or date of commencement of such Event of Force Majeure, notify the other Party of the nature and expected duration of such Event of Force Majeure and shall thereafter keep the other Party informed until such time as it is able to perform its obligations. The Parties shall use their reasonable endeavours to: (i)

overcome the effects of the Event of Force Majeure;

(ii)

mitigate the effect of any delay occasioned by any Event of Force Majeure, including by recourse to alternative mutually acceptable (which acceptance shall not be unreasonably withheld by either Party) sources of services, equipment and materials; and

(iii)

ensure resumption of normal performance of this Agreement as soon as reasonably practicable and shall perform their obligations to the maximum extent practicable,

provided that neither Party shall be obliged to settle any strike, lock out, work stoppage, labour dispute or such other industrial action by its employees.

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CREDIT RATINGS

26.1

Credit Ratings General Background

Ratings are opinions about the creditworthiness of a rated entity. They reflect both quantitative assessments of credit risk and the expert judgment of a ratings committee. Ratings convey information about the relative and absolute creditworthiness of the rated entities. Agencies often emphasize that a rating reflects the creditworthiness of the rated entity relative to that of others. That said, agencies regularly publish studies that convey the historical association of ratings and indicators of absolute creditworthiness, such as default rates and the magnitude of losses at default. In the case of structured finance products, ratings are explicitly tied to estimates of default probabilities and credit losses.

26.2

Why assessing banks' creditworthiness is difficult

The difficulties ratings agencies, credit markets and many financial analysts had in forecasting banks' performance during the recent crisis are rooted in unique features of the banking industry. Banks' role as financial intermediaries and their importance for financial stability determine the degree of external assistance they receive and shape the risk factors to which they are exposed. Assessments of bank creditworthiness thus need to account for the degree of external support, gauge the degree of systemic risk and address the inherent volatility of banks' performance.

26.3

Accounting for external support: stand-alone versus all-in ratings

Since banks play a key role as financial intermediaries, they often benefit not just from the support of the parent institution but also from that of public authorities. The recent crisis illustrated that support can come in different forms: as capital injections, asset purchases or liquidity provisions. When there is a commitment to support the creditworthiness of a bank, be it explicit or implicit, the rating agency has to evaluate not only the ability of the parent or sovereign to honour this commitment but also their willingness to do so. And even if support can be expected to be strong most of the time, what matters is its availability when the bank needs it. Given the importance of external support, rating agencies generally assign at least two different ratings to banks, which in the remainder of this feature we refer to as "stand-alone" and "all-in" ratings. A stand-alone rating reflects the intrinsic financial strength of the institution and, thus, its likelihood of default, assuming that no external support is forthcoming. In addition to accounting for stand-alone financial strength, an all-in rating factors in the likelihood and magnitude of extraordinary external support that the bank may receive if and when it is in distress. While all-in ratings matter to banks' creditors and trading counterparties, stand-alone ratings provide useful information to a prudential authority interested in the underlying strength.

26.4

Accounting for systemic risk

The recent crisis has underscored the need for a holistic approach to assessing bank risk. In particular, it has become clear that the creditworthiness of a bank depends on vulnerabilities that may build up in different parts of the financial system, as well as on interlinkages in this system. Thus, a bank's rating should not be derived in isolation but should reflect the industrial, financial and economic context of the bank's business. Adopting a system-wide perspective is not straightforward. First, there has to be an operational definition of the relevant system, which gives rise to a tension between the desire to be comprehensive and the need to be practical. Second, even when the relevant system is defined, there is no agreed formal metric for assessing systemic risk. The literature has proposed a number of model-based measures that are either overly stylized or quite data- intensive and difficult to communicate to the general public. As an alternative to model-based measures, rating agencies often rely on leading indicators based on empirical regularities that signal the build-up of vulnerabilities in the system, such as high credit growth and asset price increases.

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26.5

Accounting for earnings volatility

Another reason banks' creditworthiness is especially hard to assess is that their earnings performance is highly volatile. For instance, on the back of leverage roughly five times that of firms in other sectors, the volatility of returns on banks' stocks over the past several decades has been consistently higher than that of non-financial stocks. Evaluating the outlook for banks' earnings â&#x20AC;&#x201C; the key source of lossabsorbing capital â&#x20AC;&#x201C; is a critical component of bank credit analysis. It is important to evaluate not only the extent to which a bank's earnings can absorb adverse shocks, but also how far investors would allow the bank to retain more earnings through reduced dividend payouts when raising fresh capital is difficult. Banks that wait too long to increase earnings retention may be particularly unstable, as the speed at which distress unfolds can overwhelm banks' concurrent earnings capacity. Agencies use this argument to explain why they consider banks that consistently retain a greater share of their earnings during tranquil times as more creditworthy.

26.6

Ratings Case Study: Fitch

Fitch is a credit rating agency that has been registered with ESMA in 31 October 2011 and therefore meets the conditions to be an eligible credit assessment institution (ECAI). Fitch is an international credit rating agency that encompasses more than 30 separate ratings companies operating across more than 50 offices worldwide. On the one hand, the quantitative and qualitative information available in CEREP has been used to obtain an overview of the main characteristics of this ECAI and to calculate the default rates of its credit assessments. On the other hand, specific information has also been directly requested to the ECAI for the purpose of the mapping, especially the list of relevant credit assessments and detailed information regarding the default definition. This mapping should however be interpreted as the correspondence of the rating categories of Fitch with a regulatory scale which has been defined for prudential purposes. This implies that an appropriate degree of prudence may have been applied wherever not sufficient evidence has been found with regard to the degree of risk underlying the credit assessments. Long-term issuer default ratings (IDR) - Rated entities in a number of sectors, including financial and non-financial corporations, sovereigns and insurance companies, are generally assigned Issuer Default Ratings (IDRs). IDRs opine on an entity's relative vulnerability to default on financial obligations. The "threshold" default risk addressed by the IDR is generally that of the financial obligations whose non-payment would best reflect the uncured failure of that entity. As such, IDRs also address relative vulnerability to bankruptcy, administrative receivership or similar concepts, although the agency recognizes that issuers may also make pre-emptive and therefore voluntary use of such mechanisms. Long-term corporate finance obligation ratings - Ratings of individual securities or financial obligations of a corporate issuer address relative vulnerability to default on an ordinal scale. In addition, for financial obligations in corporate finance, a measure of recovery given default on that liability is also included in the rating assessment. This notably applies to covered bonds ratings, which incorporate both an indication of the probability of default and of the recovery given a default of this debt instrument. International fund credit ratings, defined as a rating on a particular security or obligor, although the same scale is used as for the International long-term credit ratings. The ratings only measure the aggregate credit risk of a portfolio and do not measure the expectation of default risk for a fund itself as a fund generally cannot default. Fund Credit Ratings may be accompanied by Fund Volatility.

26.6.1 Fitch Information Used to Determine a Rating The rating process incorporates information provided directly by the rated issuer, arranger, sponsor or other third party. This may include background data, forecasts, risk reports or factual feedback on proposed analytical research and other communications. In most cases, issuer management participates in the ratings process via in-person management and treasury meetings, on-site visits, ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 teleconferences and other correspondence. In addition analysts consider macroeconomic conditions, market events and any other factors deemed relevant, such as information from an issuer's peers or provided by other analytical groups within Fitch. The analytical team conducting the analysis will determine if sufficient information is available to recommend a view on creditworthiness of the issuer. Collectively, the rating committee will also consider whether there is sufficient information to support a rating. If Fitch believes that the information available, both public and private, is insufficient to form a rating opinion, no credit rating will be assigned or maintained. If sufficient information ceases to become available, Fitch will withdraw the rating. Fitch relies on information it receives from sources believed to be credible. Fitch conducts a reasonable investigation of data accuracy and obtain(s) reasonable verification of that information from independent sources. Issuers (or arrangers/sponsors) may choose not to share certain information with external parties, including rating agencies, at any time. While Fitch expects that each participating issuer in the rating process, or its agents, will supply promptly all information relevant for evaluating both the ratings of the issuer and all relevant securities, Fitch neither has, nor would it seek, the right to compel the disclosure of information by any issuer or any agents of the issuer.

26.6.2 Fitch Surveillance of Ratings Fitch's ratings are typically monitored on an ongoing basis and the review process is a continuous one. Monitored ratings are subject to regular scheduled reviews by a rating committee, typically annually, although the review frequency may vary if deemed appropriate by Fitch or where required by applicable local law. Point-in-time ratings are not monitored on an ongoing basis. Such ratings are rarely published, but where they are, they are clearly disclosed as "point-in-time" in the accompanying rating action commentary. If a business, financial, economic, operational or other development can reasonably be expected to result in a rating action, analysts will convene a committee promptly to review the rating instead of waiting for the next scheduled review. For example, operational or fiscal deterioration, an acquisition, a divestiture or the announcement of a major share repurchase may trigger an immediate rating review. Fitch's surveillance process incorporates the use of market indicators where available, such as bond and CDS pricing information, and a broader array of financial information, systemic risk and operational risk analyses. Fitch continues to develop tools appropriate to the surveillance task. Peer analysis is another surveillance method that is used primarily to assess the relative performance of comparable corporate entities and financial institutions over time. Peer groups are created based on similar fundamentals and rating levels, among other factors. Results of Fitch's peer analysis are included in research such as Ratings Navigator, a peer comparison tool used by the Corporate and Financial Institutions groups, which provides a graphical representation of key rating drivers against peer expectations for a given rating category. Scenarios for structured finance are generally based on quantitative metrics. In addition, ratings performance will be monitored with surveillance techniques to evaluate the impact of stress scenarios on multiple transactions. Such tools will typically track data from surveillance reports provided by the trustee and compare the information against original and stressed expectations to "flag" transactions where performance has diverged from established parameters.

26.6.3 Fitch Sovereign-Related Risk â&#x20AC;¨ Transactions may have partial exposures to countries whose Country Ceiling is below the highest rating of the notes and/or where Fitch applies a cap to its structured finance (SF) ratings, pursuant to the Criteria for Sovereign Risk in Developed Markets for Structured Finance and Covered Bonds (Developed Market Criteria) or the Criteria for Rating Securitizations in Emerging Markets (Emerging Market Criteria). â&#x20AC;¨

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2017 Currently, this is the case for the Fitch-rated high-yield CLOs that have exposure to peripheral Eurozone countries (Spain, Italy, Portugal and Greece), which ranges between 5% and 20% and which follows the Developed Market Criteria. For these transactions, the agency will increase correlation levels and reduce recovery rates to reflect expected higher asset performance volatility, especially at rating levels above the cap. The updated correlation and recovery assumptions are calibrated to match the expected loss at the country rating cap level to the 'AAAsf' level. The currently applicable recovery rate assumptions are shown in Appendix 5. Figure 10 shows the calibration of the correlation assumptions and the implied RDR for the respective countries compared to the standard assumptions for the peak calibration portfolio, as described in Appendix 3. For Spain and Italy, for example, the current country cap is 'AA+sf'. The correlation was increased from 4% to 6% and as result the RDR at the 'AAsf' rating level increased to 54%, which matches the 'AAAsf' RDR under the standard correlation assumptions.

26.6.4 Fitch Emerging Markets The correlation framework was further developed to incorporate assets from emerging-market countries and reflect the following additional credit views. •

Corporate credit portfolios in EM countries are likely to have more volatile portfolio default rates, indicating a higher level of correlation than similarly rated portfolios in advanced economies, regardless of region and country. Therefore, the criteria apply a 10% uplift to the correlation of any two EM assets.

•

Regional diversity is particularly important for portfolio performance within EMs, and as a result EM assets from the same region are subject to an additional 10% correlation uplift. Fitch has created four broad EM regions to implement this: EM Americas, EM Asia, EM Europe and Central Asia, and EM Africa and Middle East.

•

Country diversity within the same region is of lesser benefit than regional diversity, and assets from the same country are subject to an additional 5% correlation uplift.

•

The same credit views with regard to industry concentration apply to EM and advanced economies.

Fitch believes that a small amount of EM exposure in a well-diversified portfolio of debt from advanced economies should add geographical diversity and reduce volatility. However, it is the agency's view that large EM exposures increase the risk to the portfolio, especially in high rating scenarios, and this outweighs any diversity benefits.   By way of illustration, the correlation between Russian assets in different sectors is 26%. This is made up from the sum of 1% global base correlation, 10% EM base correlation, 10% EM region correlation and 5% EM country correlation. In comparison, the correlation between US companies would be 2% (1% global base and 1% for being in the same region). If the Russian assets are also in the same industry, they will attract a further uplift up to 22%, which would give a total correlation for such a portfolio of 48%. For EM assets from different geographical regions and sectors – for example, a Russian utilities company and an Indonesian finance company – the correlation will be 11%, ie 1% global base plus 10% EM base. Transactions with a material share of assets in EMs are unlikely to support 'AAAsf' ratings, especially if many of the assets are from low-rated sovereigns. Such structures, as well as regional or single country EM transactions, fall outside the scope of this criteria report and therefore this global correlation framework will not apply. Instead, Fitch will support its analysis with its emerging markets rating approach (Criteria for Rating Securitizations in Emerging Markets) and tailor its analysis to reflect the risks within the local economics that underpin the particular portfolio. © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 This will include a dedicated correlation framework, which may deviate materially from the one laid down in this report. A similar approach will be used for transactions where ratings are only assigned on a national scale, where the correlation framework will also be amended to reflect the particularities of the relevant jurisdiction.

26.6.5 Fitch Criteria Development Rating decisions are made in accordance with the methodologies and criteria applicable to that sector. The methodologies themselves, and the criteria that determine rating levels within each major methodology, are created and revised by the analytical teams. New and revised criteria documents are reviewed by the agency's global Criteria Committees, covering Corporate Finance, Structured Finance, Public Finance and Emerging Markets. These Committees meet regularly and are composed of senior analysts from a balanced selection of different analytical groups and international offices. New criteria that affect a wider range of analytical areas, or propose a new rating scale, are additionally submitted to Fitch's multi-disciplinary Credit Policy Board, the senior-most analytical decision-making body of the agency. The Credit Policy Board also serves as an appeal forum for the agency's Criteria Committees. Surveillance of Ratings Unless they are of a 'point-in-time' nature, Fitch's ratings are monitored on an ongoing basis and Fitch is staffed to ensure that this is possible. Analysts in all groups will initiate a rating review whenever they become aware of any business, financial, operational or other information that they believe might reasonably be expected to result in a rating action, consistent with the relevant criteria and methodologies. Thus, for example, an operational of fiscal deterioration, an acquisition, a divestiture, or the announcement of a major share repurchase may all trigger an immediate rating review. Consequently, the review process should be regarded as a continuous one. Ratings are also subject to formal periodic reviews.

26.6.6 Fitch Timing of the Process Fitch's global resources allow the agency to respond in a timely manner to requests for ratings and other credit opinions. The actual time taken to assign a new rating can vary, and will partly depend on the time required by the rated party to respond to information requests from Fitch and to review the rating feedback provided by the agency. However, Fitch will make reasonable efforts to accommodate the needs of the entity, both in terms of the timing of any rating visit and the completion of the subsequent review process. As an example, Fitch typically assumes a timeframe of six to eight weeks to provide a full corporate, financial institution or sovereign rating. Structured finance ratings may be prepared over a longer period, as rating agencies are often involved at an earlier stage in the decision to undertake a structured finance transaction, but Fitch is staffed with sufficient resources to be able to respond in a flexible manner and prepare ratings within a shorter timeframe if necessary. The timings noted provide flexibility in the process and the least time pressure on the resources of the rated party. Quality Standards Fitch places a great deal of importance on the consistency of its rating product. Thus, common processes apply for ratings assigned to entities in both emerging and developed markets and between all Fitch offices, irrespective of size or location. As mentioned earlier, the methodologies for each area of our business are generally constructed on a global basis, even where the emphasis added to individual criteria or specific qualitative or quantitative thresholds may vary from one jurisdiction to another. The scrutiny of new methodologies and criteria is carried out on an international basis and, in the case of methodologies significant enough to go before the Credit Policy Board, by senior analysts drawn from all of the agency's major analytical groups. Additionally, Fitch operates a central group – the Credit Policy Group (CPG), headed by the Chief Credit Officer – which has a cross-sector mandate to review the performance of the agency's ratings. © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 This performance review includes both quantitative measures, such as default and transition statistics and timeliness of response to events, and qualitative measures. Ad hoc reviews of individual transactions are carried out by the CPG based on price movements in the issuer's debt or equity instruments, news-flow or other market indicators. Fitch also has a compliance examination group that conducts a compliance audit program designed continually to assess Fitch's compliance with the Code of Conduct and other established policies, procedures and controls with respect to Fitch's credit ratings and related activities. This group reports to Fitch's Chief Compliance Officer.

26.6.7 Fitch Long-Term International IFS Ratings Scale Long-term international IFS ratings scale Credit assessment

Meaning of the credit assessment

AAA

Exceptionally strong. 'AAA' IFS Ratings denote the lowest expectation of ceased or interrupted payments. They are assigned only in the AAA case of exceptionally strong capacity to meet policyholder and contract obligations. This capacity is highly unlikely to be adversely affected by foreseeable events.

Very strong. 'AA' IFS Ratings denote a very low expectation of ceased or interrupted payments. They indicate very strong capacity to meet policyholder and contract obligations. This capacity is not significantly vulnerable to foreseeable events.

Strong. 'A' IFS Ratings denote a low expectation of ceased or interrupted payments. They indicate strong capacity to meet policyholder A and contract obligations. This capacity may, nonetheless, be more vulnerable to changes in circumstances or in economic conditions than is the case for higher ratings.

BBB

Good. 'BBB' IFS Ratings indicate that there is currently a low expectation of ceased or interrupted payments. The capacity to meet BBB policyholder and contract obligations on a timely basis is considered adequate, but adverse changes in circumstances and economic conditions are more likely to impact this capacity.

Moderately weak. 'BB' IFS Ratings indicate that there is an elevated vulnerability to ceased or interrupted payments, particularly as the BB result of adverse economic or market changes over time. However, business or financial alternatives may be available to allow for policyholder and contract obligations to be met in a timely manner.

Weak. 'B' IFS Ratings indicate two possible conditions. If obligations are still being met on a timely basis, there is significant risk that ceased or interrupted payments could occur in the future, but a limited margin of safety remains. Capacity for continued timely B payments is contingent upon a sustained, favourable business and economic environment, and favourable market conditions. Alternatively, a 'B' IFS Rating is assigned to obligations that have experienced ceased or interrupted payments, but with the potential for extremely high recoveries. Such obligations would possess a recovery assessment of 'RR1' (Outstanding).

CCC

Very weak. 'CCC' IFS Ratings indicate two possible conditions. If obligations are still being met on a timely basis, there is a real possibility that ceased or interrupted payments could occur in the future. Capacity for continued timely payments is solely reliant upon CCC a sustained, favourable business and economic environment, and favourable market conditions. Alternatively, a 'CCC' IFS Rating is assigned to obligations that have experienced ceased or interrupted payments, and with the potential for average to superior recoveries. Such obligations would possess a recovery assessment of 'RR2' (Superior),

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2017 Long-term international IFS ratings scale Credit assessment

Meaning of the credit assessment 'RR3' (Good), and 'RR4' (Average).

Extremely weak. 'CC' IFS Ratings indicate two possible conditions. If obligations are still being met on a timely basis, it is probable that ceased or interrupted payments will occur in the future. Alternatively, a 'CC' IFS Rating is assigned to obligations that have experienced ceased or interrupted payments, with the potential for average to below-average recoveries. Such obligations would possess a recovery assessment of 'RR4' (Average) or 'RR5' (Below Average).

Distressed. 'C' IFS Ratings indicate two possible conditions. If obligations are still being met on a timely basis, ceased or interrupted payments are imminent. Alternatively, a 'C' IFS Rating is assigned to obligations that have experienced ceased or interrupted payments, and with the potential for below average to poor recoveries. Such obligations would possess a recovery assessment of 'RR5' (Below Average) or 'RR6' (Poor).

26.6.8 Fitch Corporate Finance Obligation â&#x20AC;&#x201C; Long-Term Ratings Scale Corporate finance obligation - Long-term ratings scale Credit assessment Meaning of the credit assessment

AAA

Highest credit quality. 'AAA' ratings denote the lowest expectation of credit risk. They are assigned only in cases of exceptionally strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events.

Very high quality. 'AA' ratings denote expectations of very low default risk. They indicate very strong capacity for payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events.

High credit quality. 'A' ratings denote expectations of low default risk. The capacity for payment of financial commitments is considered strong. This capacity may, nevertheless, be more vulnerable to adverse business or economic conditions than in the case for higher ratings.

BBB

Good credit quality. 'BBB' ratings indicate that expectations of default risk are currently low. The capacity for payment of financial commitments is considered adequate but adverse business or economic conditions are more likely to impair this capacity.

Speculative. 'BB' ratings indicate an elevated vulnerability to default risk, particularly in the event of adverse changes in business or economic conditions over time; however, business or financial alternatives may be available to allow financial commitments to be met.

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2017 Corporate finance obligation - Long-term ratings scale Credit assessment Meaning of the credit assessment B

High speculative. 'B' ratings indicate that material credit risk is present.

CCC

Substantial credit risk. 'CCC' ratings indicate that substantial credit risk is present.

Very high level of credit risk. 'CC' ratings indicate very high levels of credit risk

Exceptionally high levels of credit risk. 'C' indicates exceptionally high levels of credit risk.

Default obligations typically are not assigned 'RD' or 'D' ratings, but are instead rated in the 'B' to 'C' rating categories, depending upon their recovery prospects and other characteristics. This approach better aligns obligations that have comparable overall expected loss but varying vulnerability to default and loss.

26.6.9 Fitch Long-Term Issuer Credit Ratings Scale Long-term issuer credit ratings scale Credit assessment

AAA

Meaning of the credit assessment Highest credit quality. 'AAA' ratings denote the lowest expectation of default risk. They are assigned only in cases of exceptionally strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events. Very high quality. 'AA' ratings denote expectations of very low default risk. They indicate very strong capacity for payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events.

BBB

Good credit quality. 'BBB' ratings indicate that expectations of default risk are currently low. The capacity for payment of financial commitments is considered adequate but adverse business or financial flexibility exists which supports the servicing of financial commitments.

Speculative. 'BB' ratings indicate an elevated vulnerability to default risk, particularly in the event of adverse changes in business or economic conditions over time; however, business or financial flexibility exists which supports the servicing of financial commitments.

Highly speculative. 'B' ratings indicate that material default risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is vulnerable to deterioration in the business and economic environment.

CCC

Substantial credit risk. Default is a real possibility

Very high level of credit risk. Default of some kind appears probable.

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2017 Long-term issuer credit ratings scale Credit assessment

Meaning of the credit assessment

Exceptionally high levels of credit risk. Default is imminent or inevitable, or the issuer is in standstill. Conditions that are indicative of a 'C' category rating for an issuer include: (a) the issuer has entered into a grace or cure period following non-payment of a material financial obligation; (b) the issuer has entered into a temporary negotiated waiver or standstill agreement following payment default on a material financial obligation; or (c) Fitch Ratings otherwise believes a condition of 'RD' or 'D' to be imminent or inevitable including through the formal announcement of a distressed debt exchange.

Restricted default. 'RD' ratings indicate an issuer that in Fitch Ratings' opinion has experienced an uncured payment default on a bond, loan or other material financial obligation but which has not entered into bankruptcy filings, administration, receivership, liquidation or other formal winding-up procedure, and which has not otherwise ceased operating.

Default. 'D' ratings indicate an issuer that in Fitch Ratings' opinion has entered into bankruptcy filings, administration, receivership, liquidation or other formal winding-up procedure, or which has otherwise ceased business.

26.6.10

Fitch Credit Ratings and Rating Scales Credit Ratings and Rating Scales

SA Exposure classes

Name of credit rating

Credit rating scale

Long-term ratings Central governments/ Central banks Long-term issuer default ratings Long-term corporate obligation ratings

finance Corporate finance obligations Long-term ratings scale

Regional and local governments and PSEs Long-term issuer default ratings Long-term corporate obligation ratings Institutions

Corporates

Long-term issuer credit ratings scale

finance Corporate finance obligations Long-term ratings scale

Long-term issuer default ratings Long-term corporate obligation ratings

Long-term issuer credit ratings scale

finance Corporate finance obligations Long-term ratings scale

Long-term issuer default ratings Long-term corporate obligation ratings

Long-term issuer credit ratings scale

finance Corporate finance obligations Long-term ratings scale

Long-term international insurer Long-term international financial strength (IFS) ratings ratings scale Covered bonds

Long-term

corporate

IFS

finance Corporate finance obligations -

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2017 Credit Ratings and Rating Scales SA Exposure classes

CIUs

Name of credit rating

Credit rating scale

obligation ratings

Long-term ratings scale

International fund credit ratings

Long-term issuer credit ratings scale

Short-term ratings Central governments/ Central Banks Short-term issuer ratings

Short-term ratings scale

Regional and local governments and PSEs Short-term issuer ratings

Short-term ratings scale

Institutions

Short-term issuer ratings

Short-term ratings scale

Short-term obligation ratings

Short-term ratings scale

Short-term issuer ratings

Short-term ratings scale

Short-term obligation ratings

Short-term ratings scale

Corporates

26.6.11

Rating Methodologies for Banks

Rating methodologies for banks

Fitch

Moody's

Standard & Poor's

Emphasis on forwardlooking Focus on off- assessments of Stand-alone balance sheet capital ratios, assessments commitments, based on Focus on risk-adjusted (intrinsic financial funding and embedded performance and ability to grow strength) liquidity risk capital from profits expected losses Based on a joint default analysis of Distinct ratings of banks and All-in ratings sovereign support providers of Anticipated support increases with (with external support) provide a floor support the bank's systemic importance

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Rating methodologies for banks

Fitch

Moody's

Based on: - macro indicators - average bank rating System-wide assessment Country

None

Based macro industry and environment

on: indicators regulatory

rating

Not explicitly; anticipated support increases with the bank's systemic Does systemic risk importance but affect banks' ratings? falls in times of generalized distress Last major changes

26.6.12

Standard & Poor's

Not explicitly; anticipated support increases with the bank's systemic importance

Yes, through: - macro indicators for countries where the bank operates - assessments of the industry and regulatory environment in the home country

2005: systemic risk 2007: joint default 2011: overhaul of the rating analysis analysis in support methodology. assessment Greater emphasis on: system-wide risks - link from earnings to capital

Differences Across Ratings Agencies Differences across rating agencies Averages of notch differences All-in ratings

Moody's vs Fitch Moody's vs S&P Fitch vs S&P

Stand-alone ratings

Mid-2007

April 2011

Mid-2007

April 2011

1.59

0.82

1.26

1.44

(54)

(56)

(64)

(62)

1.63

1.04

(57)

0.12

0.28

(60) (60) A stand-alone (or financial strength) rating is referred to as an "individual rating" by Fitch and as a "bank financial strength rating" by Moody's. An all-in rating, which accounts for financial strength and external support, is referred to as a "long term issuer default rating" by Fitch and an "issuer rating" by Moody's and Standard & Poor's. Stand-alone ratings are translated into the all-in ratings' (standard) scale on the basis of mapping tables in Fitch (2010) and Moody's (2007). Then ratings are translated into numbers as follows: AAA = 20, AA+ = 19, AA = 18, ..., C = 0. A notch is the difference between two consecutive ratings.

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26.6.13

Fitch Credit Ratings Scale

Long-term issuer credit ratings Short-term issuer credit ratings scale scale AAA AA+ AA

F1+

AAA+ F1

A A-

BBB+ BBB

BBBBB+ BBB

B+ B BCCC

CC C RD/D

26.6.14

RD/D

Fitch Short-Term IFS Ratings Scale

Short-term IFS ratings scale Credit assessment Meaning of the credit assessment

Insurers are viewed as having a strong capacity to meet their near-term obligations. When an insurer rated in this rating category is designated with a (+) sign, it is viewed as having a very strong capacity to meet near-term obligations.

Insurers are viewed as having a good capacity to meet their near-term obligations.

Insurers are viewed as having an adequate capacity to meet their near-term obligations.

Insurers are viewed as having a weak capacity to meet their near-term obligations.

Insurers are viewed as having a very weak capacity to meet their near-term obligations.

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26.6.15

Fitch Short-Term Ratings Scale Short-term ratings scale

Credit assessment

Meaning of the credit assessment

Highest short-term credit quality. Indicates the strongest intrinsic capacity for timely payment of financial commitments; may have an added "+" to denote any exceptionally strong credit feature.

Good short-term credit quality. Good intrinsic capacity for timely payment of financial commitments.

Fair short-term credit quality. The intrinsic capacity for timely payment of financial commitments is adequate.

Speculative short-term credit quality. Minimal capacity for timely payment of financial commitments, plus heightened vulnerability to near term adverse changes in financial and economic conditions.

High short-term default risk. Default is a real possibility.

Restricted default. Indicates an entity that has defaulted on one or more of its financial commitments, although it continues to meet other financial obligations. Typically applicable to entity ratings only.

Default. Indicates a broad-based default event for an entity, or the default of a short-term obligation.

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CHAPTER 4: CREDIT SUPPORT AND COLLATERAL NEGOTIATION AND DOCUMENTATION FOR SWAPS OUTLINE ■

■

ISDA® CSA (New York Annex and English Deed Security Interest)(English Annex Outright Transfer), Threshold Amount. Exposure, Eligible Collateral, Valuation Day, Collateral Calls, Transfer Timing, Segregation of Independent Amounts, Failure to Deliver Margin and Cure Periods, Risks in Credit Exposure, Credit Enhancement Techniques, Bankruptcy-Remote Entities, Credit Risk Policy, Debt Management Strategy). Liquidity Management (Contingent Liquidity, Custodial Services Offerings).

CHAPTER 4 ABBREVIATIONS

■ ■

Table 17: Chapter 4 Abbreviations Abbreviation

Term

CAD

Collateral Asset Definitions

CCP

Central Counterparty Clearing House

CDR

Client Deposit Rate

CDS

Credit Default Swap

CSA

Credit Support Annex

CSD

Credit Support Document

EMIR

European Market Infrastructure Regulation

ETF

Exchange Traded Funds

European Union

FHIs

Financial Health Indicators

FHLB

Federal Home Loan Banks

FHLMC

Freddie Mac

FNMA

Fannie Mae

FRA

Forward Rate Agreements

GUI

Graphical User Interface

HQHL

High Quality High Liquidity

Independent Amount

ICAD

The ISDA Collateral Definition

ISDA

International Swaps and Derivatives Association

ITM

In-The-Money

ITM Counterparty

Counterparty

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Term

LDR

London Deposit Rate

MTM

Mark-to-Market

NAV

Net Asset Value

OIS

Overnight Index Swap

OIS

Overnight Index Swaps

OTC

Over the Counter

OTM

Out-Of-The-Money

OTM Counterparty

Out-Of-The-Money Counterparty

RDR

RepoClear Deposit Rate

SAAS

Software as a Service

SPV

Special Purpose Vehicle

United States

VAR

Value-at-Risk

Variation Margin

NEGOTIATING AND DOCUMENTING THE ISDA® CSA

28.1

Overview of Counterparty Risks

•

Counterparty risk associated with a change in market conditions (i.e. substitution cost increases the longer the time between the trade date and the settlement date).

•

Currency trade also subject to counterparty risk associated with the settlement of the trade.

Ways to manage and/or mitigate counterparty risk include: •

Choice of counterparty.

•

Choice of financial instruments.

•

Choice of maturities of trades.

•

Use of Central Clearing Counterparties (CCPs).

•

Use of bilateral Credit Support Annexes (CSAs).

•

Use of High Quality High Liquidity (HQHL) collateral such as cash or securities.

•

Limitation of collateral re-hypothecation rights.

•

Counterparty risk associated with a change in market conditions (i.e. substitution cost increases the longer the time between the trade date and the settlement date).

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28.2

ISDA® 2015 Margin Survey Results

ISDA (2015). ISDA MARGIN SURVEY 2015, August 2015. The International Swaps and Derivatives Association. Historically, market participants have valued derivatives cashflows using LIBOR. However, many firms began using the overnight index swap (OIS) rate as a discount rate for cash-collateralised derivatives in the wake of the financial crisis, as this is the rate used to determine the interest paid on cash collateral. This trend continued last year, with the move to OIS discounting motivated by better funding alignment and the reduction of liquidity risk…The use of OIS discounting is most broadly observed in the interest rate derivatives category, but increased at the fastest rate for foreign exchange and equity derivatives – by 16.3% and 13.3%, respectively. Other CSA-specific methodologies were most prevalent in the equity and commodity classes. (ISDA, 2015, p.21).

•

The combined collateral of 41 participants was approximately $2.04 trillion at the end of 2014.

•

Total collateral (reported plus estimated) supporting non-cleared derivatives transactions decreased by 6.2% ($5.34 trillion in 2013, $5.01 trillion in 2014).

•

Total reported collateral for cleared derivatives transactions (received and delivered for house and client cleared trades) rose 54% ($295 billion in 2013, $455 billion in 2014).

•

Total collateral (received and delivered) related to client clearing more than quadrupled, increasing by 262.5%.

•

The 1994 ISDA CSA (New York Law) (pledge) comprised the largest share of non-cleared agreements, accounting for 46.8%, followed by the 1995 ISDA CSA (English Law) (title transfer) accounting for 30.1%.

•

The use of CSAs for non-cleared derivatives increased across every asset class in 2014, with credit derivatives (97.0%) and equity derivatives (91.3%) showing the highest usage.

•

Lower percentages of cash, government securities and other securities were eligible for rehypothecation in 2014, with cash comprising over 90% of collateral eligible for rehypothecation and more than 80% of collateral actually rehypothecated.

•

Nearly two-thirds (65.9%) of cleared house trades used Central Counterparty (CCP) agreements.

•

The majority of firms increased the number of agreements supporting client cleared transactions, with large firms increasing client clearing agreements by approximately 67% year-over-year.

•

More than 85% of all firms surveyed this year indicated they manage their collateral process in-house, small firms manage collateral exclusively internally, it is a near-exclusive process at medium-size firms and larger firms outsource about a third of that business.

28.3

Overview of Types of CSA

CSAs are used to manage counterparty risk throughout the life of the over-the-counter (OTC) derivatives transaction. CSAs involve the counterparties setting exposure limits to each other, agreeing on the frequency of portfolio measurement and collateral posting, minimum amounts to be transferred, and the posting of collateral. The collateral that is transferred is typically based on the parties' net exposure to each other under specified derivatives transactions undertaken at any one time. The ISDA CSA contains provisions relating to the calculation of the exposure of each of the parties to the OTC transaction, the posting and transfer of collateral, and the return of any collateral taken.

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2017 On some markets this bilateral collateral framework may be undertaken on a discretionary basis whilst on other regulated markets the regulatory framework may be specified in advance for all market participants, e.g. in the European Union (EU) under the European Market Infrastructure Regulation (EMIR). The type of collateral that is acceptable may also be dictated by pre-existing market practices, e.g. cash collateral exclusively used in the European interbank market. Under United States (US) law collateral is managed by third-party custodians (e.g. Bank of New York Mellon, Northern Trust, State Street) whereas under English law collateral is typically posted directly with the counterparty.

28.4

1994 CSA (Security Interest – New York Law)

This CSA allows parties to establish bilateral mark-to-market (MTM) security arrangements and is designed for use in transactions subject to New York law. The parties' MTM exposure across all OTC derivatives transactions subject to the Master Agreement can be calculated, for example on a daily basis, to allow the In-The-Money (ITM) counterparty (ITM Counterparty) to make calls for collateral from the Out-Of-The-Money (OTM) counterparty (OTM Counterparty).

28.5

1995 English Credit Support Deed (Security Interest)

This allows parties to establish bilateral MTM collateral arrangements under English law whilst relying on the creation of a formal security interest in collateral in the form of securities and/or cash. It is a stand-alone document (not an Annex to the Schedule) but similar to the format of typically CSAs.

28.6

1995 English Annex (Transfer – English Law) (Outright Transfer)

This CSA allows parties to establish bilateral MTM arrangements under English law whilst relying on transfer of title to collateral in the form of securities and/or cash. In the event of default, inclusion of collateral values within the close-out netting is provided by section 6 of the ISDA Master Agreement. The English CSA does not create a security interest but instead relies on netting for its effectiveness.

28.7

ISDA 2013 Standard Credit Support Annex (Security Interest - New York Law)

The 2013 Standard ISDA Credit Support Annex allows parties to establish bilateral mark-to-market security arrangements that create a homogeneous valuation framework, reducing current barriers to novation and valuation disputes. This alternative to the 1994 ISDA Credit Support Annex seeks to standardize market practice regarding embedded optionality in current Credit Support Annexes, promote the adoption of overnight index swap discounting for derivatives, and align the mechanics and economics of collateralization between the bilateral and cleared OTC derivative markets. This document serves as an Annex to the Schedule to the ISDA Master Agreement and is designed for use in transactions subject to New York law.

28.8

ISDA 2013 Standard Credit Support Annex (Transfer - English Law)

The English Standard Credit Support Annex allows parties to establish bilateral mark-to-market arrangements under English law relying on transfer of title to collateral in the form of securities and/or cash and, in the event of default, inclusion of collateral values within the close-out netting provided by Section 6 of the ISDA Master Agreement. The English Standard Credit Support Annex does not create a security interest, but instead relies on netting for its effectiveness. This alternative to the 1995 ISDA Credit Support Annex (Transfer - English Law) further seeks to standardize market practice regarding embedded optionality in current Credit Support Annexes, promote the adoption of overnight index swap discounting for derivatives, and align the mechanics and economics of collateralization between the bilateral and cleared OTC derivative markets. This document, like the New York Credit Support Annex, is an Annex to the Schedule to the ISDA Master Agreement.

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28.9

ISDA 2014 Standard Credit Support Annex (Security Interest - New York Law)

The 2014 Standard ISDA Credit Support Annex allows parties to establish bilateral mark-to-market security arrangements that create a homogeneous valuation framework, reducing current barriers to novation and valuation disputes. This document retains and accepts intraday settlement risk by allowing multi currency settlement in lieu of net settlement in a single Transport Currency under the ® 2013 SCSA published by ISDA in June 2013. This alternative to the 1994 ISDA Credit Support Annex seeks to standardize market practice regarding embedded optionality in current Credit Support Annexes, promote the adoption of overnight index swap discounting for derivatives, and align the mechanics and economics of collateralization between the bilateral and cleared OTC derivative markets. This document serves as an Annex to the Schedule to the ISDA Master Agreement and is designed for use in transactions subject to New York law.

28.10 ISDA 2014 Standard Credit Support Annex (Transfer - English Law) The 2014 English Standard Credit Support Annex allows parties to establish bilateral mark-to-market arrangements under English law relying on transfer of title to collateral in the form of securities and/or cash and, in the event of default, inclusion of collateral values within the close-out netting provided by Section 6 of the ISDA Master Agreement. The English Standard Credit Support Annex does not create a security interest, but instead relies on netting for its effectiveness. This document retains and accepts intraday settlement risk by allowing multi currency settlement in lieu of net settlement in a ® single Transport Currency under the 2013 SCSA under English Law published by ISDA in June 2013. This alternative to the 1995 ISDA Credit Support Annex (Transfer - English Law) further seeks to standardize market practice regarding embedded optionality in current Credit Support Annexes, promote the adoption of overnight index swap discounting for derivatives, and align the mechanics and economics of collateralization between the bilateral and cleared OTC derivative markets. This document, like the New York Credit Support Annex, is an Annex to the Schedule to the ISDA Master Agreement.

28.11 2016 Credit Support Annex for Variation Margin (VM) (Title Transfer – English Law) The 2016 Credit Support Annex for Variation Margin (VM) is an updated version of the 1995 ISDA Credit Support Annex (Title Transfer - English Law) that is limited to variation margin, and allows parties to establish variation margin arrangements that meet the requirements of new regulations on margin for uncleared swaps. Like the 1995 CSA, this document serves as an Annex to the Schedule to the ISDA Master Agreement and is designed for use in transactions subject to English law.

28.11.1

Independent Amount Provisions

The Independent Amount (IA) Provisions set out Amendments for Independent Amounts to be included in Paragraph 11 of the English law 2016 Credit Support Annex for Variation Margin (VM). It contains terms that parties can include to modify Paragraph 11 of the Credit Support Annex (making appropriate elections in respect of the bracketed sections) in order to add Independent Amounts to the margin calculation and delivery requirements in the Credit Support Annex. The 2016 Credit Support Annex for Variation Margin (VM) is an updated version of the 1994 ISDA Credit Support Annex (Security Interest - New York Law) that is limited to variation margin, and allows parties to establish variation margin arrangements that meet the requirements of new regulations on margin for uncleared swaps. Like the 1994 CSA, this document serves as an Annex to the Schedule to the ISDA Master Agreement and is designed for use in transactions subject to New York law.

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28.12 ISDA 2016 Credit Support Annex for Variation Margin (VM) (Security Interest - New York Law) The 2016 Credit Support Annex for Variation Margin (VM) is an updated version of the 1994 ISDA Credit Support Annex (Security Interest - New York Law) that is limited to variation margin, and allows parties to establish variation margin arrangements that meet the requirements of new regulations on margin for uncleared swaps. Like the 1994 CSA, this document serves as an Annex to the Schedule to the ISDA Master Agreement and is designed for use in transactions subject to New York law.

28.12.1

Independent Amount Provisions

The Independent Amount (IA) Provisions set out Amendments for Independent Amounts to be included in Paragraph 13 of the New York law 2016 Credit Support Annex for Variation Margin (VM). It contains terms that parties can include to modify Paragraph 13 of the Credit Support Annex (making appropriate elections in respect of the bracketed sections) in order to add Independent Amounts to the margin calculation and delivery requirements in the Credit Support Annex.

28.13 1994 ISDA Credit Support Annex (Subject to New York Law Only) Preamble to the CSA Paragraph 1

Interpretation

Paragraph 2

Security Interest

Paragraph 3

Credit Support Obligations

Paragraph 4

Conditions Precedent, Transfer Timing, Calculations and Substitutions

Paragraph 5

Dispute Resolution

Paragraph 6

Holding and Using Posted Collateral

Paragraph 7

Events of Default

Paragraph 8

Certain Rights and Remedies

Paragraph 9

Representations

Paragraph 10

Expenses

Paragraph 11

Miscellaneous

Paragraph 12

Definitions

Paragraph 13

Elections and Variables

28.14 ISDA 1995 Credit Support Annex (Subject to English Law) Preamble to the CSA Paragraph 1

Interpretation

Paragraph 2

Credit Support Obligations

Paragraph 3

Transfers Calculations and Exchanges

Paragraph 4

Dispute Resolution

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Paragraph 5

Transfer of Title, No Security Interest, Distributions and Interest Amount

Paragraph 6

Default

Paragraph 7

Representations

Paragraph 8

Expenses

Paragraph 9

Miscellaneous

Paragraph 10

Definitions

Paragraph 11

Elections and Variables

28.15 Key Credit Provisions Term

Provision

Credit Support Amount

The risk exposure that needs to be collateralised.

Credit Support Balance

The amount of collateral held for the risk exposure.

Credit Support Document

Any Credit Support Document (CSD) must be specified in Part 4(f) of the ISDA Schedule.

Credit Support Provider

Any party delivering or issuing a CSD on behalf of a party that secures the ISDA obligations of such party, and they must be specified in Part 4(g) of the ISDA Schedule.

Exposure

Means for any Valuation Date or other date for which Exposure is calculated and subject to Paragraph 5 in the case of a dispute, the amount, if any, that would be payable to a party that is the Secured Party by the other party (expressed as a positive number) or by a party that is the Secured Party to the other party (expressed as a negative number) pursuant to Section 6(e)(ii)(2)(A) of this Agreement as if all Transactions (or Swap Transactions) were being terminated as of the relevant Valuation Time; provided that Market Quotation will be determined by the Valuation Agent using its estimates at midmarket of the amounts that would be paid for Replacement Transactions (as that term is defined in the definition of "Market Quotation").

Independent Amount

This is often also referred to as 'Initial Margin'. This can mean the amount that the parties may need to transfer at the start of the OTC derivatives trade, or alternatively an agreed sum that is agreed to be transferred afterwards if the risk exposure or counterparty risk profile changes. An Independent Amount overcollateralises OTC derivatives risk exposure.

Minimum Transfer Amount

This refers to a minimum floor which applies to any calls for collateral. Therefore under the Master Agreement framework any collateral calls for amounts that are smaller than the Minimum Transfer Amount are not permitted under the CSA. The Minimum Transfer Amount provides operational efficiency as it prevents small amounts having to be paid or received thereby adding to daily operational costs.

Threshold Amount

This is the unsecured credit exposure that the Secured Party is willing

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Provision to allocate to the Pledgor. Under the Master Agreement framework this means that the Pledgor is not required to post collateral unless and until the Secured Party's exposure equals or exceeds the Threshold Amount.

Where Master Agreements are supported by liens a CSD may include the relevant security agreement, deed of trust, or any other document granting the lien. Independent Amounts can cover numerous risks including: (1)

the estimated volatility of a specific Transaction where a counterparty believes it to attract higher risk than normal;

(2)

a time gap between the collateral call and the actual delivery of the collateral (e.g. long settlement cycle);

(3)

to cover credit risks that are identified as potentially arising (e.g. linked to a credit rating table or Net Asset Value (NAV). Independent Amounts can refer to a specific fixed monetary amount or can be based upon low credit ratings, NAV, or expressed as a percentage (e.g. percentage of a specified notional amount).

ISDA CSA Paragraph 11 (English) or 13 (New York) Elections

The elections that are specified in the CSA will address: (1)

the mechanics of collateral transfers;

(2)

the forms of acceptable collateral;

(3)

the care given to such collateral;

(4)

the timing of collateral calls;

(5)

Threshold Amounts;

(6)

Independent Amounts;

(7)

Transfer Timing;

(8)

the right of a party holding the collateral to rehypothecate the collateral;

(9)

Minimum Transfer Amount;

(10)

Valuation Date;

(11)

Threshold;

(12)

Distributions and Interest Amount;

(13)

Rating Triggers.

Under the CSA the Secured Party is the party that is holding the collateral and the Pledgor is the party that has delivered the collateral.

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29.1

Security Interest

Paragraph 2 of the CSA (New York Law) creates a security interest in the posted collateral. Each party, as the Pledgor, hereby pledges to the other party, as the Secured Party, as security for its Obligations, and grants to the Secured Party a first priority continuing security interest in, lien on and right of Set-off against all Posted Collateral Transferred to or received by the Secured Party hereunder. Upon the Transfer by the Secured Party to the Pledgor of Posted Collateral, the security interest and lien granted hereunder on that Posted Collateral will be released immediately and, to the extent possible, without any further action by either party.

Eligible Collateral that is posted with a Secured Party is referred to as 'Posted Collateral'. The security interest provisions only apply to Posted Collateral and not to Posted Credit Support. A security interest may apply to financial assets such as cash, bonds, equities, or treasuries, but not to other forms of credit support such as Letters of Credit.

29.2

Threshold Amount and Minimum Transfer Amount

The Threshold Amount reflects a credit risk that the Secured Party is willing to allocate to the Pledgor before requiring any collateral to cover such credit risk. A counterparty with strong credit ratings may be able to negotiate a Threshold Amount but it is rarer nowadays in a post-Lehman world to negotiate this. If for example Counterparty A negotiates a Threshold Amount of $5 million with Counterparty B, then Counterparty B is only required to post collateral when the negative mark-to-market of the swap rises above $5 million. The higher Counterparty B's Threshold Amount is, the less likely it is that Counterparty A will ever receive collateral for the "in the money" value of its transactions. Where a counterparty negotiates a very high Threshold Amount the CSA has effectively been modified into a one-way collateral arrangement. A firm can adopt a ratings based approach. A laddered approach can also be used to set appropriate collateral posting thresholds. Collateral payment may only be triggered when the MTM amount goes beyond a pre-determined level. AAA Rated

AA Rated

A Rated

Lower Rated

$50 mm

$25 mm

$10 mm

29.3

Credit Support Amount "Credit Support Amount" means, unless otherwise specified in Paragraph 13, for any Valuation Date (i) the Secured Party's Exposure for that Valuation Date plus (ii) the aggregate of all Independent Amounts applicable to the Pledgor, if any, minus (iii) all Independent Amounts applicable to the Secured party, if any, minus (iv) the Pledgor's Threshold; provided, however, that the Credit Support Amount will be deemed to be zero whenever the calculation of Credit Support Amount yields a number less than zero.

29.4

Independent Amount

In Paragraph 12 (Definitions) of the New York CSA, Independent Amount is defined to mean "with respect to a party, the amount specified as such for that party in Paragraph 13; if no amount is specified, zero." The Independent Amount is an additional Credit Support Amount that is required over and above the market value of the trade portfolio. It is used to directly address changes in the market value of the ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 trades between collateral calls. It can be either a fixed amount, a percentage of the nominal size of the portfolio, or a computation of value-at-risk (VAR). It can be defined at the level of the portfolio of transactions between two parties or can be uniquely defined for each individual transaction. For example, a counterparty may include a default Independent Amount of 10% of the notional amount of a Transaction, for any Transaction where the parties did not negotiate a specific Independent Amount. Parties should be wary when negotiating the availability of Independent Amounts, especially if they refer to the notional principle which may be high for interest rate swaps. The posting of an Independent Amount may often be linked to some kind of downgrade trigger, i.e. ratings downgrade, NAV downgrade.

29.5

Segregation of Independent Amounts

There are essentially three different ways of holding Independent Amounts: (1)

direct holding of Independent Amount;

(2)

third party custody holding of Independent Amount; and

(3)

tri-party collateral agent holding of Independent Amount.

29.5.1 Direct Holding of Independent Amount In a direct holding of Independent Amount scenario, the Independent Amount is delivered by the End User to the Dealer, and the Dealer holds the Independent Amount or alternatively holds it through an affiliate entity. For example, when Counterparty A (Dealer) directly holds £100 million of collateral from Counterparty B (End User) the net Mark-to-Market (MTM) amount of the portfolio totals £140 million. The Independent Amount that Counterparty B must pay Counterparty A is £20 million, and therefore a collateral call by Counterparty A will be for the amount of £60 million (i.e. £160 million collateral call but £100 million collateral already held. The main risk to Counterparty B is if Counterparty B has rehypothecation rights and there are no formal mechanisms in place to segregate the Independent Amount. In this scenario there is no legal segregation of the collateral and therefore a claim in the event of an insolvency event would likely be a general unsecured creditor claim. Alternatively, if Counterparty B has rehypothecation rights then in the event of an insolvency event Counterparty A may have no direct claim against a third party holding the Independent Amount that has been rehypothecated.

29.5.2 Third Party Custody Holding of Independent Amount In a third party custody Independent Amount scenario, a third party (e.g. unaffiliated bank, brokerdealer, other party) operates under an agreement with one of the two counterparties to provide typical custody and safekeeping services. The third party custodian holds the Independent Amount without rehpothecation rights. In this scenario the costs to Counterparty B may be higher (because of the use of a third party custodian). However, in the event of an insolvency scenario the Independent Amount assets can be traced and identified to the third party custodian, so long as Counterparty B holds the relevant information (e.g. custodian name, address, and account number). In the situation where the third party custodian is afforded rehypothecation rights then traceability of assets will be limited. Any bilateral agreement between Counterparty A and Counterparty B should therefore directly address the rights of each Counterparty in the event of an insolvency event.

29.5.3 Tri-Party Collateral Agent Holding of Independent Amount In a tri-party holding of Independent Amount arrangement, a three-way agreement is put in place between Counterparty A, Counterparty B, and the third party custodian (e.g. custodian bank). In this situation Counterparty B will deliver the Independent Amount to the third party custodian acting as a collateral agent, and the Independent Amount is deposited in a custody account in the name of Counterparty B. Counterparty A is granted a security interest in the Independent Amount. In © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 jurisdictions where security interests must be perfected, Counterparty A would have to fulfil all the conditions of perfection in order to benefit from the legally granted security interest. In this situation, legally both Counterparty A and Counterparty B can enforce their rights over the Independent Amount as there is direct privity of contract with the collateral agent and Counterparty A and B.

COLLATERAL

Collateralization is one of the main ways of managing credit exposure among financial market participants. In essence, swaps counterparties take collateral against credit exposures they may be exposed to when dealing with other swaps counterparties. When taking collateral, firms must seek to ensure that the collateral falls within the parameters of a pre-determined Eligible Collateral Schedule. Table 18: Eligible Collateral Schedule (Adapted from ETF Securities, 2017)

ITEM

DESCRIPTION

Liquidity

Collateral should be highly liquid and traded on a Regulated Market or Multilateral Trading Facility with transparent pricing that facilitates a quick sale at a price close to pre-sale valuation.

Valuation

Collateral should be valued on a regular (or daily basis). Assets with high price volatility require conservative haircuts to be applied.

Issuer Credit Quality

Collateral should be of a high quality.

Correlation

Collateral should be issued by an entity that is independent of the counterparty, and does not display a high correlation with the performance of such counterparty.

Diversification (Asset Concentration)

Collateral should be sufficiently diversified in terms of country, markets, and issuers with a maximum exposure to a given issuer of a percentage of the NAV (e.g. 20%).

Availability

Collateral should be capable of being fully enforced at any time without reference to, or approval from, the counterparty.

30.1

Collateral Exposure

Exposure is defined in a technical way under the New York CSA to mean the netted mid-market M2M value of the transactions in the portfolio between the parties. The overall collateral requirement between the parties is generally dictated by the level of exposure. The reason that the collateral requirement is based around the Exposure is because it represents an approximation of the amount of credit default loss that would occur between the parties if one were to default. Exposure is calculated at mid-market levels in order to be fair on both parties In order to monitor and mitigate credit risk counterparties should monitor their credit exposures on a daily basis, i.e. calculation of exposure at the end of each business day. Exposure is the total of the positive and negative mid-market valuations of the outstanding transactions under the Master Agreement framework. Figure 17: Secured Party is Under-Collateralized

Secured Party

If the Secured Party's exposure exceeds the value of collateral posted by the Pledgor for all transactions, the Secured Party is overexposed giving risk to a collateral call to cover the additional credit risk.

The Pledgor

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Figure 18: Secured Party is Over-Collateralized

Secured Party

30.2

If the Secured Party's exposure is less than the value of the collateral it is holding for all transactions, the Pledgor may call for a return of collateral owing to the reduced credit risk.

The Pledgor

Eligible Collateral

The types of collateral that may be permitted under the CSA varies considerably and may include for example cash and government bonds. Eligible Collateral may often refer to an individually tailored list of items, to specific items listed in the Collateral Asset Definitions, or to different specified tables of items with attending Valuation Percentages. Figure 19: Example Eligible Collateral Definition (Collateral Asset Definitions) (b)

Credit Support Obligations (i)

"Delivery Amount", "Return Amount" and "Credit Support Amount" will have the meanings specified in Paragraphs 3(a), 3(b), and 3, respectively.

(ii)

Eligible Collateral shall consist of those assets identified by the ICAD codes listed below, as they are defined in the Collateral Asset Definitions. Percentage shown in the Valuation Percentage applicable to the indicated combination of ICAD and Remaining Maturity. Remaining Maturity

ICAD Code US-CASH US-TBILL US-TNOTE US-TBOND US-STRIP US-TIPS US-GNMA US-GNMAMBS US-ARM (ii)

One (1) year or under 100% 98.5% 97.5% 96% 95% 95% 96% 96% 96%

More than one (1) year up to and including N/A N/A 97.5% 96% 95% 95% 96% 96% 96%

More than five (5) years up to and including ten (10) years N/A N/A 97.5% 96% 95% 95% 96% 96% 96%

More than then (10) years N/A N/A N/A 96% 95% 95% 96% 96% 96%

There shall be no "Other Eligible Support" for Party A or Party B for the purposes of this Annex.

The ISDA Collateral Definition (ICAD) code is a unique identifying code used in the Collateral Asset Definitions to identify a particular type of collateral asset being defined. For example, the collateral asset 'US Treasury Bills' has been assigned the ICAD code 'US-TBILL'.

30.2.1 LCH Eligible Collateral Policy Clearing Members including FCM Clearing Members may elect to use cash or securities to cover margin requirements at the Clearing House; please note that realised variation margin may only be covered in cash. To facilitate delivery, members may lodge securities either directly or using a tri-party mechanism. Details of haircuts applied to securities collateral can be found at the following link: Acceptable Securities Collateral And Haircuts (as of 19/12/2016) Notes:

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Members should refer to LCH Limited's General Regulations, Default Rules, and Procedures (Section 4 – Collateral) for more information. Alternatively, please telephone LCH Limited Treasury Operations on +44 20 7426 7505 for information relating to the acceptance of collateral.

•

Before any securities are accepted, members must complete a legal form of charge, for further information telephone LCH Limited Membership department on +44 20 7426 7627 / 7063 / 7891.

•

The following currencies are acceptable as cash collateral; Sterling, Euros, and US Dollars. Other ccys may be posted in limited quantities.

•

The above link refers to securities collateral acceptable to LCH Limited as margin cover for business cleared. Certain European regulators have agreed that OTC instruments registered with LCH Limited should be exempt (following Directive 2000/12/EC of 20 March 2000) from credit equivalent amount add-on. Any such exemption applies to LCH Limited members only where initial margin requirements are met with Cash or the Government Securities acceptable by LCH Limited. Members are responsible for ensuring that they comply fully with regulatory requirements in this respect.

•

Charge and Credits

i. Cash - Currently there are three different rates with which Clearing Members accrue interest against cash balances held with LCH, namely: •

Client Deposit Rate (CDR) Applicable to EUR, GBP, USD cash balances held on SwapClear client accounts

•

RepoClear Deposit Rate (RDR) Applicable to EUR, GBP, USD cash balances held on RepoClear accounts

•

London Deposit Rate (LDR) Applicable to all other cash balances (Default Fund excluded)

ii. Securities - LCH Limited charges 10 basis points (annualised) for utilisation of non cash collateral to cover house and client margin in all Clearing Services but charges 0% where non cash collateral is used to cover a Client margin requirement in the SwapClear service. Credits and charges accrue daily and are charged/paid on a monthly basis to the PPS account. • Government Agency securities collateral is subject to a minimum nominal size and sufficient market quotes. Set by clearing member, concentration limits are the lower of 20% of the margin requirement or 500 million - USD for US agencies; EUR for European agencies with separate limits applied to GNMA MBS securities. A 10% limit of the total amount outstanding on any Agency ISIN will also be applied at a clearing member level. Acceptable issues will be maintained using ISIN lists. •

Certain taxation restrictions and requirements may apply to securities including, but not limited to:

i. Before pledging Spanish Governments, members will be required to provide LCH Treasury Operations with details of their tax status, in accordance with Spanish tax law ii. Before pledging Italian Governments, members will be required to complete a Tax Exemption Application Form, which can be obtained from LCH Treasury Operations •

For FCM purposes, cash collateral can only be accepted in USD.

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LCH Limited acceptable securities are also eligible for FCM collateral purposes and will be subject to all other constraints applicable to margin collateral more generally.

•

Please note that LCH has limited capacity for certain currencies outside GBP, USD and EUR. Those currencies that are acceptable but currently have limits include: Canadian Dollars, Swiss Francs, Japanese Yen, Swedish Krona, Danish Krone and Norwegian Kroner. Please contact Elissa Holme elissa.holme@lch.com (0207 426 7525) or Andrew Warren andrew.warren@lch.com (0207 426 7141) in the event of wishing to place these currencies.

•

LCH requires a minimum of 2 working days notice for any substitution of collateral in excess of 100mn cash value this applies in respect of cash being substituted for noncash, or vice versa and substituting cash for cash in an alternative currency.

•

LCH reserves the right to increase the standard notice period and/or exclude specific days by providing advanced notice to Clearing Members via a member circular.

The above applies to both Clearing Member's Proprietary and Client business.

30.2.2 SwapClear Eligible Collateral Policy SwapClear Global Service Acceptable Cash (SwapClear Members) US dollars; Euros; Sterling; Canadian dollars; Swiss francs; Japanese yen; Swedish krona; Danish Krone; Norwegian kroner. SwapClear Global Service Acceptable Cash (Futures Commission Merchants) US dollars. SwapClear Global Service Acceptable Securities (Acceptable issues maintained using ISIN lists) Sovereign and government-guaranteed debt of Australia, Austria, Beligium, Canada, Denmark, Finland, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Norway, Spain, Sweden, and the UK. KfW (formerly KfW Bankengruppe) bonds are also accepted. US dollar-denominated securities comprising all US Treasury securities (except strips) and debentures issued by Fannie Mae (FNMA), Freddie Mac (FHLMC), and Federal Home Loan Banks (FHLB).

30.3

Valuation Date, Valuation Time, Notification Time

Valuation Date, Valuation Time, and Notification Time are specified in Paragraph 12 (Definitions) and are cross-referred to as being specified in Paragraph 13 (Elections and Variables) of the CSA. The Valuation Date identifies the regularity of the counterparties in calculating or estimating their respective M2M exposure for the purpose of determining any required collateral. Valuation Date is defined to mean each and every Local Business Day commencing on the first such date following the date hereof. Valuation Time is defined to mean a choice between: (1)

the close of business in the city of the Valuation Agent on the Valuation Date or date of calculation, as applicable;

(2)

the close of business on the Local Business Day before the Valuation Date or date of calculation, as applicable;

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Provided that the calculations of Value and Exposure will be made as of approximately the same time on the same date. Notification Time is defined to mean 1:00 pm, New York time, on a Local Business Day.

30.4

Collateral Calls

Collateral calls are determined by the call frequency specified in the NY CSA and whether or not the parties have specified a MTA. The tendency in the market is to have daily collateral calls, however older CSAs may still refer to weekly or even monthly collateral call frequencies. Margining is the term that refers to the process of calling for additional collateral or for excess collateral to be returned

30.5

Transfer Timing Paragraph 4. Conditions Precedent, Transfer Timing, Calculations and Substitutions (b) Transfer Timing. Subject to Paragraphs 4(a) and 5 and unless otherwise specified, if a demand for the Transfer of Eligible Credit Support or Posted Credit Support is made by the Notification Time, then the relevant Transfer will be made not later than the close of business on the next Local Business Day; if a demand is made after the Notification Time then the relevant Transfer will be made not later than the close of business on the second Local Business Day thereafter.

Transfer Timing refers to the period within which any collateral that has been called for must be transferred under the CSA. A failure to transfer within the period provided by the Transfer Timing requirements will give rise to a potential Event of Default, i.e. any event which would constitute an Event of Default with the giving of notice or the lapse of time, or both. Changes in the Transfer Timing requirements may have to reflect operational feasibility within the particular firm in question, as late notification times (e.g. 1.00 pm) may make it difficult for the Pledgor to satisfy rapid transfer times. For parties that are in different geographical locations Transfer Timing requirements may have to reflect existing differences in time zones of the parties.

30.6

Distributions and Interest Amount Paragraph 6. Holding and Using Posted Collateral (d)

Distributions and Interest Amount (i)

Distributions. Subject to Paragraph 4(a), if the Secured Party receives or is deemed to receive Distributions on a Local Business Day, it will Transfer to the Pledgor not later than the following Local Business Day any Distributions it receives or is deemed to receive to the extent that a Delivery Amount would not be created or increased by that Transfer, as calculated by the Valuation Agent (and the date of calculation will be deemed to be a Valuation Date for this purpose).

(i)

Interest Amount. Unless otherwise specified in Paragraph 13 and subject to Paragraph 4(a), in lieu of any interest, dividends or other amounts paid or deemed to have been paid with respect to Posted Collateral in the form of Cash (all of which may be retained by the Secured Party), the Secured Party will Transfer to the Pledgor at the times specified in Paragraph 13 the Interest Amount to the extent that a Delivery Amount would not be created or increased by that Transfer as calculated by the Valuation Agent (and the date of calculation will be deemed to be a Valuation Date for this purpose). The Interest Amount or portion thereof not Transferred pursuant to this Paragraph will constitute Posted Collateral in the form of Cash and will be subject to the security interest granted under Paragraph 2.

Paragraph 12. Definitions

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2017 "Interest Amount" means, with respect to an Interest Period, the aggregate sum of the amounts of interest calculated for each day in that Interest Period on the principal amount of Posted Collateral in the form of Cash held by the Secured Party on that day, determined by the Secured Party for each such day as follows

This paragraph specifies that any cash posted as collateral will earn interest during the period in which the Pledgor has posted the collateral and is unable to use it.

30.7

Failure to Deliver Margin and Cure Periods

Failure to deliver margin under a CSA will constitute an Event of Default under the Failure to Pay or Deliver Event of Default in the ISDA Master Agreement.

30.8

Collateral Management Dispute

Counterparties should address the risk of discrepancies arising in their respective valuations of collateral or calculation of exposure amount. Trade reconciliation may be undertaken prior to commencement of collateralisation. Disputes may arise because of variations in the data used for valuation, e.g. yield curves used at different times and from different sources.

CREDIT POLICIES AND STRATEGIES

A firm's credit policies and strategies should be identified and defined in advance so the firm can have operational clarity when dealing with swaps counterparties on a regular basis. In addition to clearly identifying credit policies and credit risk mitigation strategies in advance, all individuals involved within the swap dealing function should ensure that they have a good understanding of the credit terminology that is applicable under the Master Agreement framework, i.e. an understanding of Eligible Collateral; Eligible Credit Support; Eligible Currency; Threshold; Interest Rate; Ratings-Based Initiation Margin. Different approaches to booking and modelling of CSA terms may lead to inconsistent and nontransparent valuations when assigning or re-couponing trades. For corporations the shareholders' equity or members' capital may be used to determine financial health indicators (FHIs), or the Net Asset Value (NAV) for an investment firm. The FHIs or NAV should be monitored on a monthly basis and risk mitigation policies put in place in order to identify an unacceptable rate of decline of FHIs or NAV. These declines in value should be addressed in advance under the Master Agreement framework via specification of 'Additional Termination Events' that can be triggered by a decline in NAV during a specified period or a decline in specified Credit Ratings, or a decline in FHIs.

31.1

OTC Derivatives Policy

Prior to putting a CSA in place, a firm should expressly set out an OTC derivatives policy that includes a CSA policy. The OTC derivatives policy should cover at a minimum: (1)

the types of OTC derivatives that the firm may deal with;

(2)

the counterparty types that the firm may deal with;

(3)

the counterparty credit ratings that the firm's counterparties must at a minimum have;

(4)

procedures to assess the creditworthiness of a counterparty;

(5)

the legal agreements that will be used to document the OTC derivatives trades;

(6)

the financial information that will be required to be provided to a firm prior to putting in place an ISDA Master Agreement trading framework;

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the deliverables that will be required of corporations, partnerships, investment firms, hedge funds, and the timeframes required for the delivery of the deliverables (e.g. annual and quarterly financial statements, or annual and monthly financial statements);

(8)

whether a counterparty is obliged to provide advanced notice of a default in order to allow the firm to reduce its exposure via limiting new trades and/or novation of existing trades prior to default;

31.2

CSA Policy

The CSA policy should cover at a minimum: (1)

the objectives of putting in place a CSA;

(2)

whether the CSA will be administered in-house or outsourced, and the reasons why this is so;

(3)

what the collateral management process will consist of (e.g. collateral calls and returns, collection of valuation data, valuation percentage, acceptable collateral, Independent Amounts, Thresholds, Minimum Transfer Amounts, Rounding Amounts, Currencies);

(4)

definitions of Low Maintenance CSAs and High Maintenance CSAs (i.e. in terms of threshold levels and likelihood of frequent collateral exchanges); and

(5)

a scheduled regular internal review of the existing CSA framework;

(6)

appropriate escalation processes for disputes and defaults.

The use of asymmetrical CSAs is uncommon but can be used in some instances (e.g. special covered transactions, trading with weaker banks, if Credit Default Swap (CDS) spreads differ significantly between the company (counterparty) and the bank (counterparty). The aims of implementing a cohesive CSA policy include: (1)

protecting the firm in the event that a counterparty's credit rating is downgraded;

(2)

minimising the levels of collateral that must be posted by a firm;

(3)

streamlining CSA administration processes;

(4)

Able to effectuate better pricing structures through mitigated credit risk or non-performance risk.

31.3

Credit Risk Policy, Collateral Management, and Credit Enhancement Techniques

By identifying the range of credit exposure risks that a firm is exposed to, this can allow the internal compliance function to develop and finalise credit risk policies, collateral management policies, and to put in place credit enhancement techniques. Collateral management policies can help firms to reduce potential credit losses, capital usage, and dealing spreads. Credit risk policies may cover more frequent measurements of portfolio value, lower limits for uncollateralised counterparty exposures, and more frequent exchanges of collateral. Firms may wish to consider harmonization of key terms across all agreements (e.g. same threshold schedule, frequency of posting, minimum transfer amount, calculation agent) in order to reduce the overall complexity of credit risk policies. Electing to make a counterparty default public can have a significant impact on the value of a position and this possibility was most acutely seen in the Lehman Brothers bankruptcy in 2008. Credit risk policies should seek to cover such eventuality. Credit enhancement techniques include: ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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(1)

putting in place ISDA CSA frameworks;

(2)

negotiating key credit provisions (CSD, Cross-Default, Credit Event Upon Merger, Set-off);

(3)

negotiating relevant Downgrade Events (e.g. where the credit rating of a party or its CSP falls below a stated credit rating threshold);

(4)

ensuring that the ISDA Master Agreement netting provisions are enforceable;

(6)

where no ISDA CSA is in place, requiring "Adequate Assurance of Performance" (i.e. cash, letters of credit) which can be added in the Schedule as a Miscellaneous provision with an amount to be requested as reasonably determined by the Secured Party);

(6)

establishing collateral management risk guidelines;

(7)

establishing haircuts in line with the firm's risk appetite profile;

(8)

requiring guarantees (e.g. third party or parent guarantee);

(9)

requiring letters of credit (e.g. a financial institution agrees to pay up to the value of the letter of credit);

(10)

requiring a first lien;

(11)

verifying and making use of Collateral Opinions issued by ISDA provide legal opinions that collateral that is posted under a particular CSA cannot be set aside in the event of insolvency within a particular jurisdiction;

(12)

consider putting in place bilateral break clauses can be negotiated into swap agreements which allow either party to break the swap on agreed future dates, with the MTM value exchanged at that point in time.

31.4

Valuation Percentages or 'Haircuts'

Valuation percentages or 'haircuts' are a risk-mitigating tool that can b e used in collateralizing exposure. A haircut is expressed as a percentage deduction from the market value of collateral (e.g. 2%). Assets that contain material credit and/or liquidity risks can be used for the purposes of providing collateral but are generally not accepted for their full market value. Generally speaking the rationale behind haircuts is to apply a reduction to the value of an asset in order to provide a kind of safety buffer against any loss in value and the time it takes to sell the collateral. Factors that may influence the haircut include how risky that type of asset is, how volatile is its price, and how liquid the asset is. Cash is valued at 100% and any other financial instruments such as securities are valued as a percentage of the fair market value to protect the Secure Party against a subsequent decline in the value of the asset. The riskier the asset the higher the haircut will be. The haircut represents a potential loss of value of the asset: (1)

due to price volatility between regular margining dates (e.g. default between a calculation of a margin call and payment or transfer of margin in response to the margin call, the effect of exchange rate fluctuations if cash and collateral are denominated in different currencies);

(2)

probable cost of liquidating collateral following an event of default;

(3)

inconsistencies between the valuation methodologies used in margining and for a default.

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31.5

Bankruptcy-Remote Entities

A bankruptcy remote entity is a special-purpose vehicle (called SPV) which is composed of different assets, with the purpose of protecting these assets from being administered as property of a bankruptcy estate. Even though the objective is to separate the credit that allowed the original financing from the credit and bankruptcy risks of the companies that has taken part in it; the bankruptcy risk remains and it cannot be avoided every time. There are conditions to be considered as 'bankruptcy remote entity': borrower and affiliated must be legally, economically and physically separated, it cannot take out any debt or obligations and has to have both asset and purpose, which would be respectively the property securing a loan/debt and the management of this property. In order to reduce the existing risk for SVP to go bankrupt, some limitations can be set up (on the authorisation of bankruptcy filing given by directors for instance). Bankruptcy courts, however, allowed these entities to file for bankruptcy over their lender's objections. They also have the extreme power to provoke the bankruptcy of SVP with the bankruptcy estates of affiliated entities, using a substantive consolidation, with the aim to more equally distribute the property to creditors. When the bankruptcy remote entity is under its control, the Court can decide the sale of the lender's collateral and obtain an important value for its assets.

LIQUIDITY MANAGEMENT

32.1

Liquidity Risk

Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. Effective liquidity management helps to ensure that a bank's ability to meet cash flow obligations, which are uncertain as they are affected by external events and other agents' behaviour. Areas which are covered by liquidity management frameworks include: (1)

the importance of establishing a liquidity risk tolerance;

(2)

the maintenance of an adequate level of liquidity, including through a cushion of liquid assets;

(3)

the necessity of allocating liquidity costs, benefits and risks to all significant business activities;

(4)

the identification and measurement of the full range of liquidity risks (including contingent liquidity risks;

(5)

the design and use of severe test scenarios;

(6)

the need for a robust and operational contingency funding plan;

(7)

the management of intraday liquidity risk and collateral;

(8)

public disclosure in promoting market discipline.

32.2

Contingent Liquidity Risk

Contingent liquidity risk is the risk associated with funding additional funds or replacing maturing liabilities under potential, future stressed market conditions.

32.3

BIS Principles for the management and supervision of liquidity risk

FUNDAMENTAL PRINCIPLE FOR THE MANAGEMENT AND SUPERVISION OF LIQUIDITY RISK Principle 1:

A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains

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2017 sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources. Supervisors should assess the adequacy of both a bank's liquidity risk management framework and its liquidity position and should take prompt action if a bank is deficient in either area in order to protect depositors and to limit potential damage to the financial system. Governance of liquidity risk management Principle 2:

A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system.

Principle 3:

Senior management should develop a strategy, policies and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity. Senior management should continuously review information on the bank’s liquidity developments and report to the board of directors on a regular basis. A bank’s board of directors should review and approve the strategy, policies and practices related to the management of liquidity at least annually and ensure that senior management manages liquidity risk effectively.

Principle 4:

A bank should incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole.

MEASUREMENT AND MANAGEMENT OF LIQUIDITY RISK Principle 5:

A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk. This process should include a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons.

Principle 6:

A bank should actively monitor and control liquidity risk exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to the transferability of liquidity.

Principle 7:

A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding. It should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providers to promote effective diversification of funding sources. A bank should regularly gauge its capacity to raise funds quickly from each source. It should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates of fund raising capacity remain valid.

Principle 8:

A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.

Principle 9:

A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets. A bank should monitor the legal entity and physical location where collateral is held and how it may be mobilised in a timely manner.

Principle 10:

A bank should conduct stress tests on a regular basis for a variety of short-term and protracted institution-specific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a bank’s established liquidity risk tolerance. A

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2017 bank should use stress test outcomes to adjust its liquidity risk management strategies, policies, and positions and to develop effective contingency plans. Principle 11:

A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust.

Principle 12:

A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources. There should be no legal, regulatory or operational impediment to using these assets to obtain funding.

PUBLIC DISCLOSURE Principle 13:

A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgement about the soundness of its liquidity risk management framework and liquidity position.

THE ROLE OF SUPERVISORS Principle 14:

Supervisors should regularly perform a comprehensive assessment of a bank’s overall liquidity risk management framework and liquidity position to determine whether they deliver an adequate level of resilience to liquidity stress given the bank’s role in the financial system.

Principle 15:

Supervisors should supplement their regular assessments of a bank’s liquidity risk management framework and liquidity position by monitoring a combination of internal reports, prudential reports and market information.

Principle 16:

Supervisors should intervene to require effective and timely remedial action by a bank to address deficiencies in its liquidity risk management processes or liquidity position.

Principle 17:

Supervisors should communicate with other supervisors and public authorities, such as central banks, both within and across national borders, to facilitate effective cooperation regarding the supervision and oversight of liquidity risk management. Communication should occur regularly during normal times, with the nature and frequency of the information sharing increasing as appropriate during times of stress.

32.4

Custodial Services Offerings

Collateral segregation services can include: •

Independent safekeeping of assets;

•

Independent collateral safekeeping;

•

Independent collateral pricing and valuation;

•

Reporting and valuation services (in formats and frequencies required);

•

Securities lending services;

•

Sourcing and monitoring local sub-custodians;

•

Settlement;

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2017 •

Collecting income and processing corporate actions;

•

Providing tax services;

•

Administering proxy voting;

•

Automated eligibility processing and ruleset requirements;

•

Efficient collateral substitution;

•

Real-time reporting;

•

Collateral transformation programmes;

•

Operational risk reduction through the use of scaled automated solutions;

•

The ability to reuse collateral.

Complex OTC derivatives often require costly valuation models and significant technology investment. Custodians can therefore provide clients with the benefits of economies of scale because of the multiple clients they service.

COLLATERAL AND MARGIN TECHNOLOGY FIRMS

There are a number of collateral and margin technology firms on the market today that provide additional margin and collateral management services. An overview of a few of these firm offerings is presented here.

33.1

Bloomberg MARS Collateral Management

Bloomberg MARS Collateral Management is a solution helping banks, investment firms and corporations facilitate the collateral management and reconciliation process to adhere to these new requirements. Services provided: •

Value complex derivatives.

•

Manage collateral agreements.

•

Calculate margin requirements.

•

Send margin calls to counterparties.

•

Reconcile trades and book collateral to their portfolio.

•

Allow customers to centralize their collateral management workflow and automate how they manage and monitor risk exposure and collateral positions.

•

Cross-product.

•

Cross-asset support for Dodd-Frank and EMIR compliance.

•

Effective capture of legal documentation.

•

Automated messaging.

•

Risk analytics and portfolio reconciliations.

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2017 In addition, Bloomberg licensed ISDA's Standard Initial Margin Model for calculating initial margin to help trading desks and collateral managers calculate the amount of collateral that need to be posted. It also provides a data license product and look-up feature on the Bloomberg Terminal that helps investors identify collateral eligible to post in different jurisdiction. Bloomberg also provides aggregation and eligibility checking services for bilateral and triparty repo agreements.

33.2

CAARS Collateral Management

CAARS Collateral Management System is a comprehensive solution that automates the time consuming task of collateral management. With CAARS, senior officers and operations analysts know the exact positions of their collateral assets in real time, allowing them to better manage capital and mitigate risk. Services provided •

Automated internal and broker collateral holding reconciliation.

•

Real-time collateral inventory tracking.

•

Instant margin communication with backup documentation.

•

Consolidated collateral agreement management.

•

Exposure & margin management.

•

Automated reporting and auditing.

•

Interactive graphical dashboards.

•

What-if analysis and reconciliation.

•

First class support.

•

Support for non-cash/securities collateral.

Benefits (according to IntegriDATA website) •

Mitigate risk: Efficiently allocate capital and actively manage returns. Monitor counterparty exposure and reduce risk.

•

Increase transparency: Centralized view of all collateral and eligible positions reconciled between internal and broker records. Clear, accurate, and flexible collateral reporting.

•

Strengthen internal controls: Quickly identify over-pledge positions and minimize the risk of failed trades.

•

Eliminate manual data entry and lessen the chance for human error.

•

Improve flexibility:

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2017 Increase velocity and scalability of collateral movements. Reliably use securities as collateral taking account fluctuations and haircuts. •

Enhance Efficiency: Improve analyst productivity, reduce collateral management rime by up to 87%. Save time and reduce operating costs.

33.3

NEX TriOptima (Tri Resolve and Tri Reduce)

33.3.1 TriResolve TriResolve is a provider of post trade reconciliation, counterparty exposure management and margin management services for OTC derivatives trades. Benefits (according to NEX website) •

Facilitates regulatory compliance: Market participants across the globe must comply to trade reporting, portfolio reconciliation, dispute resolution and uncleared margin rules for their OTC derivative portfolios.

•

Reduces credit risk: Reducing counterparty credit risk. Proactive reconciliation an accurate view and validation of your counterparty exposure so you can mitigate credit risk more effectively. With automated margin call processing through TriResolve margin, market participants can employ an exception based collateral management process. By focusing on the resolving of disputes participants can drive accurate collaterisation.

•

Offer robust communications and strong analytics: The triResolve web-based platform enables immediate communication with counterparties or internal stakeholders; and provides strong analytics capability to deliver information reporting for regulatory or internal purposes. Identify disputes, track trends and efficiency gains over time, and benchmark operational performance quickly and easily.

•

Easy to implement and maintain: Implementation is quick, easy, low cost, and easily scalable across the organization. The fully web-based service keeps maintenance costs to a minimum while ensuring maximum flexibility in service enhancements and extensions.

TriResolve Portfolio reconciliation •

Easy onboarding: The central web-based service means on-boarding is flexible and easy. Trade data can be sent in any format securely to triResolve meaning data transfer with your counterparties is efficient and secure.

•

Algorithmic matching: triResolve uses algorithms to match trades so reconciliation results are available quickly and match rates are high.

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2017 •

Work together with your counterparties: triResolve makes the reconciliation results available to you and your counterparty so that you are both working on the same trade matching and difference information.

•

Flexible GUI and reporting: An intuitive, flexible GUI means you can choose how to view and report on reconciliation results. Extensive report building and pivot tables enables you to look at results by asset class, product class, underlier, currency and much more.

33.3.2 TriReduce Benefits (according to NEX website) •

Optimizing leverage ratio: Emerging capital rules for derivatives and anticipation of Basel III implementation has focused attention on reducing gross notional exposures. Lower gross notional exposure contributes to bringing an institution's leverage ratio in line with regulatory expectations, an important foal for financial institutions. The new clearing thresholds in EMIR have also attracted the attention of non-banks in the commodity space who wish to proactively managing their gross notional exposures through triReduce.

•

Manage counterparty credit risk: Managing counterparty credit exposure changes through triReduce opens up credit line capacity for new business. Multilateral termination removes transactions and reduces collateral requirements by keeping portfolios trimmed down. Participating in triReduce cycles reduces both the regulatory and economic capital costs associated with OTC derivatives, especially for capital intensive emerging market transactions.

•

Reduce line items, operational risk and costs: Trades that are eliminated, reducing line items in a portfolio, no longer require periodic payments to be calculated and settled, reducing operational costs significantly. In addition, potential errors and the costs associated with resolving errors, including operational risk capital charges, are eliminated.

TriReduce Rates •

Reduces costs and capital in a competitive market.

•

Product scope for cleared and uncleared swaps: Interest rate swaps Overnight index swaps (OIS) Forward rate agreements (FRA) Amortizing interest rate swaps Compounding interest rate swaps

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2017 Cross currency swaps Inflation swaps Basis swaps

TriReduce CCS •

Compression for cross currency swaps to help the industry manage its credit and capital costs as well as minimize settlement risk for this asset class.

Benefits •

Improved leverage ratio

•

Reduction in counterparty settlement risk

•

Regulatory capital & RWA reduction

•

Reduction in country risk

•

Ability to increase trading with parties under currency controls

•

Simplified portfolio to manage in the event of counterparty default

TriReduce Credit •

Meeting industry commitments: In order to aid the industry in achieving standardization and clearing targets, TriOptima offers many forms of standardization and compression cycles across single names and index tranche trades while continuing to schedule compression cycles in all major CDS indices.

•

Interoperability: TriOptima understands the importance of facilitating data exchange and automating workflow. All our triReduce Credit services interoperate with DTCC's Trade Information Warehouse to save our clients time and effort and ensure data record accuracy.

•

Credit event management: TriOptima has always assisted the industry in meeting the challenges of credit events from the first special default cycles for the automotive industry through the bankruptcies of the financial crisis. Since then, the industry has regularly turned to TriOptima to assist with reducing their exposures to credit event processing.

•

TriReduce FX: Enhance financial stability by providing risk mitigation services for the global FX market.

Benefits •

Improves the CRD4 element of the Leverage Ratio calculation under Basel III, which requires PFE add-ons for FX forward products. (1% for trades < 1 year, 5% for trades 1-5 years, and 7.5% for trades > than 5 years, per page 15 of the Basel III leverage ratio framework and disclosure requirement).

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2017 •

Assists firms that meet the ESMA volume thresholds to comply with the business conduct compression requirements. triReduce FX offers a platform for multiple institutions to compress regularly, thus efficiently fulfilling the ESMA requirements for many counterparties at the same time.

•

Enables firms to manage their gross notional exposures and redistribute counterparty exposure in order to achieve regulatory and economic capital benefits and reduce direct costs to the business.

TriReduce extends the operational efficiency of clearing OTC derivatives and also reduces the potential for systemic risk by compressing trades cleared through a Central Counterparty (CCP). Regulations indicate that portfolio compression for swaps in LCH SwapClear, SGX, JSCC, CME, Eurex, and Nasdaq and is actively engaged with other CCPs globally to make compression available to the industry wherever possible.

33.4

NEX ENSO

Enso provides hedge fund managers with everything they need to optimize all of their counterparty relationships and produce informational alpha that uncovers collaborative opportunities. Enso helps to: •

Monitor, understand and optimize counterparty relationships.

•

Analyze margin, commission, clearing and financing costs.

•

Benefit from comprehensive broker and wallet share analyses.

•

Take advantage of a fully-hosted software as a service (SaaS) platform.

33.4.1 ENSO Core Features •

Dashboard views.

•

Counterparty exposure and risk metrics.

•

Peer benchmarking.

•

Securities lending and repo financing analytics.

•

Broker gross and net wallet share.

•

Cash and collateral management.

•

Margin summary and detail.

•

Bank color.

•

All modules are filterable, sortable and exportable for easy daily management.

A fully hosted web-based solution which provides managers access to security lending and repo financing analytics, counterparty exposure and risk metrics, wallet share, cash and collateral management, margin analysis, peer benchmarking, as well as bank commentary.

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2017

•

Scalable treasury and portfolio finance tools to grow your business.

•

Evaluate and manage counterparty relationships.

•

Independently validate counterparty strengths with ENSO Broker Scorecards.

•

Support the investor due diligence process.

33.4.3 ENSO Control Features •

Fully hosted solution for all levels of reconciliation.

•

Exceptions-driven results.

•

Full audit trail and case tracking.

•

Supports regulatory reporting and compliance needs.

•

Reconcile virtually anything.

33.4.4 ENSO Locate Features •

Comparative real-time borrow availability.

•

Located ID numbers and timestamps.

•

Supports multiple funds, strategies, and regions.

•

Maintain manual and automated lists.

•

API for integration with external systems.

•

Unlimited individual user setup.

33.4.5 ENSO Color Features •

Color indicators linked to securities within ENSO Core.

•

Request commentary directly from brokers.

•

Custom filters and preferences.

•

14 prime brokers.

•

+ 100 authors.

•

+ 4,000 unique color posts.

•

+ 1,000 individual securities.

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33.4.6 ENSO Broker Vote Features •

Track all your meetings.

•

Fully integrated Wallet Share and Broker Vote tool.

•

Aids fund investors and portfolio managers.

•

Computes, manages, tracks and stores Execution Wallet and Financing Wallet.

•

Create customized voting parameters.

•

Facilitates the vote and produces the result.

•

Historical analysis of the vote, reporting and analytics.

•

Dealer return on assets reporting.

33.4.7 Reporting and Extracts Features •

Regulatory reporting extracts.

•

Investor due diligence reporting.

•

Custom extracts.

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CHAPTER 5: THE ISDA MASTER AGREEMENT 2012: A MISSED OPPORTUNITY? ®

OUTLINE ■ ■ ■ ■ ■ ■ ■

Introduction. An Overview of the ISDA Master Agreement 1992. An Overview of the ISDA Master Agreement 2002 Updates. Legal Developments affecting the ISDA Master Agreement Framework. Laying the Groundwork for the ISDA Master Agreement 2012. The ISDA Master Agreement 2012. Conclusion.

CHAPTER 5 ABBREVIATIONS

Table 19: Chapter 5 Abbreviations ABBREVIATION

TERM

CADRP

Calculation Agent Dispute Resolution Procedure.

CCP

Central Counterparty.

CDRP

Collateral Dispute Resolution Procedure.

CME

Chicago Mercantile Exchange.

CoA

Court of Appeal.

CSAs

Credit Support Annexes.

CSD

Credit Support Document.

CSP

Credit Support Provider.

EMIR

The European Market Infrastructure Regulation.

European Union.

FCs

Financial Counterparties.

FFAs

Forward Freight Agreements.

ISDA

International Swaps and Derivatives Association.

LIFFE

London International Financial Futures and Options Exchange.

Net Asset Value

Net Asset Value.

NFCs

Non-Financial Counterparties.

OTC

Over-the-counter.

United States.

INTRODUCTION

In essence, derivatives are financial instruments that derive their financial value either directly or 1 Although many indirectly from an underlying asset, such as a share price or equity index. standardised derivatives such as futures and options are traded on centralised exchanges (e.g. the London International Financial Futures and Options Exchange (LIFFE) or the Chicago Mercantile Exchange (CME)), historically the majority of derivatives transactions have taken place between © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 market participants on a bilateral basis, leading to the development of what has been referred to as a virtual "over-the-counter" (OTC) derivatives market, i.e. specific tailoring of derivatives contractual terms to suit the parties' subjective requirements. This OTC derivatives market burgeoned throughout the 1980s, featuring core OTC derivatives 2 3 4 products such as "caps" , "floors" , "collars" , and "swaps". In respect of the latter, the majority of progenitor OTC derivatives involved different versions of an OTC swap, which essentially consists of parties to the contract agreeing to exchange periodic payments which are calculated by multiplication 5 of an agreed "notional" amount of the transaction by a pre-agreed rate, price or index. For example, in a "plain vanilla" (the most basic) interest rate swap, "parties agree to swap payment obligations based upon a specified "notional amount". The notional amount is never exchanged between the 6 Nevertheless, in reality considerable parties, but is used to calculate the payment amounts." difficulties arose owing to the complicated, prolonged, and expensive nature of the bilateral negotiations that took place between counterparties to each derivatives transaction. 7

In light of this Harding notes that the International Swaps and Derivatives Association, Inc. (ISDA) was formed in New York in 1985 in order to standardise OTC derivatives market practice and 8 documentation. Harding further observes that ISDA published two "Swap Codes" in 1986 and 1987 (to cover United States (US) $ interest rate swaps), and also an Interest Rate Swap Agreement in 9 1987 (to cover US$ swaps) (the 1987 Swap Agreement). Subsequently in January 1993 ISDA also published a 17 page standard form document entitled the "ISDA Master Agreement 1992" (the 1992 Agreement), in order to inter alia expand upon the product range of the 1987 Swap Agreement; 10 promote "netting" across swap products; take account of legislative changes since 1987 (e.g. bankruptcy laws); and take account of drafting amendments sought by ISDA members due to market 11 practice changes. The 1992 Agreement was a boilerplate bilateral framework agreement which provided a standardised format for a "master" agreement to govern all future OTC derivatives transactions between two counterparties. The standardised provisions included different sections relating to choice of law (New York or English law); close out and payment netting; covenants (obligations and representations); early termination; events of default; and termination events. The parties were then free to negotiate individual economic terms governing the transaction in the amendable Schedule to the 1992 Agreement, as well as choosing from either the Local Currency-Single Jurisdiction (single currency 12 and jurisdiction), or the Multicurrency-Cross Border (multiple currency and jurisdictions) versions. Ten years later ISDA announced the publication of the "ISDA Master Agreement 2002" (the 2002 Agreement) on January 8, 2003. The 2002 Agreement was intended to update the somewhat dated 1992 Agreement in line with amendments reflecting documentation issues that were highlighted in market failure events such as the currency debt default crises in Asia (1997) and Russia (1998), as well as the failure of the Long Term Capital Management hedge fund, and the Hong Kong broker13 Since that time, the ISDA Master Agreement has dealer Peregrine Investments Holdings Limited. become the de facto standard agreement governing OTC derivatives transactions globally. Consequently, in principle ISDA has achieved its objective of market standardisation of OTC derivatives documentation. Nevertheless, a number of subsequent legal developments have affected the clarity and interpretation of the ISDA Master Agreement framework, including several English legal cases, as well as the recent enactment of the European Market Infrastructure Regulation 14 (EMIR) in the European Union (EU), and the Doddâ&#x20AC;&#x201C;Frank Wall Street Reform and Consumer 15 Protection Act 2010 (Dodd-Frank Act) in the US. It will therefore be argued here that there is a plethora of complexities facing OTC derivatives market participants today, and that the existing standardisation of OTC derivatives documentation in itself (via the 1992 and 2002 Agreements), is nowadays insufficient for the purposes of suitably guiding market participants. Instead, in light of complexities exposed by a number of legal cases, together with increasing across-the-board operating and regulatory costs, it is argued here that as a global trade association for OTC derivatives, ISDA has an obligation to regularly and consistently update the ISDA Master Agreement framework. This should be undertaken, at an absolute minimum, every decade (i.e. 1992, 2002, 2012, etc.) if not sooner, meaning that the theoretical "ISDA Master Agreement 2012" (the 2012 Agreement), represents a significant missed opportunity for ISDA to provide a much needed and justified overhaul of the ISDA Master Agreement architecture. The chapter will therefore ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 seek to first provide the reader with an overview of the most relevant operating provisions and negotiating issues pertinent to the 1992 Agreement, together with the 2002 Agreement updates. Thereafter, it will discuss a select range of legal developments affecting the ISDA Master Agreement framework, and will also lay the groundwork arguments in favour of the proposed ISDA Master Agreement 2012. Finally, the chapter will aim to support the need for the 2012 Agreement, with a critical discussion of a range of obstacles currently facing the ISDA Master Agreement, and solutions and provisions which the 2012 Agreement might provide.

AN OVERVIEW OF THE ISDA MASTER AGREEMENT 1992

In a nascent OTC derivatives market that was characterised by across-the-board subjective customisation, the Master Agreement framework provided by the 1992 Agreement injected a much needed standardisation of relevant operational terms. It did this by ensuring that the core Master Agreement document contained standardised terms governing all future OTC derivatives transactions between two counterparties. It also allowed the parties to individually tailor the 1992 Agreement via elections or amendments contained in the Schedule to suit their requirements. In practice, once the 1992 Agreement was executed, then individual financial and economic terms governing each subsequent specific derivatives transaction were contained in either short form, or long form, 16 More importantly, all parts of the 1992 Agreement formed one confirmations (Confirmations). agreement for legal purposes, with section 1(c) stating: "Single Agreement. All Transactions are entered into in reliance on the fact that this Master Agreement and all Confirmations form a single agreement between the parties (collectively referred to as this "Agreement"), and the parties would not otherwise enter 17 into any Transactions." The main part of the 1992 Agreement consisted of a pre-printed form which contained fourteen sections which were traditionally themselves never amended. These included: (i) Interpretation; (ii) Obligations; (iii) Representations; (iv) Agreements; (v) Events of Default and Termination Events; (vi) Early Termination; (vii) Transfer; (viii) Contractual Currency; (ix) Miscellaneous; (x) Offices; Multibranch Parties; (xi) Expenses; (xii) Notices; (xiii) Governing Law and Jurisdiction; and (xiv) Definitions. Furthermore, the 1992 Schedule contained five Parts, namely: Part 1 (Termination Provisions); Part 2 (Tax Representations); Part 3 (Agreement to Deliver Documents); Part 4 18 (Miscellaneous); and Part 5 (Other Provisions). Overall, the 1992 Agreement significantly reduced documentation costs through widespread market standardisation, as well as reduction of credit, operational and legal risks, whilst at the same time increasing certainty and protection as between the contracting parties. D'Ambrosio notes that in terms of credit or counterparty risk, provisions are customarily added under the ISDA Master Agreement framework in order to mitigate this type of risk, for example by defining termination events, 19 Indeed the 1992 ISDA Master Agreement events of default, guarantees, escrows and collateral. framework allows counterparties to more effectively understand and manage the extent of credit risk, by ensuring that counterparties know which events will terminate the agreement, or trigger Events of 20 Default, and what levels of default are required through the use of a specified "Threshold Amount" in 21 the Schedule. D'Ambrosio further states that operational risk is reduced as the 1992 Agreement contains procedural details relating to the transfer of assets or delivery of collateral, as well as the provision of information 22 (e.g. financial statements, or reports of net asset value (NAV)). Legal risk is also directly addressed at multiple levels. Firstly, at a jurisdictional level the 1992 Agreement allows counterparties to specify 23 This provides either English or New York law as pertaining to the governing law and jurisdiction. increased legal certainty at a macro level deriving from the highly developed Common Law legal systems of England and New York, and in this regard Hudson notes that they have the most mature systems of commercial law, as well as "unparalleled judicial expertise in dealing with international 24 commercial disputes." At a micro level legal risks are reduced as the counterparties better understand how netting will take place, and how payments will be calculated upon termination. This legal certainty is bolstered through the use by ISDA of specially commissioned legal opinions which provide certainty regarding ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 the legal application and enforceability of netting provisions under the 1992 Agreement in a multitude 25 of jurisdictions , together with legal opinions relating to the use and enforceability of collateral arrangements under ISDA sanctioned documentation, such as ISDA Credit Support Annexes (CSAs) 26 or Deeds. In practice it is submitted that, apart from the aforementioned legal opinions, the most significant and important issues relating to the 1992 Agreement, include coverage of: (i) Events of Default; (ii) 27 Termination Events; (iii) "withholding tax" provisions; (iv) collateral provisions; and (v) netting and close out provisions. The main thrust behind the 1992 Agreement, is that the Master Agreement architecture facilitates the efficient and effective closing out of all open OTC derivatives positions upon the occurrence of a negative credit event, and that the contractual netting provisions allow for a netting of amounts owed by either counterparty, thereby facilitating a reduction in overall credit risk. Firstly, the 1992 Agreement provides for eight independent Events of Default, which include: (i) 28 29 30 Failure to Pay or Deliver ; (ii) Breach of Agreement ; (iii) Credit Support Default ; (iv) 31 32 33 34 Misrepresentation ; (v) Default under Specified Transaction ; (vi) Cross Default ; (vii) Bankruptcy ; 35 and (viii) Merger Without Assumption. Consequently, a default will occur where a counterparty fails to make a payment or delivery under the 1992 Agreement or Schedule, and that failure is not 36 remedied by the third "Local Business Day" after notice of such failure is given by a counterparty. Any breach of a term of the 1992 Agreement is also made a breach of a condition of the contract (independent of governing law principles of contract law), triggering an Event of Default after a thirty 37 Two difficulties day "grace period" allowing for the breaching counterparty to remedy the breach. that subsequently arose from this provision in practice, were firstly that the clause did not address clear repudiation of the contract, meaning that a counterparty was required to wait and rely on actual default. Secondly, in light of subsequent market and institutional failures, the thirty day grace period was seen to be too long a period to allow for curing the breach, especially since this could mean underlying derivatives assets might have significantly devalued in the meantime. Harding notes that under the 1992 Agreement a Credit Support Provider (CSP) (identified in the Schedule) is "a third party providing security or a guarantee for a party's liabilities. It can also be one of the parties to the 38 Agreement providing security for itself (e.g. a corporate providing an all moneys debenture)." This is relevant within the current context since any misrepresentation of either the counterparty or the CSP, constitutes an Event of Default. An Event of Default will also occur where a counterparty or any CSP breaches its obligations under 39 any Credit Support Document (CSD) , or the CSD becomes ineffective, is repudiated, disaffirmed or disclaimed, or its validity is challenged. The Bankruptcy provisions are also drafted broadly in order to cover the initiation of bankruptcy and insolvency proceedings relating to a counterparty under either 40 Furthermore, these provisions also cover counterparties, CSPs, or any English or New York law. other "Specified Entity" under the 1992 Agreement. Under the Schedule, Specified Entities can be 41 specifically defined individually in relation to each relevant Event of Default , so that counterparties can stipulate other parties which have such a close financial or operating impact on the counterparty (e.g. parent or subsidiary companies or corporations, or certain Special Purpose Entities), that their inclusion in Events of Default clauses is warranted. The "Merger Without Assumption" provision covers situations where companies or entities may merge, but without them assuming a counterparty's existent obligations under the 1992 Agreement, or a counterparty's or a CSP's existent obligations under a CSD, i.e. a consequential weakening of financial obligations. Under section 14 of the 1992 Agreement, "Specified Indebtedness" is defined to mean, "subject to the Schedule, any obligation (whether present or future, contingent or otherwise, as principal or surety or otherwise) in respect of borrowed money." It is presumed to apply unless a different definition is specified in Part 1(c) of the Schedule. Since it can be amended, and since it refers only to borrowed money, this definition can be either restricted (e.g. to exclude normal bank deposits or only applicable to end-users), or expanded (e.g. to include other financial dealings such as derivatives, repurchase agreements, or securities lending agreements).

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2017 Specified Indebtedness is included within the trifecta of substantive conditions required to be fulfilled prior to the triggering of an Event of Default by Cross Default. Firstly, Cross Default must be elected to apply in the Schedule; secondly it must relate to the defined Specified Indebtedness; and thirdly it must apply in an aggregate amount of at least the sum of the applicable Threshold Amount. In practice, problems with the effective monitoring of cross default events by non-defaulting counterparties, has meant that cross default counterparty notification provisions are sometimes 42 negotiated into the 1992 Schedule. Also, under section 5 relating to Events of Default and Termination Events, section 5(a)(vi) (Cross Default) states inter alia "the applicable Threshold Amount (as specified in the Schedule) which has resulted in such Specified Indebtedness becoming, or become capable at such time of being declared". If the phrase "or becoming capable at such time of being declared" is deleted in the Schedule, then this changes the cross default provision to a cross-acceleration provision, thereby requiring the Specified Indebtedness to have actually been accelerated, and preventing "technical defaults" from triggering an Event of Default. This is sometimes undertaken in order to increase the negotiating power of any counterparty in any 1992 Agreement informal "workout" discussions. An Event of Default will also occur where a Default under Specified Transaction takes place, which in essence includes any default under a very broad range of other derivatives contracts which the 43 The 1992 Agreement also counterparty, its CSP, or other stated Specified Entities are a party to. includes additional "Termination Events", the occurrence of which will trigger a termination of 44 45 obligations under the 1992 Agreement. These include: (i) Illegality ; (ii) Tax Event ; (iii) Tax Event 46 47 48 Upon Merger ; (iv) Credit Event Upon Merger ; and (v) Additional Termination Event. Muscat explains that in outline these events comprise: illegality arising out of changes in law making payments or other obligations unlawful; the imposition (or substantial likelihood of its imposition) of a withholding tax due to a change in law; the imposition of a withholding tax due to the merger of a counterparty, or the transfer of all, or substantially all, of its assets to another entity; the merger of a counterparty or similar corporate restructuring resulting in the weakening credit position of a 49 Muscat counterparty; or any other additional events expressly specified by the counterparties. further explains that Termination Events may occur sans fault of the counterparties; that Termination Events only apply to the transactions affected by the event (not all outstanding obligations); and that both affected counterparties are responsible for calculating close-out payments for Termination 50 Events. Finally, Muscat notes that the 1992 Agreement specifically incorporated withholding tax provisions, meaning that ISDA counterparties make payer tax representations confirming the absence of 51 applicable withholding taxes in their respective jurisdictions. Where a withholding tax becomes due, the payer is required to "gross-up" any payments due under the 1992 Agreement in order to ensure 52 that the payee is paid the full agreed amount, thereby ensuring certainty for both counterparties. Law and Smullen define "collateral" to generally mean a form of security, especially impersonal forms 53 of security such as life-assurance policies or shares, used to secure a bank loan. Within the context of bilateral OTC derivatives transactions, it is noted that the intrinsic value of swap transactions may vary on a daily basis owing to market fluctuations, and thus it has become market practice for 54 counterparties to "mark-to-market" the value of transactions regularly, and to seek to "collateralise" 55 existing OTC derivatives positions. In practice this is effectuated by counterparties making calls on collateral when underlying OTC derivatives transactions exceed agreed financial thresholds, in order to mitigate credit risk exposure; maximise lines of credit from new or existing counterparties; reduce capital maintenance regulatory obligations; and observe operating or prudential requirements from 56 national financial regulators. The modular nature of the 1992 Agreement meant that ISDA drafted CSAs to be used specifically with it for collateralisation purposes, in similar fashion to margining requirements for exchange traded derivatives. Thus, for example, unlike a unilateral pledge agreement, the ISDA 1995 Credit Support Annex (Transfer â&#x20AC;&#x201C; English Law) required bilateral (to and fro) provision of collateral by counterparties. 57 Collateral could take the form of Eligible Currency, Government negotiable debt obligations , or other 58 collateral as agreed between counterparties. However, the CSA did not create a security interest in underlying collateral, but instead required outright transfer of title of collateral, whenever a derivative ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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transaction was "out-of-the-money" , and exceeded a pre-specified mark-to-market exposure 60 threshold. One of the most important provisions under section 2(c) of the 1992 Agreement, is the netting of two or more OTC derivatives transaction payments made on the same day and in the same currency, i.e. "payment" or "settlement" netting. For active OTC derivatives end users, this means that payments are simplified, and counterparty risk is significantly reduced for all OTC derivatives open positions. Section 2(c) states "Netting. If on any date amounts would otherwise be payable;â&#x20AC;&#x201D;(i) in the same currency; and (ii) in respect of the same Transaction". In practice during negotiations, deletion of the phrase "in respect of the same Transaction" in Part 5 of the 1992 Schedule will remove the wording restricting netting to a single transaction, thereby allowing cross-netting to occur under the Master Agreement Framework, if so desired. However, Johnson notes that the primary objection to cross-netting has been that the payment and receipt of individual payments under various transactions (sometimes hundreds of transactions) 61 becomes that much more difficult, if not impossible, to monitor and safeguard effectively. The 1992 Agreement also provides for close-out netting, or the calculation and netting of all outstanding transactions upon "Early Termination" of the 1992 Agreement. If this occurs under the 1992 Agreement, there are four ways of calculating outstanding payments to be made, namely: (i) First Method and Market Quotation; (ii) First Method and Loss; (iii) Second Method and Market Quotation; 62 and (iv) Second Method and Loss. Upon the occurrence of an Event of Default, it is stated that under the First Method if a lump-sum termination payment amount is calculated to be positive, then it is paid to the non-Defaulting party, but 63 On the other hand under the Second if negative, no payment is due by the Defaulting Party. Method if a lump-sum termination payment amount is positive, the Defaulting Party will pay it to the non-Defaulting Party, but if it is negative, then the non-Defaulting Party will pay to the Defaulting Party 64 In short, the First Method effectively allows the non-Defaulting the absolute value of that number. 65 Party to "walk away" (a walk-away clause ) from its obligations, whereas under the Second Method the non-Defaulting Party must make a payment to a Defaulting Party (as the Defaulting Party is 66 entitled to payments upon Early Termination, regardless of whether it was "in-the-money" for its 67 outstanding derivative transactions). Consequently, as regards close-out mechanics utilising Market 68 69 Quotation and Loss , Johnson states that: "Market Quotation is generally considered more objective because the non-Defaulting Party solicits quotations from dealers as to the value of the transactions to be terminated. Loss, on the other hand, permits the non-Defaulting Party itself to determine its 70 damages."

AN OVERVIEW OF THE ISDA MASTER AGREEMENT 2002 UPDATES

Operational market experience acquired since the publication and use of the 1992 Agreement, led ISDA Working Groups to propose a host of new updates and amendments to the ISDA Master Agreement architecture via the 2002 Agreement. The key substantive changes included: (i) a new methodology for calculating positions upon termination of derivatives positions; (ii) inclusion of a new set-off provision; (iii) reduction of grace periods; (iv) an amendment of an Illegality Termination Event and the new inclusion of a Force Majeure Event; (v) expanded Events of Default to cover repudiation; (vi) expanded Specified Transaction to cover new derivatives products; and (vii) expanded Credit Event Upon Merger to include a substantial change in capital structure, and a change in control via acquisition of a beneficial or other ownership interest. Nevertheless, there were also a number of secondary substantive changes as well, including: (i) reductions in grace periods for Bankruptcy Events of Default; (ii) updated and consolidated interest and compensation provisions; (iii) amendment of Absence of Litigation representation; (iv) amendment of jurisdiction clause; and (v) amendment of notice provisions to now include facsimile 71 The 2002 Master Agreement retained the transmission and electronic mail (e-mail) provisions. same document structure, with the main part also still consisting of a pre-printed form containing ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 fourteen sections with the same headings, except for section 6 which was amended to read "Early Termination; Close-Out Netting". The 2002 Schedule also still contained the same five Parts. One of the most important developments under the 2002 Agreement related to the new close-out valuation methodology for Events of Default or Termination Events. Firstly, it is noted that although the Market Quotation method had worked well, especially in stable and non-complex markets, a number of market participants had experienced difficulties when attempting to obtain appropriate price quotations in turbulent markets, especially for complex structured transactions, i.e. lack of market 72 liquidity. These types of valuation difficulties came to the fore in situations heavily involving 73 derivatives transactions, such as the currency debt default crises in Asia in 1997 and in Russia in 74 1998 , as well as widely publicised failures of long-established financial institutions such as the Bankers Trust Company in 1995, and the Long Term Capital Management hedge fund and Hong Kong broker-dealer Peregrine Investments Holdings Limited in 1998. It is further noted that other relevant factors, included the development of sophisticated internal valuation systems (which provided more appropriate transaction valuation methodologies); English 75 court decisions creating uncertainty regarding the interpretation of the 1992 provisions ; and the fact that whilst the Loss measure "had provided greater flexibility in valuing complex, structured transactions, concern had been expressed that too much discretion was left in the hands of the 76 determining party." It was also noted that the First Method of payment was rarely selected in practice because under the 77 1998 Accord and Basel II , parties seeking to rely on netting agreements for capital adequacy purposes were required to ensure that the netting agreements not contain walk-away clauses, which the First method did (thereby precluding use of ISDA netting agreements for capital adequacy purposes). Consequently, a new single "Close-out Amount" replaced the First and Second Methods under the 1992 Agreement, with a view to combining the benefits of both. Johnson states that the 78 Close-out Amount aims to calculate a payment amount that would provide the non-Defaulting Party with the "economic equivalent" of the terminated transactions (in terms of the material terms and option rights of the transactions), meaning that the non-Defaulting Party is to be put in the same 79 position it would have been in had the transactions not been terminated. The Close-out Amount is to be determined by the non-Defaulting Party (Determining Party) who "will act in good faith and use commercially reasonable procedures in order to produce a commercially 80 reasonable result." In calculating the Close-out Amount the Determining Party is entitled to consider any relevant information, including: (i) firm or indicative quotations (for replacement transactions supplied by one or more third parties who may consider creditworthiness); or (ii) relevant market data (supplied by one or more third parties) such as "rates, prices, yields, yield curves, volatilities, spreads, correlations". However, if the Determining Party "reasonably believes in good faith that such quotations or relevant market data are not readily available or would produce a result that would not satisfy those standards", it may then obtain quotations or relevant market data from internal sources, as long as it is used in the "regular course of its business for the valuation of similar transactions." This provision therefore aims to directly address situations pertaining to market turmoil or systemic risk events. Section 6(f) of the 2002 Agreement now also provides for a new right of "Set-Off", whereby any Early 81 Termination Amount which is payable by the Payer to the Payee, may be reduced by its set-off 82 against any other amounts payable by the Payee to the Payer (at the option of the Non-defaulting Party or the Affected Party). The counterparty choosing to Set-Off may do so without prior notice, but must give subsequent notice of having done so to the other counterparty. Furthermore, not only may the counterparty setting-off 83 convert any relevant amount into other currencies , but may also, if an obligation is unascertained, "in good faith estimate that obligation and set off in respect of the estimate, subject to the relevant party accounting to the other when the obligation is ascertained." The 2002 Agreement has also reduced grace periods relating to two Events of Default, namely curing 84 85 a Failure to Pay or Deliver and Default Under Specified Transaction , from three Local Business 86 Days to one Local Business Day. The Illegality Termination Event has been significantly amended, ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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and a new "Force Majeure Event" Termination Event added. Firstly, an operational hierarchy now exists for the Illegality Termination and Force Majeure Events, meaning that counterparties must first give effect "to any applicable provision, disruption fallback or remedy specified in, or pursuant to" any relevant Confirmation or specified elsewhere in the 2002 Agreement (e.g. express reference to ISDA Definitions). 88

Next, counterparties must also now undertake a "Waiting Period" , consisting of three (Illegality) and eight (Force Majeure Event) Local Business Days during which payments and delivery obligations are 89 deferred. Finally, counterparties must now no longer "use all reasonable efforts" to transfer Affected 90 91 92 93 Transactions to other Offices or Affiliates (as was required under the 1992 Agreement ), but must only make all reasonable efforts (not requiring a counterparty to incur a loss, except for 94 immaterial or incidental expenses) to "overcome such prevention, impossibility or impracticability". Although the terms "force majeure" and "act of state" are left undefined, the provisions are applicable to all relevant counterparty payment and delivery Offices, as well as counterparties and CSPs in relation to any CSD obligations. Furthermore, to remedy its absence in the 1992 Agreement, a new Event of Default was inserted for Repudiation of Agreement where a party "disaffirms, disclaims, repudiates or rejects, in whole or in part, or challenges the validity of", the 2002 Agreement or any 95 Confirmation. The 2002 Agreement was also updated to reflect product innovation developments in the derivatives markets, meaning that a Default Under Specified Transaction was amended to cover new derivatives products such as credit swaps and credit default swaps, and repurchase or weather 96 index transactions. However, the susceptibility of certain types of derivatives products such as repurchase agreements to technical defaults, led to the inclusion of the need for a liquidation or acceleration of obligations, or early termination of Specified Transactions, as a condition precedent. The Credit Event Upon Merger provisions in the 2002 Agreement were also changed to include reorganisations, reincorporations or reconstitutions into another entity, as well as adding change in control and substantial change in 97 Change in capital structure provisions triggering a Credit Event Upon Merger Termination Event. control occurs where any person, related group of persons or entity directly or indirectly acquires beneficial ownership of equity securities (giving them power to elect a majority of board of directors), or any other ownership interest allowing it to exercise control. Finally, substantial change in capital structure may arise owing to the issuance, incurrence or guarantee of debt or preferred stock (or 98 securities convertible or exchange into debt or preferred stock). In terms of secondary amendments, section 5(a)(vii) of the 2002 Agreement has now been amended to reflect a shortened grace period of fifteen days (from thirty days) for a counterparty to obtain a dismissal, discharge, stay, or restraint of involuntary proceedings for insolvency, bankruptcy or other relief under bankruptcy or insolvency law, i.e. Bankruptcy Event of Default. Johnson remarks that as a general rule, most market participants believed that even thirty days was "probably insufficient to obtain a dismissal", but that fifteen days "should be sufficient for a party to communicate with its counterparty and persuade them that, even if it has not been cur-rently dismissed, the involuntary 99 bankruptcy proceeding would be dis-missed in the near future." Significant amendments were included in section 9(h) of the 2002 Agreement to cover Interest and Compensation provisions, prior to and upon Early Termination, with interest to be calculated on a 100 The Absence of Litigation daily compounding and actual number of days elapsed basis. Representation has been amended to only refer to a counterparty, any of its CSPs, or applicable 101 The 1992 Agreement covered reference to any of a counterparty's Affiliates, and Specified Entities. it was market practice to amend such a broad and encompassing reference via the 1992 Schedule. Finally, section 13 of the 2002 Agreement has been amended to allow for exclusive jurisdiction if any 102 proceedings involve a "Convention Court", and non-exclusive jurisdiction otherwise.

LEGAL DEVELOPMENTS AFFECTING THE ISDA MASTER AGREEMENT FRAMEWORK

There are a number of legal developments that can be said to have affected the ISDA Master Agreement framework since the inception of the 1992 Agreement. Firstly, there are certain notable legal cases that have clarified and updated the law in this area, but at the same time also raised other ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 problematic questions. Secondly, there are certain legislative developments, on both sides of the Atlantic, that have significantly affected OTC derivatives market practice, including the recent 103 104 in the EU, and the Dodd–Frank Act in the US. Firstly, there are two promulgation of the EMIR cases involving the use of Forward Freight Agreements (FFAs) (a type of cash settled contract for difference with monthly calculation of "settlement sums" due), and governed by the 1992 Agreement (Multicurrency – Cross Border) that are of note. 105

upheld the validity of the The court in Britannia Bulk Plc (In Liquidation) v Pioneer Navigation Ltd Second Method and Loss under the 1992 Agreement, so that the calculation of loss by a nonDefaulting Party had to include sums which would have become payable to the Defaulting Party, had it not been subject to an Event of Default. It has been commented that whilst this confirms financial institutions' market view of the 1992 Agreement (i.e. fault is irrelevant), shipping companies using the ISDA Master Agreement framework did not fully understand its effects in practice, and consequently 106 had assumed that only innocent parties could demand payment under the 1992 Agreement. 107

upheld the The court in Marine Trade SA v Pioneer Freight Futures Co Ltd BVI and another enforceability in English law of the application of section 2(a)(iii) of the 1992 Agreement, namely that it is a condition precedent that no Event of Default or Potential Event of Default has occurred, prior to 108 Flaux J held that Marine Trade was payment obligations arising under the 1992 Agreement. therefore entitled to rely on Pioneer's continuing bankruptcy to withhold payment under section 2(a)(iii), as well as holding that no amount was payable under the netting provisions under section 2(c) of the 1992 Agreement because no amount was "payable" because of a failure to satisfy the condition precedent. Whilst this brought increased legal certainty to the 1992 Agreement, White & Case noted that Marine Trade was forced to make a payment "under protest", and that the court held that money paid out in 109 Consequently, it was noted that going such way was not a mistake, thereby precluding recovery. forwards the only clear way of addressing this issue is to include an express contractual provision in 110 the ISDA Master Agreement for such type of repayment. In Marine Trade Flaux J also held, albeit obiter, that section 2(a)(iii) was a "one time" provision for the calculation and assessment of monthly settlement sums due, and that accordingly payment obligations were not suspended by an Event of Default, but extinguished. Thereafter Linklaters argued that not only did this contradict established commentator views on the applicability of this provision, it also "leads to an extremely uncommercial result" and is at odds with the interpretation 111 What is more, Linklaters argued that Flaux given to the identical provisions in the 2002 Agreement. J's conclusion would also lead to: "...the paradoxical situation that if A is owed an amount by B but A is, on the due date, subject to an Event of Default which is subsequently cured, the amount due to A would never become payable while the ISDA Master Agreement subsists, but on an early termination of the Agreement it would be an Unpaid Amount... It would, therefore, be 112 taken into account in the Early Termination Amount." Indeed, the approach championed by Flaux J was expressly rejected by the Court of Appeal (the 113 CoA) in Lomas v JFB Firth Rixson Inc , which held that the payment obligation of a non-Defaulting 114 This meant that the Party under the 1992 Agreement was suspended, rather than extinguished. payment obligation would revive upon the cure of an Event of Default prior to the termination of outstanding transactions, as "To treat the payment obligation as extinguished was altogether too 115 drastic a remedy in favour of the non-defaulting party". It was also held that the payment obligation would not terminate upon maturity of the transaction, so that automatic early termination could occur after the maturity date of the transaction (if specified in the Schedule). The CoA also overruled Marine Trade by stating that the netting process under section 2(c) 1992 Agreement was not subject to the satisfaction of conditions precedent under section 2(a)(iii). Finally, it was held by the CoA that although the suspensory effect of section 2(a)(iii) might be criticised as imperfect, it was not uncommercial and therefore did not offend against the "anti116 deprivation principle".

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It should also be noted that recent regulatory developments within both the EU (the EMIR) and the 118 US (Title VII of the Dodd-Frank Act) , have mandated the need for centralised clearing of OTC derivatives by central counterparty (CCP) clearing houses. Although a detailed discussion of the content of these initiatives is beyond the scope of this chapter, in short, although both regimes differ in the actual underlying substantive requirements, the overall aims include the mitigation of counterparty and systemic risk through the use of CCPs by mandated centralised clearing of the majority of different classes of OTC derivatives for Financial Counterparties (FCs). This means that the majority of OTC derivatives which have inter alia high volumes and liquidity, standardised contractual terms (e.g. common legal documentation including master netting agreements and definitions), and wide availability of fair, reliable and generally accepted price information, will be subject to centralised 119 clearing. In practice this will require FCs to update all existing ISDA Master Agreements for either the EMIR or Dodd-Frank through ISDA sanctioned updating "Protocols", e.g. the ISDA March 2013 EMIR NonFinancial Counterparty (NFC) Representation Protocol (EMIR Protocol) and a Timely Confirmation Amendment Agreement; and the ISDA August 2012 Dodd-Frank Protocol Agreement (Dodd-Frank Protocol) and Adherence Letter. What is more, non-centrally cleared OTC derivatives will also be 120 Nevertheless, subject to more stringent monitoring and collateral requirements going forwards. Non-Financial Counterparties (NFCs) which only undertake OTC derivatives transactions for hedging purposes will be excluded from the central OTC derivatives clearing obligation under the EMIR, and similar provisions apply under the Dodd-Frank Act.

LAYING THE GROUNDWORK FOR THE ISDA MASTER AGREEMENT 2012

When ISDA was formed in 1985, one of its overarching objectives was to standardise OTC derivatives market practice and documentation. In this regard, there can be absolutely no doubt that 121 in 2013 ISDA has achieved this ambition. Indeed, at First Instance in Lomas v JFB Firth Rixson Inc Briggs J accepted that the ISDA Master Agreement served as the contractual foundation for more than 90 per cent of OTC derivatives transactions globally, and that it was "one of the most widely used forms of agreement in the world. It is probably the most important standard market agreement 122 Moreover, Briggs J was also of the opinion that it was "axiomatic that it used in the financial world." should, as far as possible, be interpreted in a way that serves the objectives of clarity, certainty and 123 predictability, so that the very large number of parties using it should know where they stand". Nevertheless, here, it is opined, is where its interpretation, as well as the ISDA Master Agreement itself, begins to somewhat falter. Firstly, Edwards contends that "the Master Agreement is itself fraught with legal intricacies, from the Single Agreement and Entire Agreement concepts to the Events of Default, Early Termination, close124 Indeed, the ubiquitous highly nuanced and protracted out netting and the hybrid set-off clause." ISDA negotiation process evidences the large number of complex Master Agreement and Schedule deletions, insertions, amendments and consultations that take place, in order to establish the final Master Agreement governing framework for counterparties. Neither can it be said that there is now only one standard governing Master Agreement for counterparties to contend with. Instead for example, Kramer and Harris observed that whilst the 2002 Agreement had been available for over eight years, it had not entirely replaced the 1992 Agreement, since dealers generally preferred the 125 Consequently, they stated that "many 2002 version and end-users preferred the 1992 version. end-users prefer to start with the 1992 version because it may allow them to avoid having to negotiate 126 'away' many of the dealer friendly provisions in the 2002 version but not in the 1992 version." Added to this, not only have experienced market counterparties often floundered with the correct interpretation of Master Agreement provisions (e.g. shipping companies using FFAs and the 1992 Agreement in Britannia Bulk), but so too have experienced judges (e.g. Flaux J in Marine Trade was overruled by the CoA in Firth Rixson, and Briggs J at First Instance in Firth Rixson overruled by the CoA (suspension of obligations does not end with expiry date of transaction, but has no end date as long as there is a continuing Event of Default). Moreover, the 1992 ISDA Master Agreement framework and archaic language that was put in place twenty years ago is, to all extents and purposes (barring some cosmetic updates in the 2002 Agreement), still in place. ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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According to Clifford Chance, ISDA's Master Agreement "does what it says on the tin". Perhaps so, but it is opined that the real question to be asked now is, "is this really enough"? In response, it is submitted that the answer is an unequivocal "No", and that ISDA's "standardisation" sophistry no longer rings true. In fact further to this argument, Baker submits that the OTC derivatives market is experiencing a period of unprecedented change; that regulatory pressure is moving many of the basic assumptions and concepts on which the dynamic OTC derivatives market rests; and that consequently "there is a pressing need for market participants to evaluate existing OTC concepts and 128 ensure they remain "fit for purpose" in the new derivatives world." In practice, counterparties will now have to contend with a plethora of operating complexities, including a choice of 1992 or 2002 Master Agreements; Master Agreement Schedule negotiations and amendments; collateral, CSA or CSD negotiations and amendments; choice of relevant ISDA Definitions (e.g. ISDA's 2005 Commodity Definitions, 2006 Definitions, or 2011 Equity Derivatives 129 Definitions); execution of relevant ISDA Protocols (e.g. ISDA Close-out Amount Protocol 2009 ; 130 Protocol 2012; Dodd-Frank Protocol 2012; EMIR Protocol 2013) and adherence letters; FATCA and execution of CCP clearing agreements, and clearing compensation and give-up agreements under the EMIR, or Futures Commission Merchant customer account agreements, and give-up 131 agreements under the Dodd-Frank Act. To this, the Aite Group add that as regards equity OTC derivatives, not even all the dealers have master confirmation agreements in place, meaning that when it comes to getting proper 132 documentation to their buy-side clients, dealers first have to establish exact products and regions. Thereafter, they note that "In many cases, large packets of legal documentation, spanning multiple regions and products are sent to clients, overwhelming them with massive packages of legal 133 It is therefore contended by them, that the hodge-podge of regionalized master documentation." confirmation agreements and non-ISDA documentation across a broad range of products, "suggests that moving to more automated processes will pose considerable difficulties without substantially 134 more standardization in documentation." In the twenty-first century, and in a post-EMIR and post-Dodd-Frank era replete with increased across-the-board regulatory overheads, what is needed is no longer standardisation, but simplification, streamlining, increased efficiency and reduced costs. Whereas once standardisation offered the benefits of cost-effectiveness and business efficacy (through increased legal certainty), nowadays the clarity of the Master Agreement framework and the burgeoning associated costs must 135 also be weighed into the balance. ISDA's Mission Statement is that "ISDA fosters safe and efficient derivatives markets to facilitate 136 This is to be achieved through its effective risk management for all users of derivative products." multilateral strategy incorporating elements such as, the provision of "standardized documentation globally to ensure legal certainty", and "Promoting infrastructure that supports an orderly and reliable 137 Since ISDA is the de facto global trade marketplace as well as transparency to regulators". association for OTC derivatives, it is opined that at the very least ISDA should also undertake a regular update of its Master Agreement framework to take account of market problems and developments, and that at an absolute minimum this should occur at least every decade (i.e. 1992, 2002, 2012, etc.), if not sooner. In effect, this means that in principle the ISDA Master Agreement 2012 therefore represents a vital missed opportunity for a much needed and justified overhaul of the ISDA Master Agreement architecture by ISDA.

THE ISDA MASTER AGREEMENT 2012

In further support of this contention, it is submitted that fundamental obstacles are encapsulated by an anecdotal online comment remarking that: (i) the 1992 drafting was even more paleolithic than it is now; (ii) there is no prospect of any updated ISDA Master Agreement version being much different as there are billions of dollars hanging on the agreement wording; and (iii) that although huge swathes of it could be improved, since litigation has decided what these clauses mean, ISDA will just let sleeping 138 It would seem to be that the difficulty is that ISDA considers that a dogs lie in terms of drafting. static and well-established document best suits and reflects the OTC derivatives markets needs, and that no change is warranted because this might increase legal uncertainty for market participants.

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2017 This is despite the fact that the ISDA Master Agreement was last updated more than ten years ago. Moreover, the evidence would suggest that this might not necessarily be the case, and that instead what is now needed is a dynamic document that is continually evolving, and one which has been refined and updated to suit modern times and usage. A further difficulty is that, whereas once ISDA was a smaller streamlined organisation which was free to pioneer OTC derivatives markets, nowadays it acts constrained by its approximately 800 members spanning 60 countries. It is submitted that its loss of organisational momentum is likely attributable to a more conservative 139 positive consensus decision-making, rather than more culture, which surely reflects GATT 1947 140 141 facilitative post-WTO negative consensus decision-making. The author has a future vision of ISDA that would broadly encompass a wholly digital ISDA software 142 However, such a operating system for universal use by all OTC derivatives market participants. vision cannot occur without prior simplification and streamlining of the ISDA Master Agreement Framework. Consequently in favour of this, it is argued here that ISDA standardisation has established, not simply the ISDA Master Agreement document, but the actual concepts and principles underlying the Master Agreement itself – the netting, the tax withholding, the Events of Default, the Termination Events, and the Close-out valuation methodologies. On the whole, market participants now more clearly understand how these function. Therefore, post-standardisation, the ISDA Master Agreement needs to achieve increased simplicity, efficacy and become more diaphanous in nature for market participants. It is submitted that an update and refinement of the ISDA Master Agreement would update the framework without losing its existing configuration and legal certainty, thereby ensuring the continuity of approach necessary to comfort OTC derivatives market participants. At the same time, not only would the ISDA Master Agreement 2012 address ISDA negotiating complexities and legal problems previously addressed, but it would also tackle a host of other pressing concerns. These will be briefly touched upon, and include: (i) technical issues; (ii) negotiating perspectives; (iii) Close-out valuation methodologies; (iv) problems with "good faith" and "commercial reasonableness" standards; (v) dispute resolution; (vi) "value clean" concerns; and (vii) flawed asset arguments. Technical issues that could be improved in the 2012 Agreement include drafting improvements and incorporation of aspects of ISDA negotiation. For instance, it has been argued that the drafting in the ISDA Master Agreement is "pretty ragged", and examples include references to future tense instead of simple present; unhelpful subheadings (e.g. General Conditions include obligations); ambiguous adjectives (e.g. amounts "payable" implies discretion); awkward use of the passive voice (e.g. "The election may be made"); redundant or illogical references (e.g. "those Transactions" when no other transactions referred to); non-integrated or non-autonomous definitions (e.g. "Multiple Transaction 143 Netting" ); mixed hanging indents, first-line indents, and dangling text; and needless abstract nouns 144 For the ISDA uninitiated, the (e.g. "by giving notice" instead of "notifying") and linguistic iterations. clause numbering might also be changed to allow instant recognition, instead of having to constantly check back a few pages to identify the exact clause number. In terms of pertinent examples of negotiation perspectives, firstly ISDA could increase transparency and efficacy by drafting and updating an annual "Negotiating Compendium" in print and online. In similar fashion to the ISDA Master Agreement "User's Guides", the Compendium could include a 145 The guide to negotiating issues relevant to each of the ISDA Master Agreement clauses. effectiveness of Know-How precedents and databases in law firms has been widely established as 146 improving law firm efficiencies and firm knowledge overall , and this type of centralisation of knowledge by ISDA could only help to speed up ISDA negotiations and increase the transparency of the ISDA Master Agreement framework. Other negotiating issues which the 2012 Agreement could seek to improve include increased objectivity and transparency, by for example, ensuring that the Affected Party (the counterparty that has merged) provides justified reasons for its subjective opinion of "materially weaker" after 147 Greenidge and de Vries Robbé declaration of a Credit Event Upon Merger Termination Event. have argued that the broad nature of the transfer of business provisions in the ISDA Master Agreements, means that end-users have an increased probability of default, e.g. if an end-user 148 divests itself of any significant activities because of strategic changes.

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2017 Moreover, since quick tests such as creditworthiness (i.e. credit ratings), NAV, share value or financial ratios are likely to be used "immediately after" an occurrence, these tests may not be objective enough (because credit rating or value may actually quickly rebound), and these provisions should therefore include grace periods or the possibility of posting collateral, or other credit enhancements, 149 Greenidge and de Vries RobbĂŠ also contend that for the sake of fairness to end-users in particular. change of control and capital structure provisions for Credit Event Upon Merger Termination Events 150 They assert that "any other ownership interest enabling it are especially problematic for end-users. to exercise control of X" is not sufficiently defined; is broadly applicable (to all CSPs and designated Specified Entities); and leaves "many end users exposed to events which they have little or no control 151 over." The inclusion of substantial changes in capital structure also means that end-users may be overly restricted in their financial and capital arrangements leading to frequent technical breaches, e.g. bond issues, drawing on capital markets via medium term notes or commercial paper, re-negotiation of loan 152 The 2012 Agreement could therefore be documentation or re-phrasing of parental guarantees. drafted to specifically redress the potential imbalance of these issues. So too could the specificity of interest provisions be improved, in order to obviate potential "hidden penalties", in particular in the 1992 Agreement, relating to Default Rates payable by a non-Defaulting Party to a Defaulting Party as 153 regards costs of funding. In principle the widespread continuing use of the 1992 Second Method, as well as Market Quotation and Loss, means that their incorporation within the 2012 Agreement would provide much demanded alternatives to a single Close-out Amount. The ISDA Master Agreement 2012 should not simply be about providing a mandated template, but instead a range of choices which actively best reflect market practices and demand from market participants should be offered. Indeed there is little point in mandating a single Close-out Amount methodology if, for example, buy-side market participants are continuously amending ISDA Schedules to incorporate 1992 Agreement Market Quotation valuation methodologies, which are seen to be more objective. On the other hand, dealer banks may view Close-out Amount as more favourable since it affords greater flexibility in terms of obtaining market quotations. There is therefore an argument to be made that a 2012 Agreement that provides market counterparties with a choice of Close-out valuation methodologies, as well as the ability of counterparties to place them within a default "hierarchy" (i.e. ability to choose which valuation methodology can be used in lieu of the first chosen method under certain circumstances such as market illiquidity or turmoil), would improve ISDA market practices. In addition, the valuation methodologies could also be updated in the 2012 Agreement to provide for more egalitarian, accurate and transparent determinations. Firstly, both the definition of "Loss" in the 1992 Agreement, and Close-out Amount in the 2002 Agreement make reference to the ability of a counterparty to consider (without duplication) "any loss or cost incurred as a result of its terminating, liquidating, obtaining or re-establishing any hedge or related trading position", or "any loss or cost incurred in connection with its terminating, liquidating, or re-establishing any hedge related to a Termination Transaction" respectively. The commercial subjectivity of these provisions, and express ousting of English Common Law 154 quantification of damages for breach of contract, has been confirmed by the English courts. Consequently, in light of the extent of potential opacity of these types of (unsuccessful) "hedging" transactions evidenced by recent financial institutional failures (e.g. the derivatives trading losses amounting to circa US$6.2 billion accrued by JP Morgan, and the lack of linkage of derivatives to 155 specific assets within hedging portfolios ), the subjectivity, or at least the underlying counterparty justification for this valuation methodology needs to be specifically addressed. Greenidge and de Vries RobbĂŠ state that dealers may argue that it is generally "commercially reasonable" to includes such losses for transactions in illiquid markets or for complex products, but 156 They also argue for demonstrating the 2002 Agreement does not make such distinction. commercial reasonableness of costs of funding, as well as express provisions for the "basis, reasons 157 and source of information used in the calculations" for the determination of Close-out Amounts. Such express justification would certainly increase objectivity and certainty for the valuation methodology in the 2012 Agreement. However it is noted that the ISDA drafting committee expressly ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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approach in section It has also been argued by Baker that the conditionality of the "flawed asset" 2(a)(iii) in the 2002 Agreement, is no longer fundamentally valid because its purpose (to manage 174 counterparty risk), is now already effectively addressed in other parts of the 2002 Agreement. Consequently, not only would the 2012 Agreement expressly seek to make the implications between choice of value clean and "dirty" valuations clearer, but would also allow market participants the choice (via election in the Schedule) to opt for a flawed asset or a non-flawed asset approach.

CONCLUSION

One of the difficulties facing OTC derivatives market participants is that their participation, by its very nature, requires them to become highly au fait with the ISDA Master Agreement documentation architecture. Consequently, it becomes that much more difficult for market participants to be objective as regards operational documentation complexities, obstacles, or deficiencies, since they have, to all extents and purposes, become highly "acclimatised" to the ISDA framework. Accordingly, the overall aim of this chapter has been to objectively demonstrate the significant and justified need for a new 2012 ISDA Master Agreement to govern OTC derivatives transactions. At the same time, it is hoped this chapter will catalyse further market debate on whether such a need exists, perhaps with a view to developing a new Master Agreement further along the line. As a final corollary objective, this chapter has also aimed to bring to the fore the underlying objectives of ISDA as the de facto global trade association for OTC derivatives, especially as regards its obligations vis-Ă -vis the regular updating of the ISDA Master Agreement framework. In furtherance of these objectives, the documentation and negotiation complexities pertinent to the 1992 and 2002 Agreements have been presented. As has been seen, the introduction of the 2002 Agreement has not resulted in a complete replacement of the 1992 Agreement. There are therefore positive aspects of the 1992 Agreement (e.g. Second Method and Market Quotation or Loss valuation) that market participants have sought to introduce via amendment in the 2002 Schedule, illustrating that a 2012 Agreement could incorporate the proven benefits of both Agreements in an updated Agreement. Furthermore, the chapter also highlighted a number of legal cases that have affected operational aspects of the ISDA Agreements, such as payments made under protest; suspended obligations; the application of the anti-deprivation principle; and new CCP central clearing requirements. These legal developments have been used to demonstrate the need for a new ISDA 2012 Agreement to directly address and remedy the relevant underlying legal issues. Moreover, in further support of the 2012 Agreement, the chapter has sought to highlight potential areas of complexity, or particular problems in the 1992 and 2002 Agreements that the 2012 Agreement could remedy via express drafting. These are not exhaustive, but have been used to overall demonstrate the large number of difficulties and problems that OTC derivatives market participants currently have to contend with. Consequently summa summarum, in the ten years since the 2002 Agreement, a large number of legal, regulatory and operational difficulties have arisen which have affected ISDA Master Agreement drafting and negotiations overall. The 2012 ISDA Master Agreement therefore represents a significant missed opportunity for ISDA to improve and update the ISDA Master Agreement operating framework.

Email: rodrigo.zepeda@storm-7.com, Linkedin: http://uk.linkedin.com/in/rodrigozepeda/.

See: Steven Edwards, "Legal principles of derivatives." (2002) (Jan) Journal of Business Law 1, 30.

Gooch and Klein state "In a conventional rate cap transaction, one party, usually called the "seller," agrees to make a series of payments to the other measured by the excess of an index rate over an agreed "cap rate" or "strike rate." For this protection against rate increases, the "buyer" pays a premium, which, in a conventional cap, takes the form of a single payment made at inception." Anthony C Gooch and Linda B Klein, Documentation for Derivatives Volume I (Euromoney Books, 2002) 439. ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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Gooch and Klein state "The structure of the rate floor is much like that of the cap: the seller agrees to make a series of payments to the buyer measured by the extent to which a given index rate drops below the agreed "floor rate"; the buyer pays a premium, usually in the form of a single, up-front payment. The rate floor is used primarily by holders of floating-rate assets to protect themselves against falling rates." Anthony C Gooch and Linda B Klein, Documentation for Derivatives Volume I (Euromoney Books, 2002) 442.

Gooch and Klein state "A rate collar transaction can best be understood as a combination of a cap and a floor in a single transaction. One party, the "seller" of the cap element of the collar, agrees to make a series of payments to the other measured by the excess of an index rate over an agreed "cap rate" or "strike rate," and the "buyer" of the cap also sells back a floor. That is, it agrees to make a series of payments measured by the extent to which the same index rate drops below an agreed "floor rate" lower than the cap rate. One of the parties, usually the buyer of the cap, also pays a premium". Anthony C Gooch and Linda B Klein, Documentation for Derivatives Volume I (Euromoney Books, 2002) 448.

Christian A Johnson, The Guide to using and Negotiating OTC Derivatives Documentation (Institutional Investor Books, 2005) 8.

Christian A Johnson, The Guide to using and Negotiating OTC Derivatives Documentation (Institutional Investor Books, 2005) 9.

"Since its founding in 1985, the International Swaps and Derivatives Association has worked to make over-the-counter (OTC) derivatives markets safe and efficient. ISDA’s pioneering work in developing the ISDA Master Agreement and a wide range of related documentation materials, and in ensuring the enforceability of their netting and collateral provisions, has helped to significantly reduce credit and legal risk. The Association has been a leader in promoting sound risk management practices and processes, and engages constructively with policymakers and legislators around the world to advance the understanding and treatment of derivatives as a risk management tool. Today, ISDA has over 800 member institutions from 60 countries. These members include a broad range of OTC derivatives market participants including corporations, investment managers, government and supranational entities, insurance companies, energy and commodities firms, and international and regional banks. In addition to market participants, members also include key components of the derivatives market infrastructure including exchanges, clearinghouses and repositories, as well as law firms, accounting firms and other service providers. ISDA’s work in three key areas – reducing counterparty credit risk, increasing transparency, and improving the industry’s operational infrastructure – show the strong commitment of the Association toward its primary goals; to build robust, stable financial markets and a strong financial regulatory framework." ISDA 'About ISDA' at http://www2.isda.org/about-isda/ [Accessed April 7, 2013].

"In this it has been a resounding success because previously there was little standard documentation in the market and high legal fees abounded as lawyers Concorded across the Atlantic to complete individual deals. With more complex Transactions this wide variety of documentation caused legal uncertainty." Paul Harding Mastering the ISDA Master Agreements (1992 and 2002) (FT Prentice Hall, 2004) 19. It should also be noted that ISDA was originally named the International Swap Dealers Association (initially Co-Chaired by Thomas Jasper and Artur Walther) but later changed its name to the current title in 1993.

Paul Harding Mastering the ISDA Master Agreements (1992 and 2002) (FT Prentice Hall, 2004) 19.

Wood notes that netting generally includes either "close-out netting" or "settlement netting" and defines both: (i) "Close-out netting is the cancellation of a series of open executory contracts between two parties, eg for a sale of goods or foreign exchange or investments, on the default of the counterparty and the set-off of the resulting gains and losses. Close-out netting requires two steps on a counterparty default: cancellation of the unperformed contracts, and then set-off of the gains and losses on each contract, so as to produce a single net balance owing one way or the other"; and (ii) "Settlement netting is the advance set-off by contract of equivalent fungible claims under executory contracts, eg for commodities or foreign exchange, where the mutual deliveries fall due for payment © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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or delivery on the same day. The object is to reduce exposures in relation to reciprocal deliveries due on the same day where often the deliveries are commodities or foreign exchange deliverable under executory contracts so that set-off of debts is not available." Philip R Wood, Set-Off and Netting, Derivatives, Clearing Systems: v. 4 (Sweet & Maxwell, 2007) 4. See further: David Mengle, "The Importance of Close-Out Netting." (2010) Number 1 ISDA Research Notes. 11

Paul Harding Mastering the ISDA Master Agreements (1992 and 2002) (FT Prentice Hall, 2004) 19.

Harding observes that the main difference between the Single and Multicurrency Master Agreements is that the Local version excludes a number of provisions which are unnecessary when transacting business in the same currency and jurisdiction, this includes: (i) provisions relating to tax matters (section 2(d) (Deduction or Withholding for Tax), Sections 3(e) and (f) (Payer and Payee Tax Representations), Sections 4(a)(i) and (iii) (Agreements to provide tax forms or documents), Section 4(d) (Tax Agreement), Section 4(e) (Payment of Stamp Tax), Sections 5(b)(ii) and (iii) (Tax Event and Tax Event Upon Merger), Section 11 (Stamp Tax reference), Part 2 of the Schedule (Tax Representations); (ii) provisions relating to currency issues (Sections 6(e)(i) and (ii) (references to Termination Currency Equivalent), Section 8 (Contractual Currency)); and (iii) other provisions (Section 6(b)(ii) (Transfer to Avoid Termination Event), Section 10 (Offices; Multibranch Parties, Section 13(c) (Service of Process, Section 14 (deletion from some Definitions of matters raised above). Paul Harding Mastering the ISDA Master Agreements (1992 and 2002) (FT Prentice Hall, 2004) 26.

Paul Harding Mastering the ISDA Master Agreements (1992 and 2002) (FT Prentice Hall, 2004) 139.

The Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties (CCPs) and trade repositories (TRs) (EMIR), which entered into force on August 16, 2012.

Pub. Law 111–203, H.R. 4173, enacted on July 21, 2010.

For short-form Confirmations Johnson explains that "The Confirmation documents the economic terms of an individual trans-action. The Confirmation describes how the cash flows between the parties will be calculated and when and where the payments are to be made... Each Confirmation has several economic terms that should be addressed... the Confirmation should describe the tenor of the transaction and identify key dates such as the transaction's effective, trade, and termination dates. The notional amount and payment calculation terms and mechanics should also be specified." For a long-form Confirmation Johnson explains that "This is an agreement that combines the Confirmation with many of the terms found in the ISDA Master Agreement. In a long-form Confirmation, the legal terms usually found in the ISDA Master Agreement are integrated into the Confirmation. This is typically done if the parties anticipate only one trans-action between them. Parties using long-form Confirmation hope – fre-quently unwisely so – that its use will save negotiating time and effort." Christian A Johnson, The Guide to using and Negotiating OTC Derivatives Documentation (Institutional Investor Books, 2005) 26.

Section 9(a) reinforces this provision by stating "Entire Agreement. This Agreement constitutes the entire agreement and understanding of the parties with respect to its subject matter and supersedes all oral communications and prior warnings with respect thereto."

It should be noted that the ISDA Master Agreement 1992 provides for a hierarchy of interpretation in section 1(b): "Inconsistency. In the event of any inconsistency between the provisions of the Schedule and the other provisions of this Master Agreement, the Schedule will prevail. In the event of any inconsistency between the provisions of any Confirmation and this Master Agreement (including the Schedule), such Confirmation will prevail for the purpose of the relevant Transactions."

Thomas V. D'Ambrosio, 'Negotiating and Renegotiating ISDA Master Agreements for Derivative Transactions' (March 2009) International Actuarial Association Newsletter, 7.

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Field Fisher Waterhouse comment that the level of the Threshold Amount is the amount of affected Specified Indebtedness that must be affected by the default before the Event of Default is triggered, and that "Some market participants like to specify this as a proportion of shareholders' equity or net worth, others prefer a specified figure. The latter approach has the advantage of certainty, whereas the former may be useful where two parties with a significant disparity in size want a Threshold Amount that is directly comparable as between them." Field Fisher Waterhouse, 'Commentary on the ISDA Master Agreements' (February 2008) 1, 15.

Part 1, (c) Schedule to the ISDA Master Agreement 1992.

Thomas V. D'Ambrosio, 'Negotiating and Renegotiating ISDA Master Agreements for Derivative Transactions' (March 2009) International Actuarial Association Newsletter, 8.

Section 13(a) and (b) and Schedule to the ISDA Master Agreement 1992.

Alastair Hudson, The Law on Financial Derivatives (Sweet & Maxwell, 2002) 124.

Harding notes that by June 2003 ISDA "had commissioned 39 netting legal opinions in many jurisdictions in respect of the 1992 Agreement and 36 opinions in respect of the new 2002 Agreement with the aim of providing its members with a library of legal opinions." Paul Harding Mastering the ISDA Master Agreements (1992 and 2002) (FT Prentice Hall, 2004) 361.

This includes the 1994 ISDA Credit Support Annex (Security Interest – New York Law); the 1995 ISDA Credit Support Annex (Transfer – English Law); the 1995 ISDA Credit Support Deed (Security Interest – English Law); and the 1995 ISDA Credit Support Annex (Security Interest – Japanese Law). See further: Nigel Brahams, "Collateral and the OTC derivatives after the credit crunch." (2009) 24(5) Journal of International Banking and Financial Law 262.

A withholding tax is a government tax requiring tax payers to withhold tax from a payment at source, and instead of paying the gross amount to the payee, to pay the withholding tax directly to the government. It may often take the form of a tax which is levied on income from payment of interest or dividends to be received by non-residents.

Section 5(a)(i) of the 1992 Agreement.

Section 5(a)(ii) of the 1992 Agreement.

Section 5(a)(iii) of the 1992 Agreement.

Section 5(a)(iv) of the 1992 Agreement.

Section 5(a)(v) of the 1992 Agreement.

Section 5(a)(vi) of the 1992 Agreement.

Section 5(a)(vii) of the 1992 Agreement.

Section 5(a)(viii) of the 1992 Agreement.

Local Business Day is defined in section 14 of the 1992 Agreement.

The thirty day grace period commences from the date after notice of failure by the breaching party to perform contractual obligations is given to the non breaching party.

Paul Harding Mastering the ISDA Master Agreements (1992 and 2002) (FT Prentice Hall, 2004) 54.

Section 14 (Definitions) of the 1992 Agreement specifies that Credit Support Document "means any agreement or instrument that is specified as such in this Agreement." © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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See: Merrill Lynch International Bank Ltd (formerly Merrill Lynch Capital Markets Bank Ltd) v Winterthur Swiss Insurance Co [2007] EWHC 893 (Comm).

Under Part 1(a) (Termination Provisions) of the Schedule this includes "Specified Transaction"; "Cross Default"; "Bankruptcy"; and "Credit Event Upon Merger".

See Abu Dhabi Commercial Bank PJSC v Saad Trading, Contracting & Financial Services Co [2010] EWHC 2054 (Comm) for the English courts approach to interpreting cross default provisions under the ISDA Master Agreement.

Section 14 (Definitions) of the 1992 Agreement specifies that Specified Transaction refers to "a rate swap transaction, basis swap, forward rate transaction, commodity swap, commodity option, equity or equity index swap, equity or equity index option, bond option, interest rate option, foreign exchange transaction, cap transaction, floor transaction, collar transaction, currency swap transaction, crosscurrency rate swap transaction, currency option or any other similar transaction (including any option with respect to any of these transactions)".

Section 5(b)(i) of the 1992 Agreement

Section 5(b)(ii) of the 1992 Agreement.

Section 5(b)(iii) of the 1992 Agreement.

Section 5(b)(iv) of the 1992 Agreement.

Section 5(b)(v) of the 1992 Agreement.

Bernadette Muscat, 'OTC Derivatives: Salient Practices and Developments Relating to Standard Market Documentation" (Spring 2009) Bank of Valetta Review, No. 39, 32, 40-41.

Bernadette Muscat, 'OTC Derivatives: Salient Practices and Developments Relating to Standard Market Documentation" (Spring 2009) Bank of Valetta Review, No. 39, 32, 41.

Bernadette Muscat, 'OTC Derivatives: Salient Practices and Developments Relating to Standard Market Documentation" (Spring 2009) Bank of Valetta Review, No. 39, 32, 41-42.

Section 2(d) (Deduction or Withholding for Tax) of the 1992 Agreement.

Jonathan Law and John Smullen, A Dictionary of Finance and Banking (4th edition, OUP Oxford, 2008) 86.

Benjamin notes that "In order to avoid the risk that the value of the collateral should rapidly fall short of the collateralised exposure, the collateral taker specifies a margin by which the collateral value should exceed the exposure... the parties seek to preserve this margin by marking to market as follows. If at any time the value of the collateral should fall short of the agreed margin, a collateral shortfall is said to arise. This entitles the collateral taker to call for the delivery of additional collateral to restore the agreed margin. In the event of a collateral excess, the collateral giver is entitled to call for the release of margin so as to restore the agreed margin. In calculating whether there is a margin shortfall or excess, the position on all outstanding transactions is calculated on a net basis." Joanna Benjamin, Interests in Securities: A Proprietary Law Analysis of the International Securities Markets (Oxford University Publishing, 2000), 124-125.

Field Fisher Waterhouse, 'Commentary on the ISDA Master Agreements' (February 2008) 1, 4.

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These could take the form of short (having an original maturity at issuance of not more than one year), medium (having an original maturity at issuance of more than one year but not more than 10 years), or long (having an original maturity at issuance of more than 10 years) term obligations.

ISDA Credit Support Annex 1995, Paragraph 11 (Elections and Variables), (b)(ii).

"A derivative such as a swap is out of the money when, for example, the swap rate is unfavourable compared with the current market rate, so that the net present value of the derivative is negative." The Association of Corporate Treasurers "Glossary of Terms" at http://www.treasurers.org/glossary/O#Out_of_the_money [Accessed April 11, 2013].

ISDA Credit Support Annex 1995, Paragraph 5 (Transfer of Title, No Security Interest, Distributions and Interest Amount) and Paragraph 11 (Elections and Variables) (b)(iii) (Thresholds).

Christian A Johnson, The Guide to using and Negotiating OTC Derivatives Documentation (Institutional Investor Books, 2005) 47.

Section 6 (Early Termination) (e) (Payments on Early Termination) (i) (Events of Default) of the 1992 Agreement.

Allen & Overy, "An introduction to the documentation of OTC derivatives" (May 2002) (ICM:581105.3) at http://www.isda.org/educat/pdf/documentation_of_derivatives.pdf [Accessed April 14, 2013] 1, 7.

Field Fisher Waterhouse define this as "a clause which permits a non-defaulting party not to pay a net sum which it may be obliged to pay to a defaulting party on early termination after the close-out netting calculation has been made." Field Fisher Waterhouse, 'Commentary on the ISDA Master Agreements' (February 2008) 1, 6.

"A derivative such as a swap is in the money when, for example, the swap rate is favourable compared with the current market rate, so that the net present value of the derivative is positive." The Association of Corporate Treasurers "Glossary of Terms" at http://www.treasurers.org/glossary/I [Accessed April 11, 2013].

Christian A Johnson, The Guide to using and Negotiating OTC Derivatives Documentation (Institutional Investor Books, 2005) 82-83.

Sections 6(e)(i)(1), 6(e)(i)(3), and 14 of the 1992 Agreement. Johnson notes that "Under the Market Quotation method, the non-Defaulting Party solicits quotations from four dealers, referred to in the ISDA Master Agreement as "Reference Market-Makers." The quotation is the Reference MarketMakers' estimate as to how much a non-Defaulting Party would have to pay to (or be paid by) a Reference Market-Maker to step into the Defaulting Party's shoes as the counterparty under the ISDA Master Agreement and the various transactions." Christian A Johnson, The Guide to using and Negotiating OTC Derivatives Documentation (Institutional Investor Books, 2005) 83.

Sections 6(e)(i)(2), 6(e)(i)(4), and 14 of the 1992 Agreement. Johnson notes that "Under Loss, the non-Defaulting Party itself in good faith makes the calculation of what its losses and costs would be if it were in-the-money, or any gains if it were out-of-the-money with respect to the relevant Transactions... The net present value of the gain of the non-Defaulting Party (as calculated by the non-Defaulting Party) would be paid to the Defaulting party on the Early Termination Date." Christian A Johnson, The Guide to using and Negotiating OTC Derivatives Documentation (Institutional Investor Books, 2005) 84.

Christian A Johnson, The Guide to using and Negotiating OTC Derivatives Documentation (Institutional Investor Books, 2005) 83. See also: Michael Godden, "Meaning of loss and second

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method under the 1992 ISDA Master Agreement." (2011) 26(6) Butterworths Journal of International Banking & Financial Law, 330. 71

Section 12(a)(iii) and 12(a)(vi) of the 2002 Agreement.

Slaughter and May, "2002 ISDA Master Agreement Guide to Principal Changes" (March 2003) Memorandum 1, 9.

See: Eric Ghysels and Junghoon Seon, "The Asian financial crisis: The role of derivative securities trading and foreign investors in Korea." (2005) 24(4) Journal of International Money and Finance 607, and Ajit Singh, " "Asian Capitalism and the Financial Crisis" in John Eatwell and Lance Taylor, International Capital Markets: Systems in Transition (Oxford University Publishing, 2002) 339.

See: Alexander Nadmitov, "Russian Debt Restructuring Overview, Structure of Debt, Lessons of Default, Seizure Problems and the IMF SDRM Proposal." International Finance Seminar Harvard Law School at http://www.law.harvard.edu/programs/about/pifs/llm/sp26.pdf [Accessed April 10, 2013] and Abbigail J Chiodo and Michael T Owyang, "A Case Study of a Currency Crisis: The Russian Default of 1998" (2002) The Federal Reserve Bank of St. Louis, 7 at http://research.stlouisfed.org/publications/review/02/11/ChiodoOwyang.pdf [Accessed April 10, 2013].

For example, see: Peregrine Fixed Income Ltd v Robinson Department Store Public Co Ltd [2000] All ER (D) 1177 and Australia And New Zealand Banking Group Ltd v Societe Generale, Court of Appeal - Civil Division, February 17, 2000, [2000] EWCA Civ 44.

Slaughter and May, "2002 ISDA Master Agreement Guide to Principal Changes" (March 2003) Memorandum 1, 9.

"These requirements were originally based on the July 1994 Amendment to the Capital Accord of July 1988 adopted by the Basel Committee on Banking Supervision (part of the Bank for International Settlements). The update to the 1998 Accord ("Basel II") has now been published by the Base Committee and was implemented in the end of 2007." Field Fisher Waterhouse, 'Commentary on the ISDA Master Agreements' (February 2008) 1, 5.

Or the non-Affected Party in a Termination Event scenario.

Christian A Johnson, The Guide to using and Negotiating OTC Derivatives Documentation (Institutional Investor Books, 2005) 55-56.

Section 14 (Definitions) of the 2002 Agreement.

Under section 6(f) of the 2002 Agreement, the Set-Off right is occasioned "in circumstances where there is a Defaulting Party or where there is one Affected Party in the case where either a Credit Event Upon Merger has occurred or any other Termination Event in respect of which all outstanding Transactions are Affected Transactions has occurred".

Under section 6(f) of the 2002 Agreement, the Other Amounts owing occur "whether or not arising under this Agreement, matured or contingent and irrespective of the currency, place of payment or place of booking of the obligation".

Under section 6(f) of the 2002 Agreement, this includes "into the currency in which the other is denominated at the rate of exchange at which such party would be able, in good faith and using commercially reasonable procedures, to purchase the relevant amount of such currency."

Section 5(a)(i) of the 2002 Agreement.

Section 5(a)(v)(2) of the 2002 Agreement.

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Section 5(b)(ii) of the 2002 Agreement.

Sections 5(d) and 14 (Definitions) of the 2002 Agreement.

All payments will become due on the first Local Business Day following the end of the Waiting Period or the first Local Delivery Day for all deliveries due. Local Delivery Day is defined differently to Local Business Day, and means "a day on which settlement systems necessary to accomplish the relevant delivery are generally open for business so that the delivery is capable of being accomplished in accordance with customary market practice, in the place specified in the relevant Confirmation or, if not so specified, in a location determined in accordance with customary market practice for the relevant delivery." Section 14 of the 2002 Agreement.

Defined in section 14 (Definitions) of the 2002 Agreement.

Office is defined as meaning "a branch or office of a party, which may be such party's head or home office." Section 14 (Definitions) of the 2002 Agreement.

Affiliate is defined as meaning "subject to the Schedule, in relation to any person, any entity controlled, directly or indirectly, by the person, any entity that controls, directly or indirectly, the person or any entity directly or indirectly under common control with the person. For this purpose "control" of any entity or person means ownership of a majority of the voting power of the entity or person." Section 14 (Definitions) of the 2002 Agreement.

Section 6(b)(ii) of the 1992 Agreement.

Section 5(b)(ii) of the 2002 Agreement.

Section 5(a)(ii) (Breach of Agreement; Repudiation of Agreement) of the 2002 Agreement.

Section 14 (Definitions) of the 2002 Agreement specifies that Specified Transaction refers to "a rate swap transaction, swap option, basis swap, forward rate transaction, commodity swap, commodity option, equity or equity index swap, equity or equity index option, bond option, interest rate option, foreign exchange transaction, cap transaction, floor transaction, collar transaction, currency swap transaction, cross-currency rate swap transaction, currency option, credit protection transaction, credit swap, credit default swap, credit default option, total return swap, credit spread transaction, repurchase transaction, reverse repurchase transaction, buy/sell-back transaction, securities lending transaction, weather index transaction or forward purchase or sale of a security, commodity or other financial instrument or interest (including any option with respect to any of these transactions)" or any type of transaction similar to these transactions, or any combination of these transactions.

Section 5(b)(v) (Credit Event Upon Merger) of the 2002 Agreement.

Section 5(b)(v)(3) of the 2002 Agreement.

Christian A Johnson, The Guide to using and Negotiating OTC Derivatives Documentation (Institutional Investor Books, 2005) 57.

100

These provisions provided for Interest on Deferred Payments; Compensation for Defaulted Deliveries; Interest on Deferred Payments; Compensation for Deferred Deliveries; Early Termination Unpaid Amounts; and Early Termination Interest on Early Termination Amounts.

101

Section 3(c) of the 2002 Agreement.

102

It is explained that the jurisdiction clause has been amended to reflect the provisions of Article 17 of the Brussels Convention (CONVENTION of 27 September 1968 on jurisdiction and the enforcement of judgments in civil and commercial matters) and Article 17 of the Lugano Convention (CONVENTION of 16 September 1988 on jurisdiction and the enforcement of judgments in civil and commercial matters) relating to jurisdiction and enforcement of judgments, and that a Convention ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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Court is any court which is bound to apply to the Proceedings under either of those Article requirements. Slaughter and May, "2002 ISDA Master Agreement Guide to Principal Changes" (March 2003) Memorandum 1, 14. See also: Berliner Verkehrsbetriebe (BVG) Anstalt Des Offentlichen Rechts v JP Morgan Chase Bank N.A., JP Morgan Securities Limited [2010] EWCA Civ 309 and Patricia Shine, "Support from the English Courts and the European Court of Justice for Jurisdiction Clauses in the ISDA Master Agreement." [2012] Journal of International Banking Law and Regulation 38. 103

104

Pub. Law 111–203, H.R. 4173, enacted on July 21, 2010.

105

Britannia Bulk Plc (In Liquidation) v Bulk Trading SA [2011] EWHC 692 (Comm).

106

Norton Rose LLP, "English Commercial Court Friday's Decision On Derivatives/Insolvency & Shipping." (March 28, 2011) Mondovisione at http://www.mondovisione.com/media-andresources/news/norton-rose-llp-english-commercial-court-fridays-decision-on-derivatives-inso/ [Accessed April 15, 2013]. See also: Pioneer Freight Futures Co Ltd (In Liquidation) v TMT Asia Ltd [2011] EWHC 778 (Comm) (approved in Lomas v JFB Firth Rixson Inc [2012] EWCA Civ 419 (Court of Appeal)).

107

[2009] EWHC 2656 (Comm).

108

See Enron Australia v TXU Electricity [2003] NSWSC 1169 for an Australian ruling on this provision.

109

White & Case, "English Commercial Court Allows Counterparty Contractual Right to Withhold Payments under Section 2(a)(iii) of the ISDA Master Agreement" (February 2010) Insight: Derivatives 1, 4.

110

White & Case, "English Commercial Court Allows Counterparty Contractual Right to Withhold Payments under Section 2(a)(iii) of the ISDA Master Agreement" (February 2010) Insight: Derivatives 1, 4, citing Sebel Products Ltd v Commissioners of Customs and Excise [1949] 1 All ER 729 as authority for the proposal.

111

Linklaters, "Section 2(a)(iii) of the ISDA Master Agreement: does it suspend or extinguish obligations?" (9 December 2009) Bulletin 1, 3-4.

112

Linklaters reason that this is because "this term includes "the amounts that became payable (or that would have become payable but for Section 2(a)(iii)) [...] prior to such Early Termination Date")." Linklaters, "Section 2(a)(iii) of the ISDA Master Agreement: does it suspend or extinguish obligations?" (9 December 2009) Bulletin 1, 3-4.

113

Pioneer Freight Futures Co Ltd (In Liquidation) v Cosco Bulk Carrier Co Ltd; Lehman Brothers Special Financing Inc v Carlton Communications Ltd; Britannia Bulk Plc (In Liquidation) v Bulk Trading SA [2012] EWCA Civ 419. See also the decision at first instance: Lomas v JFB Firth Rixson Inc [2010] EWHC 3372 (Ch). See further: David Bunting, "The ISDA Master Agreement: a welcome step to increased certainty." (2011) 22(2) Practical Law Companies 17; Keith Blizzard, "The ISDA Master Agreement – recent judicial decisions." (2011) 18(9) Commercial Law Practitioner 199; Shearman & Sterling, "Case Comment United Kingdom: swap agreements – master agreement." (2011) 26(4) Journal of International Banking Law and Regulation N53; Robin Parson and Matthew Dening, "Firth Rixson: why didn't mandatory set-off apply?" (2011) 26(11) Journal of International Banking and Financial Law 663; and Edward Murray, "Case comment Firth Rixson: section 2(a)(iii) of the ISDA Master Agreement." (2012) 25(1) Insolvency Intelligence 1.

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See also Lehman Brothers Special Financing Inc v Carlton Communications Ltd [2011] EWHC 718 (Ch) where an argument that section 2(a)(iii) of the 1992 Agreement (Multicurrency Cross Border) constituted a walk-away clause was rejected by Briggs J.

115

116

In Perpetual Trustee Co Ltd v BNY Corporate Trustee Services Ltd [2009] EWCA Civ 1160 at [50], Lord Neuberger MR stated that the anti-deprivation principle was "essentially based on the proposition that one cannot contract out of the provisions of the insolvency legislation which govern the way in which assets are dealt with in a liquidation." This was upheld by the Supreme Court where it was stated that "The anti-deprivation principle was essentially directed to intentional or inevitable evasion of the principle that the debtor's property was part of the insolvency estate, and was to be applied in a commercially sensitive manner, taking account of the policy of party autonomy and the upholding of proper commercial bargains." Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd; Butters v BBC Worldwide ltd [2011] UKSC 38 (Supreme Court).

117

Article 4(1) (Clearing obligation) of the EMIR states: "Counterparties shall clear all OTC derivative contracts pertaining to a class of OTC derivatives that has been declared subject to the clearing obligation in accordance with Article 5(2)..."

118

Â§ 723(a) (Clearing requirement) of the Dodd-Frank Act.

119

For example, see Article 7 of Commission Delegated Regulation (EU) No .../.. of 19.12.2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, risk mitigation techniques for OTC derivatives contracts not cleared by a CCP.

120

For example see Article 11 (Risk-mitigation techniques for OTC derivative contracts not cleared by a CCP) of the EMIR.

121

[2010] EWHC 3372 (Ch).

122

[2010] EWHC 3372 (Ch) at paras. [5] and [53] per Briggs J.

123

[2010] EWHC 3372 (Ch) at para. [53] per Briggs J.

124

Steven Edwards, "Legal principles of derivatives." (2002) (Jan) Journal of Business Law 1, 30.

125

Andrea S Kramer and Alton B Harris, "Guest analysis: Negotiating over-the-counter derivative contracts" (July 20, 2010) McDermott Will & Emery LLP and Ungaretti & Harris LLP, Westlaw Business Currents, Thomson Reuters 1, 3.

126

127

Clifford Chance, "ISDA's Master Agreement: it does what it says on the tin." (December 2010) Client Briefing.

128

Carl Baker, "Rethinking the ISDA flawed asset." (2012) 27(6) Journal of International Banking Law and Regulation 250, 250.

129

Whiteley notes that "The protocol process has been developed by ISDA over a number of years as a practical and flexible way of updating huge numbers of (essentially) standard form documents. ISDA publishes the text to document the agreed changes and a prescribed form of adherence letter. ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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Market participants (and not just ISDA members) are invited to send duly executed copies of the adherence letter to ISDA which publishes a list of letters re-ceived on its website. The adherence letter includes a commitment to be bound by the changes for each bi-lateral agreement between the signatory and any other person adhering to the Protocol on those terms. ISDA acts as the parties' agent in determining when the procedural requirements of the Protocol have been met and a binding agreement crystallised between one adhering party and the rest. The key feature of this process is that no amendment or negotiation of the terms of the Protocol (or any other terms) is permitted. Parties sign as is, and must enter into separate bilateral negotiations if they want to change anything. Also, parties are required to waive any liability that ISDA might otherwise incur." Christopher Whiteley, "Valuing derivatives: the Close-out Amount Protocol." (2009) 24(4) Journal of International Banking and Financial Law 202, 202. 130

The United States Foreign Account Tax Compliance Act (FATCA), Public Law 111-147, Stat. 124 Stat. 97-117, in effect from March 18, 2010.

131

See: Frank Lambert, "OTC derivatives The Challenge of deriving clear benefits." (2011) BNP Paribas and BNP Paribas Securities Services and James M Cain, Warren N Davis, Ann M Battle, Doyle R Campbell, and Raymond A Ramirez, "Dodd-Frank necessitates new legal documentation for cleared and uncleared swaps." (July 31, 2011) 44(13) The Review of Securities & Commodities Regulation 155.

132

Aite Group, LLC, "Trends in OTC Equity Derivatives: Where do we go from here?" (October 2006) 1, 9.

133

It is further stated that "When looking at the possible combinations of product and regional documentation, there is a very cumbersome array of possibilities. They quickly add up to a significant universe of documents from both a dealer's and a buy-side client's point-of-view. For instance, a typical, large buy-side firm with just five OTCED dealer relationships would be looking at about 80 possible combinations of product and regional legal documentation." Aite Group, LLC, "Trends in OTC Equity Derivatives: Where do we go from here?" (October 2006) 1, 9.

134

Aite Group, LLC, "Trends in OTC Equity Derivatives: Where do we go from here?" (October 2006) 1, 10.

135

Steven Edwards, "Legal principles of derivatives." (2002) (Jan) Journal of Business Law 1, 30.

136

ISDA, "Mission Statement" (2013) at http://www2.isda.org/about-isda/mission-statement/ [Accessed March 15, 2013].

137

ISDA, "Mission Statement" (2013) at http://www2.isda.org/about-isda/mission-statement/ [Accessed March 15, 2013].

138

Ken Adams, "The 2002 ISDA Master Agreement Isn't a Contract-Drafting Masterpiece." (March 30, 2013) at http://www.adamsdrafting.com/the-2002-isda-master-agreement-isnt-a-contract-draftingmasterpiece/ [Accessed April 30, 2013] Comments by "Westmorlandia" in reply.

139

The General Agreement on Tariffs and Trade 1947.

140

The World Trade Organization.

141

See: Douglas a Irwin, Petros C Mavroidis, and Alan O Sykes, The Genesis of the GATT (Cambridge University Press, 2009) and Peter Van den Bossche, The Law and Policy of the World Trade nd Organization: Text, Cases and Materials (2 edition Cambridge University Press, 2008).

142

In fact, to paint a metaphorical picture, if ISDA is currently in fourth gear then it needs to skip fifth and switch on the NOS (Nitrous Oxide Systems). We are living in the twenty first century, and market counterparties should not have to settle for data rooms full of thousands upon thousands of paper ISDA agreements, with each financial institution spending untold amounts on bespoke in-house digital ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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trade automation and data capture solutions. Instead, collective solutions would significantly benefit from economies of scale, and would likely help to directly reduce spiralling operational and regulatory costs for market participants. As the late Steve Jobs once famously observed, "A lot of times, people don't know what they want until you show it to them". In the present case it is opined that what is actually needed is no longer a static paper document template, but instead the ISDA Master Agreement should be transformed into a dynamic digital ISDA software program for universal use by all market counterparties. This would be in the same vein as, or a combination of, the Microsoft ® "Word " software program, the IRIS Laserform program, and other document automation and assembly software (e.g. "Business Integrity", "HotDocs", or "XpressDox"). It is envisaged that the ISDA Master Agreement software program would transpose the ISDA Master Agreement architecture into a digital scalable form accessible by any market counterparty. What this actually means is that the ISDA Master Agreement could be created in a digital format by answering a series of questions and selecting different options, and the digital agreement could then be seamlessly passed around and amended internally or externally more quickly and efficiently. Counterparties would also have instant access to ISDA Definitions, Protocols, amendment templates, etc. at the touch of a button. The Master Agreement could also be digitally signed and executed, and then stored in a counterparty's interactive ISDA databank that would allow counterparties to inter alia digitally measure net credit exposures, threshold levels, potential default scenarios, and other metrics continuously in real-time. Walter Isaacson, Steve Jobs: The Exclusive Biography (Little, Brown, 2011). 143

Section 2(c) of the 2002 Agreement.

144

145

For example, the Compendium would include explanations or guides to potential problem issues such as the consequences of allowing default positions regarding a counterparty's right to transfer without consent (section 7 (Transfer) of the 1992 and 2002 Agreements; Incorporation of Loan Covenants in Part 5 of the ISDA Schedule; and the consequences of "Most Favoured Nation Clauses" in ISDA Master Agreements. Matt Hoffman and Mike Ashby, "ISDA Negotiations: Sweat the Small Stuff." (December 10, 2012) at http://www.chathamfinancial.com/isda-negotiations-sweat-the-small-stuff/ [Accessed April 15, 2013].

146

See: Peter Gottschalk, "Predictors of IT support for knowledge management in the professions: an empirical study of law firms in Norway." (2000) 15(1) Journal of Information Technology 69; Fawzy Soliman and Keri Spooner, "Strategies for implementing knowledge management: role of human resources management" (2000) 4(4) Journal of Knowledge Management 337; Laurie Hunter, Phil Beaumont, Matthew Lee, Knowledge management practice in Scottish law firms (April 2002) 12(2) Human Resource Management Journal 4; Vijay K Khandelwal and Petter Gottschalk, "Information Technology Support for Interorganizational Knowledge Transfer: An Empirical Study of Law Firms in Norway and Australia" (2003) 16(1) Information Resources Management Journal 14; and Matthew Parsons, Effective Knowledge Management for Law Firms (Oxford University Publishing, 2004).

147

Section 5(b)(iv) of the 1992 Agreement and section 5(b)(v) of the 2002 Agreement.

148

Karen Greenidge and Jan Job de Vries Robbé, "The 2002 Master Agreement: An End-User's Perspective." (2004) 19(7) Journal of International Banking and Financial Law 258.

149

Karen Greenidge and Jan Job de Vries Robbé, "The 2002 Master Agreement: An End-User's Perspective." (2004) 19(7) Journal of International Banking and Financial Law 258.

150

Karen Greenidge and Jan Job de Vries Robbé, "The 2002 Master Agreement: An End-User's Perspective." (2004) 19(7) Journal of International Banking and Financial Law 258.

151

Karen Greenidge and Jan Job de Vries Robbé, "The 2002 Master Agreement: An End-User's Perspective." (2004) 19(7) Journal of International Banking and Financial Law 258.

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Karen Greenidge and Jan Job de Vries Robbé, "The 2002 Master Agreement: An End-User's Perspective." (2004) 19(7) Journal of International Banking and Financial Law 258.

153

"Default Rate" is defined in the 1992 and 2002 Agreements to mean "a rate per annum equal to the cost (without proof or evidence of any actual cost) to the relevant payee (as certified by it) if it were to fund or of funding the relevant amount plus 1% per annum." Consequently, Defaulting counterparties that may be in financial difficulties, bankrupt, or insolvent, may have much higher costs of funding (e.g. 15-30% rates) which can still validly be claimed even though the counterparty has defaulted.

154

Anthracite Rate Investments (Jersey) Ltd v Lehman Brothers Finance SA (In Liquidation); Fondazione Enasarcov Lehman Brothers Finance SA [2011] EWHC 1822 (Ch).

155

Shahien Nasiripour, Tom Braithwaite, Tracy Alloway, "Report portrays loss of control at JP Morgan." (March 15, 2013) Financial Times at http://www.ft.com/cms/s/0/ccb99df4-8d75-11e2-a0fd00144feabdc0.html#axzz2R0CN8YNr [Accessed April 15, 2013].

156

Karen Greenidge and Jan Job de Vries Robbé, "The 2002 Master Agreement: An End-User's Perspective." (2004) 19(7) Journal of International Banking and Financial Law 258.

157

Karen Greenidge and Jan Job de Vries Robbé, "The 2002 Master Agreement: An End-User's Perspective." (2004) 19(7) Journal of International Banking and Financial Law 258.

158

The Global Documentation Steering Committee (GDSC), "Improving Master Agreement and Related Trading Agreement Negotiations." at http://www.newyorkfed.org/globaldoc/gd_projects.html [Accessed April 15, 2013].

159

For example, see: "acting in a reasonable manner and in good faith" (sections 8(a) and 8(b) of the 1992 Agreement); "amount that party reasonably determines in good faith to be its total losses and costs" (definition of "Loss" in section 14 (Definitions) of the 1992 Agreement); "The Replacement Transaction would be subject to such documentation as such party and the Reference Market-maker may, in good faith, agree." (definition of "Market Quotation" in section 14 (Definitions) of the 1992 Agreement); "denominated at the rate of exchange at which such party would be able, in good faith and using commercially reasonable procedures" and "X may in good faith estimate that obligation" (section 6(f) (Set-Off) of the 2002 Agreement); "acting in good faith and using commercially reasonable procedures" (sections 8(a) and 8(b) of the 2002 Agreement); "Good Faith and Commercially Reasonable Manner. Performance of all obligations under this Annex, including, but not limited to, all calculations, valuations and determinations made by either party, will be made in good faith and in a commercially reasonable manner." (section (b) of Paragraph 9 (Miscellaneous) of the ISDA CSA).

160

161

§1-201(1)(b)(20) of the Uniform Commercial Code defines good faith to mean "honesty in fact and the observance of reasonable commercial standards of fair dealing."

162

E Allan Farnsworth, "Good Faith Performance and Commercial Reasonableness Under the Uniform Commercial Code" (1963) 30 The University of Chicago Law Review 666. See also: Eisenberg who argued that "Good faith must be an integral part of all business transactions, and the term and the concept must be applied in a manner to give the term justice, to make it viable, and to permit the concept to be used on a day-to-day practical level." Russell A Eisenberg, "Good faith under the Uniform Commercial Code – A new look at an old problem." (1971) 54(1) Marquette Law Review 1, 18.

163

Burton stated " "Good faith" in contract performance means exercise-ing any discretion for reasons within the parties' justifiable expectations arising from their agreement. "Good faith" in contract enforcement means asserting any remedial powers, whether provided by contract or law, when © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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justified by their remedial purposes." Steven J Burton, "Good Faith in Articles 1 and 2 of the U.C.C.: The Practice View." (1994) 35(4) William and Mary Law Review 1533, 1536 and 1545. 164

See: Stathis Banakas, "Liability for Contractual Negotiations in English Law: Looking for the Litmus Test." (February 2009) InDret 1.

165

See: Royal Bank of Scotland v Highland Financial Partners LP [2010] EWHC 3119 (Comm) and Barclays Bank Plc v Unicredit Bank AG (formerly Bayerische Hypo-und Vereinsbank AG) ]2012] EWHC 3655 (Comm).

166

Yam Seng Pte Ltd v International Trade Corp Ltd [2013] EWHC 111 (QB). See also: Royal Brunei Airlines Sdn Bhd v Tan [1995] 2 AC 378.

167

CPC Group Ltd v Qatari Diar Real Estate Investment Co [2010] EWHC 1535 (Ch), at para. [246] per Vos J. See also: Monkland v Jack Barclay Ltd [1951] 2 KB 252; UBH (Mechanical Services) Ltd v Standard Life Assurance Company The Times, November 13, 1986; Rhodia International Holdings Limited v Huntsman International LLC [2007] EWHC 292 (Comm); and Yewbelle Limited v London Green Developments Limited [2007] EWCA Civ 475.

168

The 2012 Agreement would provide both English law and New York law definitions in section 14 (Definitions) with the final choice to be elected in the Schedule.

169

See: ISDA, "2009 Collateral Dispute Resolution Procedure." at http://www.isda.org/c_and_a/pdf/ISDA2009-Dispute-Resolution-Procedure.pdf [Accessed March 15, 2013].

170

Siddharth Dhar, "ISDA 2002 Master: should the "value clean" principle apply?" (2012) 27(8) Journal of International Banking and Financial Law 476.

171

Lehman Brothers International (Europe) v Lehman Brothers Finance SA [2012] EWHC 1072 (Ch) before Briggs J.

172

[2013] EWCA Civ 188 (Court of Appeal (Civil Division)).

173

Baker defines flawed asset by stating that "The commercial effect of s.2(a)(iii)(1) is to condition performance by a non-defaulting party. This is said to create a "flawed asset" because the obligation of a non-defaulting party to pay or deliver that would otherwise arise (i.e. the "asset") is flawed by being subject to the stated condition." Carl Baker, "Rethinking the ISDA flawed asset." (2012) 27(6) Journal of International Banking Law and Regulation 250, 250. See also: "ISDA "WITHHOLDING/CONDITIONALITY" AND "FLAWED ASSET" APPROACHES" in Anthony C Gooch and Linda B Klein, Documentation for Derivatives Volume II (Euromoney Books, 2002) 1295.

174

Baker argues inter alia that: (i) the flawed asset contributes to moral hazard risk; (ii) the flawed asset contributes to systemic risk; (iii) English case law has highlighted issues in the drafting of the flawed asset; (iv) US legislation and Bankruptcy Court rulings significantly undermine the flawed asset; (v) the flawed asset jeopardises regulatory netting; (vi) the flawed asset impedes accounting for OTC derivatives; (vii) the flawed asset has become less necessary due to evolving market practices; (viii) there is an alternative to the flawed asset already in the ISDA Agreement. Carl Baker, "Rethinking the ISDA flawed asset." (2012) 27(6) Journal of International Banking Law and Regulation 250.

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CHAPTER 6: THE ISDA MASTER AGREEMENT: THE DERIVATIVES RISK MANAGEMENT TOOL OF THE 21ST CENTURY? ®

OUTLINE ■ ■ ■ ■ ■ ■ ■ ■

Overview. Introduction. Risk Management and Financial Markets. Risk Management and OTC Derivatives Markets. Risk Management and the ISDA Master Agreement. Significant Developments in the ISDA Master Agreement Framework. Conclusion. Definitions.

CHAPTER 6 ABBREVIATIONS

Table 20: Chapter 6 Abbreviations ABBREVIATION

TERM

BFIs

Banks and Financial Institutions.

BIS

Bank of International Settlements.

CCP

Central Counterparty.

CSAs

Credit Support Annexes.

CSDs

Credit Support Documents.

CSP

Credit Support Provider.

EMIR

European Market Infrastructure Regulation.

European Union.

IIFM

International Islamic Financial Market.

IRS

Interest Rate Swaps

ISDA

International Swaps and Derivatives Association, Inc.

ISO

International Organization for Standardization.

ISO 3100

ISO 31000 – Risk Management.

MSAs

Master Swap Agreements.

NAFMII

National Association of Financial Market Institutional Investors.

OTC

Over-the-counter.

STP

Straight-Through-Processing.

The Dodd-Frank Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act 2010.

United States.

VaR

Value at Risk.

OVERVIEW

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2017 This chapter provides a critical and evaluative analysis of the ISDA Master Agreement operating architecture. It argues that in principle, the ISDA Master Agreement has come to gain the title of 'The Derivatives Risk Management Tool of the 21st Century". In order to explain and justify this conclusion, the chapter sets out the aims of risk management in financial markets and over-the-counter derivatives markets. It also examines in detail how the cumulative provisions of the ISDA Master Agreement framework operate in practice, in terms of how they effectively manage and mitigate the legal and financial risks faced by over-the-counter derivatives markets counterparties. The chapter also examines how the derivatives markets trade organisation, the International Swaps and Derivatives Association, Inc., has continually strived to develop and improve the ISDA Master Agreement operating framework during its tenure. Finally, it demonstrates how these efforts have significantly contributed to the overall development of over-the-counter derivatives markets, as well as explaining why the ISDA Master Agreement will likely continue to prevail for the foreseeable future.

INTRODUCTION 175

In today's modern world of finance, the 'ISDA Master Agreement' has become completely ingrained into the very fabric of commercial banking and finance operations. Its market ubiquity is clearly evident, from its burgeoning presence documenting hedge fund transactions, to its widespread documentation of investment portfolio derivatives hedging strategies. It is the financial tool for 176 Yet it could also be argued that documenting over-the-counter (OTC) derivatives transactions. recent regulatory developments for OTC derivatives markets on both sides of the Atlantic, have called into question its significance going forwards. For example, in the United States (US), the Dodd-Frank 177 (the Dodd-Frank Act) now requires inter Wall Street Reform and Consumer Protection Act 2010 alia the centralised clearing of OTC derivatives by centralised counterparties (CCPs). The same requirement is imposed on OTC market participants by the European Market and Infrastructure 178 Regulation (the EMIR) across the European Union (the EU). Thus in theory, it might be said that this increased standardisation of centrally cleared OTC derivatives transactions might herald the end of an era for the ISDA Master Agreement. Is such an argument well-founded, or will the ISDA Master Agreement prevail? In order to answer these questions this chapter will critically explore the ISDA Master Agreement's use as a risk management tool. Elsewhere I have previously critically argued for the need for substantive improvements to the 179 Yet, in the interests of overall fairness, I can also ISDA Master Agreement operating framework. see the need to expound upon the very significant achievements that have been made by the ISDA Master Agreement during its operating tenure. Consequently, this chapter will seek to explain in layman's terms, the overall aims of risk management as regards financial and OTC derivatives markets. It will also explain the workings of risk management, most notably in relation to counterparty risk and legal risk, as applied under the ISDA Master Agreement framework. Finally, the chapter will chart significant developments that have accrued under the ISDA Master Agreement architecture, as well as explaining why the ISDA Master Agreement will still be needed, despite recent OTC derivatives regulatory developments. The chapter will do all this with a view to objectively demonstrating that overall, the ISDA Master Agreement has clearly gained the title of 'The Derivatives Risk Management Tool of the 21st Century'.

RISK MANAGEMENT AND FINANCIAL MARKETS

Managing risk is something that comes naturally to humans. We manage risk every time we cross the road, get into a car, board a plane, or have a smoke or a drink. All these activities carry some inherent risk, for example that we might get knocked over, have a crash, or contract an illness such as lung cancer. Yet at either a conscious or subconscious level, we have already evaluated and weighed the most important attendant risks, and come to an overall decision in respect of that activity. Essentially, as humans we either ignore the risk; we accept the risk on the basis that the inherent risks have a low probability of occurring; we reject the risk and do not take part in the activity; or we mitigate the risks, by for example wearing a seatbelt or only smoking occasionally. Nevertheless, the inherent difficulty with financial markets, is they are not only predicated on artificially constructed capitalist theories, but they are also comprised of invisible and non-intuitive risks.

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2017 What this means in practice is that, in respect of the former, financial markets are essentially based on free-market economic theories of capitalism which have been created by people, but whose effects are not entirely predictable. Free markets mean financial profits for some people and losses for others, with Adam Smith's 'invisible hand' working to naturally correct any imbalances in this free 180 The artificial nature of these economic theories also means that we are unable to market. completely predict how they function in practice, because if we could, then everyone would always make profitable trades or investments. Consequently, individuals who invest in financial markets and financial instruments are essentially speculating that their investments will be profitable, and that they will see a financial return, i.e. profit. But, there is always a risk that investments will lose value, or even that all the investment will be lost. What is meant in respect of the latter point, is that financial markets and financial products carry risks which are invisible and which cannot be logically worked out by humans intuitively. Unlike a road or moving cars, financial products are not visible to the human eye â&#x20AC;&#x201C; they must be documented or created electronically. You cannot see an 'option' or a 'future', you can only see them in documentation or electronic terminals evidencing their existence. In the same way you cannot physically see what risks an option or a future carries with the human eye. If someone asks "How much risk does a pension investment carry?" it is usually not possible to immediately understand the risks involved, and provide an instant answer. Further information is required, for example, things such as what the term of the investment is; how much money is invested; which firm is the pension invested with; how creditworthy the firm is; what investments does that firm invest in; how much assets under management does that firm have; what is the legal framework governing pensions; or what taxation is applicable to pensions? In theory, these are all issues that might affect the ultimate amount of the pension investment, and either directly or indirectly, how much risk the pension investment carries. Consequently, risk management in financial markets is all about identifying risks which exist, or may exist, in financial markets or financial products, as well as developing ways to 'financially model' these risks; aggregate or combine 181 these risks; and use the information obtained to make an informed investment decision. An investor's 'risk appetite' is generally said to refer to the amount or levels of financial risk that an investor is willing to bear, or have attached to the investment. Therefore, a risk-averse investor is said to have a very low tolerance for financial risks and will wish to avoid or mitigate as much risk and uncertainty in the financial products that are invested in. Such an investor might invest in government bonds with high credit ratings such as UK 'gilts', which carry very low levels of credit risk, currency risk, and inflation risk, and therefore low investment risks overall. On the other hand, investors with higher levels of risk appetite or risk tolerance, would likely be open to investing in riskier or more speculative financial products, such as derivatives (e.g. options, futures, swaps, forwards). Indeed, in practice a large number of different financial risks exist, including (but not limited to): (i) commodity risk; (ii) counterparty risk; (iii) credit risk; (iv) foreign exchange (or currency) risk; (v) interest rate risk; (vi) legal risk; (vii) liquidity risk; (viii) reputational risk; and (ix) sovereign risk. Nevertheless, whilst in theory financial markets and financial products may be exposed to any one, or all, of these risks at any one time, in practice investors typically tend to concentrate on the risks most directly relevant to the investment. In fact according to a recent (November 2012 to January 2013) industry survey of C-Level executives, Treasurers, and other business leaders across different financial functions, the top five prioritized financial risks (ranked on a scale of 1-5) were: (i) interest rate risk (3.64); (ii) counterparty risk (3.61); (iii) sovereign risk (3.35); (iv) liquidity risk (3.19); and (v) 182 commodity risk (3.19). This prioritisation typically reflects the greater 'risk-weightings' or severity attached to these types of risks by those individuals or firms operating in financial markets, i.e. higher risk probabilities involved. For example, in very large, transparent and established financial markets, liquidity risk may be relatively smaller, because markets will normally be highly 'liquid' (i.e. lots of active trading), and there may be little probability (i.e. risk) of there being no market for a widely-traded asset. Therefore liquidity risk may not be factored into any financial risk assessment undertaken, or alternatively it may be assigned a low risk-weighting overall. At the same time, commodity risk may relate to risks that are probable but unlikely, for example extreme bad weather may affect the production of coffee beans, by limiting supply and increasing overall prices. But the probability of this type of risk is ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 normally low, because extreme weather such as inland storms, hurricanes or typhoons does not typically occur on a regular basis in many coffee producing countries. Consequently, this is likely why liquidity risk and commodity risk attract lower risk rankings overall. In reality, different financial markets and products may carry a very broad range of attendant financial risks. Those individuals or firms dealing in these financial markets may therefore also employ a very wide range of financial risk management tools and practices. For example in outline, financial modelling involves the use of a variety of quantitative statistical or mathematical tools, to build and develop an abstract 'model' that is intended to represent real world financial situations or markets. Software spreadsheets or advanced numerical analysis software can be used to create models, for example by using complex algorithms, to represent interest rates; investment portfolio predicted performance; option pricing; credit scoring or rating; or modelling Value at Risk (VaR). Other notable quantitative financial risk management tools include: (i) catastrophe modelling; (ii) default probability modelling; (iii) loss forecasting; (iv) stress testing; and (v) the Capital Asset Pricing Model. Alternatively, other commonly used financial risk mitigation strategies or techniques include the use of 183 credit ratings, 'collateral' , or 'asset securitisation'.

RISK MANAGEMENT AND OTC DERIVATIVES MARKETS

Historically speaking, 1987 was an auspicious year for financial risk management. In that year the International Swaps and Derivatives Association, Inc. (ISDA) published two standard form 'Master Swap Agreements' (MSAs) which aimed to document, simplify, and standardise 'swap' agreements made between two counterparties. These were the '1987 ISDA Interest Rate and Currency Exchange 184 185 186 and the '1987 ISDA Interest Rate Swap Agreement' . In that same year the Agreement' financial magazine 'Risk' was founded by Peter Field. Why were these two developments important? Firstly, the establishment by ISDA of the two MSAs put their usage to the market litmus test. If there had been little take-up or use by the financial markets, then they would not have gone on to become a foundation stone for ISDA's subsequent Master Agreements. As will be seen, they became very widely used by market counterparties, and their substantive operating provisions were transferred and built-upon, through the subsequent publication by ISDA of two new Master Agreements. 187 These were the 1992 ISDA Master Agreement (Local Currency – Single Jurisdiction) and the 1992 188 189 (the 1992 Master Agreement). In ISDA Master Agreement (Multicurrency – Cross Border) relation to the MSAs, one covered only interest rate swaps (IRSs) whereas the other covered both IRSs and currency swaps. Kwaw notes that a key point about the MSAs, was that they both contained accompanying 'schedules' which made it possible for counterparties to list other terms that were specific to the swap between the counterparties, i.e. they could tailor the master agreement to 190 There are a few more points about the MSAs noted by Kwaw, including that: (i) their own needs. the MSAs governed all subsequent swaps entered into by counterparties simply by referencing the MSA; (ii) this master swap provision ensured certainty for counterparties; and (iii) the swap agreement provisions applied equally to both parties (i.e. not like a debtor-creditor relationship under a loan 191 agreement). Added to this, the publication of 'Risk', a financial magazine specifically devoted to news and analysis of financial risk management, helped to pave the way for widespread origination and dissemination of financial risk information. At this time, the internet was just starting to be commercially developed, and very few financial magazines were specifically devoted to risk analysis. It is arguable that this type of dissemination of financial risk information is vital to the healthy development and functioning of 192 As the magazine's expertise grew, so too did the number of market competitors, capitalist markets. thereby allowing a financial risk information market to flourish. It can be argued that over time, this increased the market transparency of financial products; risk management tools, practices and techniques; and market developments, across-the-board. For example, from 1 July 2000 to 30 June 193 2001, Risk's total average net circulation per issue was listed as 7,728. Yet, nowadays Risk publishes "articles on the fast-moving worlds of complex and sophisticated finance, regulation, derivatives, and risk management", and attracts readers from all corners of the 194 Furthermore, it now covers an extremely broad range of risk topics, including strategic world. analysis of: (i) hedge funds; (ii) economic and regulatory risk capital, derivatives hedging instruments and structured products investments in the Asia-Pacific region; (iii) risk and capital management intelligence to the life and pensions industry; (iv) operational risk and regulation; (v) structured © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 products (i.e. guaranteed equity products, structured notes, index products, alternative investments and funds of funds; and (vi) energy risk (i.e. oil, gas, electricity, coal, emissions, freight and weather 195 These financial risk management news items, articles, and insights are accessed by markets). hundreds of thousands of readers across the world. This not only demonstrates the enormous inroads made by Risk (and other financial risk magazines) into the dissemination of financial risk management information, but also the explosion of OTC derivatives markets globally. According to recent statistics released by the Bank of International Settlements (BIS), the 'notional amount' outstanding in global OTC derivatives markets was US$693 trillion at end-June 2013, as 196 This highlights compared to the 'gross market value' of OTC derivatives valued at US$20 trillion. the extremely widespread and developed nature of global OTC derivatives markets. These markets have thrived despite the inherent complexities of OTC derivatives origination, documentation and trading. It should be noted that unlike exchange-traded derivatives, whose trading is publicly facilitated by a recognised investment exchange such as the Chicago Mercantile Exchange, historically OTC derivatives transactions have been carried out on a bilateral basis between two counterparties. This means that each counterparty has had to carry out its own risk management due diligence on the other counterparty with which it is trading with. This might include, for example, investigations into the counterparty's credit ratings, its creditworthiness, its operating structure, and its firm capitalisation. Risk management techniques in OTC derivatives markets have normally centred on directly addressing or mitigating counterparty risk exposures. This is partly because the way in which normal OTC derivatives (e.g. swaps) function, involves payments from one counterparty to another counterparty, and vice versa, depending on the 197 This means that normally, the greatest risk under obligations underlying the derivative instrument. an OTC derivatives contract, is that the other counterparty to the transaction will not be able to make its payment under the contract when the times comes, because of credit problems, i.e. counterparty risk. Counterparties to OTC derivatives transactions typically used risk management techniques such as: (i) setting credit limits for counterparties; (ii) financial guarantees; (iii) collateralisation; (iv) margin; 198 and (v) legal protection through bilateral documentation. Credit limits (or credit lines) are usually an authorised aggregate upper credit limit for all outstanding transactions set for one counterparty by another counterparty. This reflects the level of overall credit risk or exposure with which that single counterparty is comfortable with. But inherent problems do exist with these types of credit limit, as they may ultimately prove to be arbitrary or inaccurate, or may actually hinder the development of larger commercial transactions. There are also problems with the use of financial guarantees. This is because such financial guarantees are normally only accepted by counterparties if they have high levels of 'regulatory capital' (or 'capital adequacy') available. This means that for most small to medium-sized financial counterparties, financial guarantees will only be accepted from parent companies, or from much larger and established banks and financial institutions (BFIs). This may prove to be either too difficult to execute, or prohibitively expensive in practice. Consequently, collateralisation has become the norm in OTC derivatives markets. Collateralisation simply refers to the practice of using the pledge of cash or property (e.g. government securities, corporate bonds, equities) to secure a counterparty's credit obligations under an OTC derivatives contract. It involves one counterparty transferring or delivering collateral (referred to as 'posting' or 'pledging') directly to the other counterparty. If a counterparty's credit exposure is increased overall, then a 'margin call' is normally made, meaning that additional collateral is required to be posted to secure continuing obligations under an OTC derivatives contract. According to ISDA's latest 'Margin Survey', the amount of collateral in the global non-cleared OTC 199 In practice the use of derivatives market was US$3.70 trillion as at 31 December 2012. collateralisation directly reduces credit risk and has become widely used as a financial risk management tool principally because of its ease of use. Indeed ISDA observes that "This discretionary, prudential management of credit risk, which may include the use of collateral, is a common feature across a wide range of products in the capital and retail financial markets, including 200 It is also noted that the number of loans, derivatives, clearance and other types of transactions." active collateral agreements (with exposure or collateral balances) supporting non-cleared OTC

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2017 derivatives transactions was 118,853 at end-2012. 202 documented using ISDA agreements.

201

Moreover, 87% of these agreements were

RISK MANAGEMENT AND THE ISDA MASTER AGREEMENT

Is has to be said that the risk management framework conceived by the ISDA Master Agreement architecture is superb. From the de facto market standardised boilerplate OTC derivatives contracts, to the netting provisions, and right through to the Events of Default and Termination Events. Under the ISDA Master Agreement these all combine with an eloquent finesse to provide OTC derivatives market counterparties with legal certainty, effective credit risk mitigation, and business flexibility in equal measure. In short, the ISDA Master Agreement addresses OTC derivatives counterparty risk by: (i) providing clear valuation methods; (ii) clear termination provisions (i.e. Events of Default, Termination Events; Early Termination; Force Majeure provisions); (iii) enforceable close-out netting; and (iv) enhanced and efficient collateral management processes. It also addresses OTC derivatives legal risk by: (i) providing widespread assured legal enforceability (i.e. enforceability legal opinions for different jurisdictions commissioned by ISDA); (ii) increasing legal certainty through tried-and-tested and globally accepted standardised documentation for OTC derivatives, collateral and other credit support; and (iii) mitigating legal dispute risk through the provision of widespread explanatory resources in respect of the ISDA Master Agreement (e.g. ISDA guidance booklets, guidelines, legal opinions, and multiple sets of standard product definitions booklets). But this risk management framework was not dreamt up overnight. It is the product of at least two decades of OTC derivatives markets developments and adaptations, and is therefore built on very sturdy foundations. Whereas the 1987 MSAs paved the way towards market standardisation and take-up, the 1992 Master Agreement took derivatives documentation to a whole new global level. In fact, Braithwaite even argued that the ISDA Master Agreement standard form contracts metamorphosed from "simple 203 creatures of national contract law" into something akin to the status of transnational private law. What is certain, is that the 1992 Master Agreement provided an operating framework which brought much needed clarity, certainty, efficiency, standardisation and working flexibility to OTC derivatives markets. This has undoubtedly helped to facilitate the growth in OTC derivatives markets across the world. As will be seen, there are still some remaining difficulties in regards to substantive operating provisions and language, but at the end of the day, nothing is perfect. Regardless, in this short space of time the ISDA Master Agreement has gone on to become the dominant contract for documenting OTC derivatives globally. For instance, Harding remarks that, not only is it an extremely versatile agreement, but since its original publication, "it has become the pre-eminent, market standard multiprod-uct Master Agreement for parties who plan to enter into a series of OTC derivatives 204 The Honourable Mr Justice Briggs in the English legal case of transactions with each other". Lomas v JFB Firth Rixson Inc even accepted that it served as "the contractual foundation for more than 90 per cent of over-the-counter derivatives transactions globally", adding it was "one of the most widely used forms of agreement in the world. It is probably the most important standard market 205 agreement used in the financial world." From the outset, it is submitted that one of the most effective parts of the ISDA documentation architecture has turned out to be its 'modular' nature, i.e. a Master Agreement which can be 'built upon'. What this actually means is that the 1992 Master Agreement itself is essentially split into two. 206 The first part consists of an eighteen page pre-printed boilerplate form containing fourteen clauses , as well as execution blocks for each counterparty. This standard form is normally never amended by the counterparties, and the parties instead amend and tailor the second part of the document, which 207 The terms of this consists of a six page 'Schedule' to the Master Agreement (the ISDA Schedule). core operating agreement then govern all subsequent OTC derivatives transactions that are entered into between the counterparties, i.e. it is the 'master' agreement of all subsequent OTC derivatives trade agreements. The financial and economic terms of each subsequent transaction are documented in what is known 208 In addition, the counterparties can then further 'build' on this core as a 'Confirmation' document. ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 agreement by executing collateral arrangements using ISDA standard form documentation that was specifically prepared for use in conjunction with the ISDA Master Agreements. These originally 209 included: (i) the 1994 ISDA Credit Support Annex (Security Interest – New York Law) ; (ii) the 1995 210 ISDA Credit Support Annex (Transfer – English Law) ; (iii) the 1995 ISDA Credit Support Deed 211 (Security Interest – English Law) ; and (iv) the 1995 ISDA Credit Support Annex (Security Interest – 212 Japanese Law) . But they have also been updated in recent times: (i) the 2008 ISDA Credit Support 213 Annex (Loan/Japanese Pledge) ; (ii) the ISDA 2013 Standard Credit Support Annex (Transfer – 214 English Law) ; and (iii) the ISDA 2013 Standard Credit Support Annex (Security Interest – New York 215 Law). The modular nature of the ISDA Master Agreement is also bolstered by the use of a wide range of supporting materials, including: (i) many different sets of product definition booklets (which standardise commonly used terms and can be directly incorporated by reference in the ISDA 216 Schedule) ; (ii) many different sets of ISDA 'User's Guides' (which explain in detail how each 217 ; (iii) ISDA 'standard form amendments' (which standardise common document functions) 218 amendments to ISDA agreements) ; (iv) ISDA 'Protocols' (multilateral contractual amendment 219 Protocol and ISDA 2013 EMIR NFC Representation mechanisms, e.g. the ISDA 2012 FATCA 220 Protocol) ; (v) ISDA 'Opinions' (legal opinions commissioned by ISDA on the enforceability of the 221 whole or parts of ISDA Master Agreements) ; and (vi) ISDA 'Guidelines' (official guidance from ISDA 222 regarding best practices). These modular sets of ISDA documents have allowed OTC derivatives market counterparties to increasingly standardise common OTC derivatives practices, whilst at the same time providing counterparties with the wide range of flexibility needed to tailor ISDA Master Agreements to suit their own specific risk needs. What is more, the modular nature of the ISDA documents has also allowed the documents to be updated on a semi-regular basis to reflect the most current operating practices. For example, following on from the 1992 Master Agreement it was noted that inconsistencies and variations in events of default, grace periods, close-out, valuation and notice provisions, among the 223 different master agreements used in the OTC markets, created 'documentation basis risk'. This, along with other issues relating to inter alia sovereign risk, impossibility, force majeure, closeout, and valuation provisions (or the lack thereof), led to broad changes in the ISDA Master Agreement substantive framework. The new 'ISDA 2002 Master Agreement' (the 2002 Master Agreement), therefore contained a number of changed and updated provisions, including: (i) new close-out procedures and amounts; (ii) new force majeure termination events; (iii) expanded Events of Default and Credit Event Upon Merger Termination Events; (iv) a new set-off clause; and (v) reduced 224 Grace Periods. But how does the ISDA risk management framework function in practice? In truth, as has been seen by recent events in the EU and the US, the centralised clearing of the majority of OTC derivatives by CCPs is the ideal solution for very large OTC derivatives markets. This is because of the increased efficiency and transparency offered by CCPs; their overall mitigation of counterparty risk through novation of OTC contracts; their automatic use of margin calls, and by them directly addressing systemic risk concerns via mutualisation of counterparty risk, multilateral netting, crisis management rules, and large default funds. But the inherent difficulty with centralised clearing of OTC derivatives is the massive complexity and costs involved. But before OTC derivatives markets grew to such enormous sizes, historically they were unregulated and initially developed on a 'bilateral' basis, meaning that one counterparty traded with another counterparty, setting up a bilateral trading arrangement between them. The counterparties would negotiate the contractual terms governing their trades, more often than not using the ISDA Master Agreement, and amending or tailoring the ISDA Schedule to reflect the terms of the OTC derivatives trading relationship. The terms of the ISDA Schedule would typically reflect the strength of the negotiating positions of each counterparty; the credit risk profiles of each counterparty; as well as the circumstances in which either counterparty could terminate any or all open OTC derivatives positions. As OTC derivatives markets grew, and the ISDA Master Agreement became the standard operating agreement for documenting OTC derivatives transactions, ISDA updated and amended the Master Agreement to better reflect market practices and standards.

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2017 It is the cumulative effect of a number of substantive operating provisions and factors affecting the ISDA Master Agreement that make it such an effective OTC derivatives risk management tool. These include: (i) standardisation; (ii) legal certainty; (iii) netting and set-off; (iv) termination provisions and valuation methods; (v) collateral arrangements; and (vi) other supporting provisions. Firstly, because it has become the standard agreement for documenting OTC derivatives transactions, transactional costs and document basis risk are reduced. Counterparties have become highly accustomed to, and knowledgeable about, the 1992 and 2002 ISDA Master Agreement provisions; Credit Support Annexes (CSAs); Credit Support Documents (CSDs); and ISDA Definitions. There is little to no duplication of costs because there is little to no need to amend a wide range of different types of OTC derivatives documentation. Standardisation also likely increases work output efficiencies (work output increases as OTC documentation teams become increasingly acquainted with ISDA negotiation and documentation issues) as well as reducing risks of documentation errors (different types or formats of OTC documentation do not need to be reviewed). Secondly, the increased legal certainty of the ISDA Master Agreement framework has resulted in an overall reduction in legal risk as well as increased market confidence. There is an increased level of legal certainty because the ISDA Master Agreement provisions have been in operation now for a very long time, and OTC derivatives market counterparties have become highly acquainted with how they operate. In addition, over time the courts in various jurisdictions have ruled on various aspects of the substantive operating provisions of the ISDA Master Agreements, providing further legal clarification on precisely how they operate to market counterparties. For example, notable cases in the UK include cases such as (i) AS Klaveness Chartering v Pioneer 225 (ii) Marine Trade SA v Pioneer Freight Freight Futures Co., Ltd, Pioneer Metals Co., Ltd (2009) 226 227 Futures Co Ltd BVI (2009) ; Lomas v JFB Firth Rixson (2010) ; (iii) Lehman Brothers Special 228 Financing Inc v Carlton Communications Ltd (2011) ; (iv) Pioneer Freight Futures Company Ltd (in 229 230 liq) v TMT Asia Ltd (2011) ; and (v) Britannia Bulk plc (in liq) v Pioneer Navigation Ltd (2011) . Notable cases in Australia include cases such as SIMMS and Another (in their capacity as liquidators 231 of Enron Australia Finance Pty Ltd (in liq)) v TXU Electricity Ltd (2003) . Also, notable cases in the 232 US include cases such as In re Lehman Brothers Holdings, Inc. (2010) . Whilst these cases have provided elucidation of ISDA principles, they also demonstrate the low level of counterparty disputes over the application of ISDA Master Agreement principles, i.e. there are not dozens upon dozens of legal cases every year, indicating high levels of agreement over operational provisions. What is more, the ISDA Master Agreement framework has been effectively stress-tested in practice. When Lehman Brothers Holdings Inc. (Lehman) collapsed in 2008, it triggered a massive unwinding of thousands of OTC derivatives positions held and documented under the ISDA Master Agreement framework. Whilst there was a great deal of panic in the market, on the whole the framework facilitated the unwinding of the majority of counterparty derivatives positions held by Lehman. To provide a fair assessment of the situation, the collapse did highlight some deficiencies in the ISDA Master Agreement framework. Indeed ISDA has been working to rectify this situation. For example it has sought to reduce systemic risk concerns by deliberating on the possibility of including a shortterm suspension standard provision in ISDA Master Agreements, to allow for a moratorium in the 233 case of such a massive bankruptcy of a systematically important banking institution. Thirdly, the ISDA Master Agreement provides for both payment netting and close-out netting, as well as set-off provisions. Payment netting allows counterparties to OTC derivatives contracts to 'net' two 234 which are due in the same currency and on the same date. or more outstanding transactions Therefore instead of two or more gross payments there is just one net payment – an aggregate payment to the counterparty owed the highest amount. For instance, section 2(c) of the 1992 ISDA Master Agreement states: Netting. If on any date amounts would otherwise be payable:– (i)

in the same currency; and

(ii)

in respect of the same Transaction,

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2017 by each party to the other, then, on such date, each party's obligation to make payment of any such amount will be automatically satisfied and discharged and, if the aggregate amount that would otherwise have been payable by one party exceeds the aggregate amount that would otherwise have been payable by the other party, replaced by an obligation upon the party by whom the larger aggregate amount would have been payable to pay to the other party the excess of the larger aggregate amount over the smaller aggregate amount. The parties may elect in respect of two or more Transactions that a net amount will be determined in respect of all amounts payable on the same date in the same currency in respect of such Transactions, regardless of whether such amounts are payable in 235 respect of the same Transaction. This provision therefore provides for the netting of payments (or payment netting) by counterparties. If counterparties wish payment netting to apply across all outstanding OTC derivatives transactions in force between them, then they simply state in the ISDA Schedule that section 2(c)(ii) is deleted and this allows cross-netting of payments. This is legally acceptable because each transaction documented by a Confirmation forms part of a single agreement between counterparty A and counterparty B governed by the signed and executed 236 For example, say that counterparty A and counterparty B have three ISDA Master Agreement. outstanding transactions under an ISDA Master Agreement, transaction 1 favours A (+£500,000), transaction 2 favours A (+£300,000), and transaction 3 favours B (+£400,000). Without payment netting on the payment date counterparty A would have to pay B £400,000 and counterparty B would have to pay A £800,000. There is therefore a credit risk for both parties, since either party may declare insolvency and not be able to make its payment, whilst still receiving the payment from the other counterparty. The payment netting provision instead directly reduces counterparty risks in relation to the possibility of counterparty A defaulting on payments owed to counterparty B, but still receiving payments (and vice-versa), since B now only makes a single payment to A of £400,000. When you take into account the fact that there may be dozens, hundreds, or even thousands of OTC derivatives contracts between two counterparties, or between multiple counterparties across whole OTC derivatives markets, the magnitude of this simple mitigation of counterparty risk becomes clear. Section 6(f) of the 2002 Master Agreement also contains a new set-off clause (not contained in the 1992 Master Agreement), which functions in much the same way as the payment netting provisions. Wood explains that in principle, set-off "is the discharge of reciprocal obligations to the extent of the smaller obligation. It is a form of payment. A debtor sets off the cross-claim owed to him against the main claim which he owes his creditor. Instead of paying money, he uses the claim owed to him to 237 In principle the set-off clause under the 2002 Master Agreement allows pay the claim he owes." counterparties to set-off mutual debts owed between the parties. This means that any 'Early Termination Amount' owed by counterparty A to counterparty B, may be automatically set-off against any 'other amounts' owed under either ISDA Master Agreements or other 238 However, the courts in the US have confirmed that this is only authorised financial agreements. under the US Bankruptcy Code to the extent that strict mutuality of obligations exist between the counterparties, i.e. mutuality exists when "the debts and credits are in the same right and are between 239 This provision also significantly adds to the risk the same parties, standing in the same capacity". management capabilities of the ISDA Master Agreement, since it reduces overall counterparty risk for each counterparty, by allowing any other debts owed by a counterparty to be automatically set-off without the need to enforce legal contractual provisions separately in court. Nevertheless, it is the close-out netting provisions which most significantly manage and mitigate risk 240 ISDA defines close-out netting in the following way: under the ISDA Master Agreement. Close-out netting is a process consisting of three parts. The first is early termination of transactions with the defaulting counterparty. The second is valuation of defaulted transactions under a contract. The third is calculation of close-out amount as the sum of © Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 offsetting positive and negative replacement costs. If the defaulting party owes the closeout amount, it can apply collateral posted by the defaulting party and then becomes an unsecured creditor for the remainder. If the non-defaulting party owes the close-out amount, it can in many cases set off the amount against amounts owed by the defaulting 241 party but then must pay any remaining amount to the insolvency administrator. Fourthly, it can be seen that the close-out netting process is deeply integrated with the termination provisions and valuation methods. In short, the ISDA Master Agreement manages and mitigates risk because it allows the counterparties to specify under what circumstances all open transactions under the ISDA Master Agreement can be closed out. Maizar et al. add that netting of exposures across a variety of transactions (cross-product) facilitates a potential reduction of credit risk, as well as 242 recognition for risk capital purposes (e.g. under Basel II or III capital adequacy requirements). Close-out netting allows two or more transactions to be terminated and replaced by a market value or replacement cost position, with a single amount (specified in the termination currency) determined 243 payable by one counterparty to the other. This facilitates an orderly and normally efficient process in the event of the default or insolvency of a counterparty. The ISDA Master Agreement addresses counterparty risk concerns because counterparties may specify the use of any of three valuation methods in the ISDA Schedule to best suit a counterparty's commercial needs. These are: (i) the 'Loss' valuation method (1992 Master 244 245 Agreement) ; (ii) the 'Market Quotation' valuation method (1992 Master Agreement) ; and (iii) the 246 'Close-out Amount' (the 2002 Master Agreement). From a risk management perspective, Mengle explains that the need for close-out netting arises from the nature of financial intermediation by derivatives dealers, i.e. maintaining a hedged and balanced 247 In the event of counterparty A's portfolio through offsetting transactions with other counterparties. default, counterparty B must replace the defaulted transactions to maintain the existing hedge, or 248 Mengle states that the close-out netting process allows unwind the offsetting transactions. intermediaries to manage risks after a counterparty default by enabling them to re-establish a balanced book, thereby preventing open, speculative positions exposed to sudden market 249 fluctuations, and reducing deadweight losses associated with rebalancing. Bliss and Kaufman add that "Without netting the current large size, liquidity and concentration we see 250 They explain that both netting and collateral in the derivatives markets would be unlikely to exist" enhance the management of counterparty risk, thereby leading to increased depth and liquidity of OTC derivatives markets, and these benefits are transferred to end-users via lower costs and 251 The increased liquidity for hedge instruments (i.e. facilitating their ability to manage market risks). netting provisions are enhanced by the ability of counterparties to specify in advance which event or events, or under which circumstances these positions will be terminated. For instance, the 'Automatic Early Termination' provisions under section 6 of the 2002 Master Agreement allow counterparties to specify if all transactions under the Master Agreement will be automatically terminated in the event of the bankruptcy or insolvency of a counterparty. This is an important counterparty risk mitigation option for ISDA Master Agreements governed by foreign jurisdictions which do not specifically accommodate or recognise close-out netting rights. 'Termination Event' under section 14 of the 2002 Master Agreement is defined to mean "an Illegality, a Force Majeure Event, a Tax Event, a Tax Event Upon Merger or, if specified to be applicable, a Credit Event Upon Merger or an Additional Termination Event". Also, 'Events of Default' under the 2002 Master Agreement include: (i) a failure to pay or deliver; (ii) a breach or repudiation of agreement; (iii) a credit support default; (iv) misrepresentation; (v) a default under a specified transaction; (vi) cross-default; (vii) bankruptcy; and (viii) a merger without assumption. All these events, if specified to apply, will allow a counterparty to elect to terminate the Master Agreement and perform close-out netting and valuation should it wish to do so. This vast range of events allow OTC derivatives markets counterparties to significantly manage or mitigate risk by looking to specifically address what will happen if certain negative circumstances affecting a counterparty occur in the future. For example, illegality provisions address concerns regarding future changes in a country's jurisdiction that might make it illegal to continue to be a counterparty to a OTC derivatives contract. ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 France might declare war against the Russian Federation and pass legislation effecting a moratorium on all financial and economic transactions between them â&#x20AC;&#x201C; an illegality event triggering the termination of all Master Agreements between French and Russian counterparties. Force Majeure Events include continuing events that would make it impossible or impracticable to carry out the obligations under the ISDA Master Agreement, e.g. wars, riots, flooding, earthquakes, and tsunamis. Tax Events generally cover changes in the tax laws in a jurisdiction directly affecting a transaction under the ISDA Master Agreement framework, burdening a counterparty, and allowing that counterparty to terminate the Master Agreement. A Tax Event Upon Merger occurs where two entities have merged, and because of this, payments under the ISDA Master Agreement are now taxed, which therefore allows a counterparty to terminate the ISDA Master Agreement. A Credit Event Upon Merger includes situations where a counterparty, any entity specified by a counterparty (Specified Entity), or any entity providing credit support (Credit Support Provider), 252 253 Whilst 'merges' , and its creditworthiness immediately after such merger is "materially weaker". these are all standardised events that both counterparties understand may terminate the ISDA Master Agreement, the counterparties are still free to tailor the ISDA Master Agreement to their individual circumstances, by specifying any other event they believe will affect them as an Additional Termination Event. For example, if a counterparty is trading with a credit rated financial institution, then it might specify that an Additional Termination Event is triggered when that financial institution's credit rating falls below a certain level (rating downgrade) specified by a ratings agency such as Standard & Poor's or Moody's. The Events of Default also cover a wide range of circumstances which significantly aid counterparties in their management of risk. This includes an Event of Default being triggered where a counterparty fails to make a payment due under the ISDA Master Agreement, or to deliver specified documents (e.g. a signed and executed CSD) or additional collateral. Any breach, repudiation or misrepresentation by counterparty A of the Master Agreement also allows counterparty B to elect to terminate the Master Agreement. If a counterparty becomes bankrupt or defaults on its credit support obligations then this also authorises a counterparty to terminate the Master Agreement. If counterparty A cross-defaults on another obligation (e.g. under a relevant loan agreement) then counterparty B may also elect to terminate the Master Agreement. If a counterparty or any Credit Support Provider merges, and the merging entity does not assume the original obligations (including the benefits of any CSD), then a Merger Without Assumption Event of Default will occur allowing the other counterparty to terminate the Master Agreement. Alternatively, counterparties may specify any other transaction which will constitute an Event of Default, e.g. defaults under other types of agreement (not just derivatives) such as securities lending agreements, repurchase agreements, or prime brokerage agreements. Fifthly, the collateral arrangements supporting the ISDA Master Agreement framework have played a huge role in directly managing or reducing credit risk in OTC derivatives transactions. The ISDA Credit Support Deed allows counterparties to create a charge or security interest over assets if they so choose, whereas the ISDA CSA provides counterparties with the ability to establish collateral arrangements based on full transfer of assets. These set out in detail counterparty obligations relating to inter alia credit support; minimum thresholds; eligible collateral; transfers, calculations and exchanges; dispute resolution; transfer of title; distributions and interest amounts; rating triggers; default; representations; and a range of apposite definitions. Counterparties are also free to choose from English law, New York law, or Japanese law as the governing law and jurisdiction. Not only has ISDA continually improved and streamlined the collateralisation documentation process, for example by issuing the consolidated 2001 ISDA Margin 254 Provisions, but it also provided the market with the 2005 ISDA Collateral Guidelines , the ISDA Collateral Asset Definitions and updated CSAs in 2013. In fact it is noted by ISDA that there were about 117,000 ISDA collateral agreements in place between counterparties at year-end 2011, and that 84% of trades executed by large derivatives dealers were subject to collateral agreements (with 255 85% of these agreements being in the form of ISDA CSAs). Sixthly, there are a host of supporting provisions which also contribute to significantly reducing legal risk directly, or financial risk indirectly. For example, ISDA Master Agreement clauses covering: (i) the ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 256

257

Gross-Up of payments without deductions or withholding for tax ; (ii) counterparty representations (e.g. regarding status, powers, consents, binding obligations, absence of litigation, and payer and 258 259 payee tax representations); (iii) interest and compensation ; (iv) governing law and jurisdiction ; 260 All these have contributed in one way or another, to increasing legal certainty and (v) definitions. for the counterparties, as well as directly addressing what will transpire if possible future financial risks arise. Nevertheless, despite all these very extensive and comprehensive financial and legal risk management and mitigation provisions and techniques, it is admitted that the ISDA Master Agreement is not perfect. There are difficulties in practice because of the use of both the 1992 and the 2002 Master Agreement. The negotiation process is sometimes long and unwieldy, and the language and set-out of the Master Agreement is perhaps somewhat dated. It is also noted that when Lehman filed for bankruptcy protection, many swap counterparties were unable to replace hedges in a reasonable time period (because of lack of market liquidity), and there were also differences between costs incurred and ISDA settlement termination values, meaning that counterparties experienced significant 261 Indeed these problems resulted in a great deal of subsequent dispute litigation regarding losses. 262 the unwinding of Lehman's OTC derivatives counterparty positions. Other difficulties that have been put forward, include that the ISDA Master Agreement structure evolved around simpler IRSs, and that the application of close-out netting and valuation to more 263 There is also still complicated and exotic structures such as credit derivatives is largely untested. the possibility of the close-out netting provisions being held to be ineffective in practice in some jurisdictions, despite the issuance of legal opinions by ISDA, meaning that liquidators, insolvency practitioners and bankruptcy trustees might "cherry pick" transactions, i.e. selectively enforcing 264 Parker and McGarry have also beneficial transactions and disclaiming prejudicial transactions. argued that other major weaknesses in the ISDA Master Agreement structure, include that: (i) negotiated documentation is sometimes flawed; (ii) there are harsh termination notice provisions that can be sometimes easily triggered; (iii) there are sometimes difficulties in forcing close-out mechanisms; (iv) there are weaknesses in the market quotation mechanisms and fall-backs in times of distressed markets; (v) there is a lack of agreed detail in calculation statements; and (vi) there is a 265 lack of infrastructure for counterparties dealing with defaults. From one point of view, it might be argued then that these inherent flaws with the ISDA Master Agreement framework, taken together with the increased standardisation of OTC derivatives owing to central clearing requirements, mean that the significance of the ISDA Master Agreement framework is set to wane in the future. For instance, as many OTC derivatives perhaps become more standardised owing to central clearing requirements, in time they may shift onto central derivatives exchanges owing to standardised terms, and instead be governed by automated Straight-Through-Processing (STP) systems. It is acknowledged that this may be the case in ten years' time, but for now, it is virtually certain that the ISDA Master Agreement framework will continue to play a highly significant and vital role in managing risk. Firstly, the inherent difficulties and problems which have arisen in the ISDA Master Agreement have been expressly noted by market counterparties and by ISDA. Consequently, these difficulties are on the whole directly addressed in amendments to the ISDA Schedule or by ISDA working party groups which are working to improve the ISDA Master Agreement framework. Secondly, it will likely take a very long time for the centrally cleared OTC derivatives market to become standardised, as it will first require the standardisation and automation of a number of clearing agreements (e.g. CCP clearing agreements, give up agreements, clearing deed of assignments, and clearing compensation agreements). Thirdly, central clearing requirements are currently only mandatory in the EU and the US. Although some other countries such as Japan and Singapore have started to make inroads into central clearing, other countries such as Australia, South Korea and Hong Kong are still progressing. Moreover, other emerging markets such as Brazil, will likely continue to use the ISDA Master Agreement framework as their markets develop.

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2017 Fourthly, the ISDA Master Agreement and collateral framework will still remain valid for non-cleared 266 OTC derivatives , which ISDA has stated will continue to remain significant in size and play a vital role in virtually every industry in the economy (from financial services to international trade to home 267 Therefore, centralised clearing of OTC derivatives will likely not herald the end of an mortgages). era for the ISDA Master Agreement operating framework, it will likely still continue to prevail for the foreseeable future.

SIGNIFICANT DEVELOPMENTS AGREEMENT FRAMEWORK

THE

ISDA

MASTER

It is not simply the internal substantive operating provisions of the ISDA Master Agreements that make the ISDA Master Agreement framework so effective at risk management. It is also the dynamic external support that has been provided by ISDA which has enabled it to pioneer the way forward for the modern-day trillion dollar OTC derivatives industry. The OTC derivatives markets trade organisation was founded in 1985 with only 10 members, but now has accrued more than 800 268 It is this dynamic support, as well as ISDA's member institutions from across 60 countries. intensive membership participation, that has facilitated the ISDA Master Agreement's meteoric rise to the pinnacle of risk management practices. This is no puff piece. Just take a look at the facts and judge for yourself. Harding notes that ISDA was formed in order to standardise market practice and documentation, and has enjoyed a resounding success "because previously there was little standard documentation in the market and high legal fees abounded as lawyers Concorded across the Atlantic to complete individual deals. With more complex Transactions this wide variety of documentation caused legal 269 Johnson also states that the ISDA Master Agreement has become ubiquitous in OTC uncertainty." derivatives markets, as not only is it used to document virtually every OTC derivatives contractual relationship, but "it becomes impossible to discuss the legal issues and concerns in documenting OTC derivatives without refer-ing to the provisions of the ISDA Master Agreement and other ISDA 270 Indeed banks; insurance companies; accounting firms; law firms; standard documentation." supranational institutions; municipal governments; energy firms; credit unions; hedge funds; foreign exchange firms; and collective investment funds, all document OTC derivatives transactions with the ISDA Master Agreement. What is more, ISDA has not stopped there. It has perpetually lobbied governments for beneficial structural changes to legal and regulatory systems affecting OTC derivatives markets. It has continued to hold a large number of annual global or regional conferences worldwide, in key financial locations such as London, New York, Tokyo, Singapore, and Munich, in order to provide the latest 271 It has published dozens upon dozens of publications updates affecting OTC derivatives markets. covering all aspects of OTC derivatives instruments and markets. It has commissioned netting legal opinions in respect of close-out netting enforceability for over 55 jurisdictions worldwide, as well as legal opinions governing the enforceability of ISDA Credit Support Documents for over 45 jurisdictions. It has drafted the '2006 Model Netting Act â&#x20AC;&#x201C; Version 2' for legislative implementation by countries worldwide. Through joint ventures between ISDA and the global law firm 'Allen & Overy', it provides online legal 272 and risk management services through 'netalytics' (broad netting analysis software services) 273 It has drafted standard terms relating to 'CSAnalytics' (broad collateral analysis software services). regulatory requirements for government regulators such as the US Commodity Futures Trading 274 275 It has filed a large number of 'Amicus Briefs' in respect of legal cases that may Commission. potentially impact OTC derivatives markets around the world (e.g. Whyte v. Barclays Bank, et al. 276 277 (2013) , Lomas v JB Firth Rixson and Others (2012) , Swedbank AB v. Lehman Brothers Holdings 278 Inc. et al. (2010) , and Enron Corp and Enron North America Corp., v. Bear, Stearns International 279 and Bear, Stearns Securities Corp. No. 01-16034 (AJG) (2005) . It has even provided free regular updates in respect of recent Eurozone Contingency Planning events, in order to assist market 280 participants in their contingency planning efforts. All these developments have allowed the ISDA Master Agreement to exponentially propagate throughout the world, enabling the ISDA Master Agreement's risk management capabilities to flourish. However, it is also noted that financial risk management should not be viewed in isolation, but should ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 ideally take its form according to the context in which it operates in. Whether that is a developing or developed country, whether it is a small financial firm implementing ISDA Master Agreements for risk management purposes, or multinational BFIs such as 'Barclays', 'HSBC', 'Goldman Sachs', or 'Morgan Stanley', which have whole dedicated ISDA documentation desks. Viewed from this vantage point, the ISDA Master Agreement framework can clearly be said to have taken root within multiple contexts and societies, and within the whole gamut of small to global BFI operating frameworks. In addition to this, ISDA's Mission Statement is that "ISDA fosters safe and efficient derivatives 281 Its Strategy markets to facilitate effective risk management for all users of derivative products." 282 Statement includes it being: (i) the source for robust and trusted documentation ; (ii) the architect of 283 284 a secure and efficient infrastructure ; (iii) an advocate for effective risk management and clearing ; 285 286 The point being made here is that ISDA and (iv) the voice for the global derivatives marketplace . did not just create the ISDA Master Agreement as a risk management tool and then leave it to develop of its own accord. The key difference here is that, unlike other risk management tools, ISDA has not only at all times powerfully supported the ISDA Master Agreement's development throughout OTC derivatives markets across the world, but ISDA has also strived to enhance the safety and efficiency of OTC derivatives markets themselves. The ISDA Master Agreement risk management tool therefore functions at two conceptual levels (internal and external), with ever-increasing efficiency. Because such a tool is great if it is constantly being improved (internal), but it works even better if the milieu in which it is operating in (external) is also being improved (i.e. reduced risks overall). In fact, there are so, so, many developments that have significantly influenced, shaped, or impacted the ISDA Master Agreement framework over time, and have augmented its risk management capabilities. But, it really should be asked, what does a 'world class' financial risk management tool look like in practice? It needs to be more than just a single piece of proprietary risk management software, or risk management document, no matter how advanced, sophisticated or accurate its capabilities. For example, software packages or systems as financial risk management tools advanced by the likes of 'SAP', 'IBM', 'Riskdata', 'Reval', or 'FINCAD', may have been implemented in BFIs across the world, but they have not become the de facto market operating standard. ISDA and the ISDA Master Agreement framework have. Moreover, the ISDA Master Agreement is more than just a legal contract, it might be best described metaphorically as a dynamic living, breathing mechanism for facilitating increasingly effective risk management practices. It is regularly being updated, with updated derivatives product Definitions, legal opinions, standard form amendments, and new operating Protocols. The financial risk management tool must also effectively monopolise the market, not just a single jurisdiction, but multiple jurisdictions across the world, from London to New York, to Hong Kong and Japan. ISDA and the ISDA Master Agreement do. There must be across-the-board commitment, support, acknowledgement and trust from all OTC derivatives market participants. The ISDA Master Agreement has been in use for over twenty years now, and more than 90% of OTC derivatives market counterparties use the ISDA Master Agreement framework. Dealer firms, service providers, and end-users all actively participate in ISDA policy development; working groups; committees; task forces; and industry events. Global law firms such as Allen & Overy, 'Clifford Chance', 'Macfarlanes', and 'Linklaters', have whole departments dedicated to derivatives and ISDA Master Agreement expertise. There are many firms that specialise in providing ISDA Master 287 Agreement knowledge, training or expertise (e.g. 'Derivatives Documentation Limited' ). There are also swathes of books written specifically about understanding, negotiating, or documenting OTC 288 This highlights the deep commitment and trust derivatives contracts and ISDA Master Agreements. occasioned by ISDA and the ISDA Master Agreement. The financial risk management tool must be relatively easy to use, yet it must also be highly accurate, transparent, legally certain, and must produce consistently strong benefits in terms of effective and efficient financial risk mitigation. As has been seen previously, the ISDA Master Agreement ticks all these boxes. Moreover, its operating framework has even been used as a formative structure for other countries and legal systems. For instance, the 'Inter-Bank Market Financial Derivatives Master Agreement' promulgated by The National Association of Financial Market Institutional Investors

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2017 (NAFMII), of the People's Republic of China, is clearly based on the ISDA Master Agreement substantive operating architecture. The NAFMII agreement even uses a Schedule, Performance Collateral Annex and Definitions, in the same fashion as the ISDA Master Agreement. In 2010, ISDA also teamed up with The International Islamic Financial Market (IIFM) to produce an Islamic finance Shari'ah-compliant 'ISDA/IIFM 289 This has been lauded as a breakthrough in Islamic Tahawwut (Hedging) Master Agreement'. finance and risk management, and was also said to mark "the introduction of the first globally 290 standardized documentation for privately negotiated Islamic hedging products". Finally, adopting a more objective approach, the International Organization for Standardization (ISO) has developed an international standard for risk management, the 'ISO 31000 â&#x20AC;&#x201C; Risk management' 291 The ISO 3100 principles of risk management propose that risk management should: (i) (ISO 3100). create value; (ii) form an integral part of organisational processes; (iii) form a part of decision-making; (iv) explicitly address uncertainty; (v) be systematic, structured and timely; (vi) be based on the best available information; (vii) be tailored; (viii) take human and cultural factors into account; (ix) be transparent and inclusive; (x) by dynamic, iterative and responsive to change; and (xi) facilitate continual improvement and enhancement of the organisation. Evaluating these principles in light of the ISDA Master Agreement framework, it is argued here that all these principles are positively addressed by the substantive provisions or the ISDA architecture. The ISDA Master Agreement undoubtedly creates value, for all users, since its standardisation cuts financial costs, its legal certainty reduces legal risk, and its risk management provisions directly reduce counterparty risk and provide value to the firm using the agreement. The extent of the risk management framework can be seen using ISDA's calculations. For instance, ISDA states that the notional amount of derivatives is currently over US$600 trillion, but this measures activity not risk, which is instead measured by 'gross market value', and currently 292 However, ISDA also observes that after the stands at about 4% of notional (i.e. US$24 trillion). beneficial credit risk-mitigation techniques of netting and collateral are applied, the risk measurement is about 0.02% of notional, which would equate to only US$1.2 trillion. By anyone's measure of risk, this is a huge reduction in risk (a decrease of US$22.8 trillion) predominantly because of the ISDA 293 Master Agreement netting and collateral framework. It has also been seen that the ISDA Master Agreement framework has become an integral part of OTC derivatives markets counterparties, from small insurance companies to large commercial or investment banks. In addition, ISDA Master Agreement negotiations form an integral part of firms' decision-making in respect of the setting of counterparty credit limits, or by directly addressing credit risks in Master Agreement negotiations (e.g. types of Events of Default or Termination Events, whether set-off should apply, or valuation mechanisms). By the same token, it can also be clearly argued that the ISDA Master Agreement's twenty years of existence, its ubiquitous use around the world, ISDA legal opinions, and case law around the world, all significantly contribute to explicitly addressing uncertainty. As has also been seen, the modular nature of the ISDA Master Agreement framework means that the ISDA Master Agreements, the CSDs and CSAs, legal opinions, Definitions, User Guides, Protocols, etc. all significantly contribute to ensuring that the whole operating architecture is very systematic, structured and timely. In fact, the renowned lawyer and author Philip Wood QC (hon) even remarked that "This ISDA Master Agreement is probably the most remarkable standard form ever devised in view of the immense range of transactions that it covers, the gigantic amounts which rest on its provisions and the width of its use by the market. It is a world-wide standard for international and local 294 deals." The very broad and continuing range of efforts on the part of ISDA, ranging from working groups, committees, task forces, and conferences, also ensure that the ISDA Master Agreement framework remains up-to-date and based on the best available market information. Everything in the ISDA Master Agreement framework (e.g. Definitions, Protocols, standard form amendments) is also structured so as to afford market counterparties the widest choice of structural options available to specifically tailor ISDA Schedules, CSAs, or CSDs. This also specifically takes into account human ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 factors (e.g. ISDA negotiations), as well as cultural factors (e.g. the 'ISDA/IIFM Tahawwut (Hedging) 295 Master Agreement). The long-established nature of the ISDA Master Agreement means that it can be argued that OTC derivatives market counterparties now generally know and understand how the Master Agreement framework functions. This, added to the all-inclusive modular nature, means that it is also arguable that the ISDA Master Agreement fulfils the transparent and inclusive requirement. This long-standing use by OTC derivatives markets participants also means that it has facilitated the long-term learning and development of the principles underlying the ISDA Master Agreement framework. It has also allowed ISDA to adapt the Master Agreements, CSAs, CSDs, and Definitions to more accurately suit and reflect market conditions. For example, updates contained in the 2002 Master Agreement such as the new set-off and force majeure provisions, as well as a new single Close-out Amount, demonstrate that the framework is certainly responsive to change and dynamic and iterative in nature. The continued industry participation by ISDA and ISDA members certainly means that the Master Agreement framework has also facilitated to continual improvement and enhancement of OTC derivatives counterparty organisations. This is because ISDA updates, standard form amendments, conferences, etc. have all significantly contributed enhancing organisational OTC derivatives practices and updating them to reflect modern operating conditions.

CONCLUSION

It has been seen that financial risk management in financial markets is complicated owing to the inherent invisible and non-intuitive risks that exist in capitalist financial markets and financial products. It has also been seen that this therefore led to the development of advanced financial risk management techniques, tools, and strategies, such as stress testing, VaR, risk-weightings, and collateralisation. These have helped BFIs to manage or mitigate the large ranges of risks such as credit risk, legal risk, liquidity risk, and counterparty risk that exist in practice. Nevertheless, it was also demonstrated that in the OTC derivatives markets, the historical development of these markets as well as the inherent bilateral structure of counterparty relationships, meant that in practice, risk management techniques predominantly centred on managing or mitigating credit, counterparty, and legal risks. Whilst such techniques included the use of financial guarantees, or the setting of credit limits, in practice it was the use of collateralisation of outstanding OTC derivatives transactions, as well as protection though bilateral documentation that formed the most commonly used risk management strategies. It was also argued that throughout its more than twenty year tenure, the ISDA Master Agreement operating framework has come to provide a very comprehensive and effective regime for counterparties seeking to manage or mitigate the risks attendant in outstanding OTC derivatives transactions. It was also argued that the modular nature of the ISDA Master Agreement, together with the cumulative effect of a number of other substantive provisions (e.g. standardisation; payment netting; close-out netting; set-off; termination and valuation provisions; and collateral arrangements), provided the ISDA Master Agreement with a superior risk management operating framework. At the same time, the belief was also put forward that it was not just the internal substantive operating provisions of the ISDA Master Agreement, but also the overall effect of ISDA's dynamic external support, that combined to made it a world class financial risk management tool in practice. Such dynamic support included the development of CSDs; CSAs; legal opinions; Definitions; User Guides; Protocols; standard form amendments; foreign language translations; Islamic finance Master Agreement versions; as well as the continued efforts of ISDA working groups; committees; task forces; and ISDA conferences and industry events. Finally, it was argued that in theory recent efforts towards centralised clearing of OTC derivatives in the EU and the US might mean increased standardisation of OTC derivatives in the future. But it was also cogently demonstrated that these efforts will not spell the end of the use of the ISDA Master Agreement framework in practice. Indeed, both the ISDA Master Agreement will still continue to play a significant role in OTC derivatives markets, and ISDA will still continue to play a significant supporting role in OTC derivatives markets going forwards. In light of all these developments, it ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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2017 seems that the final question to ask then, is does the ISDA Master Agreement deserve the title of 'The Derivatives Risk Management Tool of the 21st Century'. I certainly believe it does, and maybe I've convinced you that you believe it does too.

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2017

DEFINITIONS

TERM

DEFINITION

Asset securitisation

This involves the pooling together of various types of assets and combining them to secure underlying obligations for securities with various levels of seniority, and which are then marketed on and sold to investors.

Capital adequacy

This represents the minimum amount of capital that a banking or financial institution is required to hold by its financial regulator, and is therefore typically a measure of the relative financial strength of a banking or financial institution, which is usually measured by a prestipulated ratio of its assets to capital maintained by the banking or financial institution.

Capital Model

Asset

Pricing

This is a financial statistical model that was developed by a number of leading individuals in the field of financial economics, and which uses the theories of diversification and modern portfolio theory to empirically predict the pricing of individual securities or portfolios.

Catastrophe modelling

This typically involves the use of information technology and computer software, as applied to geo-location data, and processed through stochastic event, hazard, vulnerability, and financial modules, in order to artificially model natural catastrophes (floods, tornados, earthquakes, tsunamis, hurricanes) or human catastrophes (terrorism, wars) ('perils'), in order to calculate the losses that might be sustained from such perils.

Collateral

This is the pledging of property such as cash or securities by one party to another party in order to secure obligations under an agreement, and typically undertaken in order to serve as protection for the pledgee against the default of the pledgor.

Commodity risk

This reflects the uncertainty or the volatility affecting the future values or income streams which derive from the price of commodities such as aluminium, coal, coffee beans, copper, gold, salt, silver, soybean, or wheat.

Counterparty risk

This is the risk that arises for each party to a contract that the other party to the contract will default on its obligations under the contract, and for over-the-counter derivatives contracts, relates to the ability of counterparties to such contracts to fulfil their underlying credit obligations for such over-the-counter contracts.

Credit ratings

These are different evaluations of the creditworthiness of commercial or corporate entities, or sovereign nations, by different credit ratings agencies such as 'Moody's', 'Standard & Poor's', or 'Fitch Ratings', and which are published as credit scores reflecting the ability of an entity to pay back the debt and the probability of a default, with poor credit scores reflecting a high risk of default on the underlying credit obligations and vice versa.

Credit risk

This is the risk that a counterparty to a credit transaction or a bank borrower will fail to meet its obligations or default under the agreed terms of the credit contract, for example a risk of failure to repay a loan.

Currency risk

This is the financial risk that may arise because of unexpected future

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2017 TERM

DEFINITION changes in the exchange rate that exists between two currencies.

Default modelling

probability

This involves the use of information technology and computer software as applied to information such as publicly available credit ratings, in order to artificially statistically model and calculate the probability of default for an obligor or counterparty,

Exchange-traded derivatives

These are standardised derivative contracts such as futures or options that are traded on a daily basis in recognised investment exchanges such as the Chicago Board of Trade (United States), the Montreal Exchange (Canada), or the London Metal Exchange (United Kingdom).

Financially model

This typically involves the use of information technology and computer software (such as computer simulation and complex algorithms) to create a mathematical 'financial model' which artificially re-creates an abstract model of a real world financial scenario (such as credit spreads of interest rate derivatives), using a wide range of quantitative inputs.

Forwards

This is a financial contract which has individually tailored and nonstandardised terms, which is not traded on a recognised investment exchange, and in which the two parties to the contract agree to buy or sell an underlying asset at a certain fixed time in the future and for a fixed price, with settlement undertaken on a cash or delivery basis.

Future

This is a financial contract which has standardised terms relating to quality and quantity of the underlying asset, which is traded on a recognised investment exchange, and which obliges the two parties to the contract to buy or sell an asset at a certain fixed time in the future and for a fixed price.

Gilts

The colloquial term for 'gilt-edged securities' which are high-grade bonds issued by a number of Commonwealth nations including historically by the British Bank of England, and which pay semi-annual payments (coupons) until the bond is redeemed at maturity and the principal sum is returned to the holder.

Gross market value

This is typically the cost of replacing all outstanding over-the-counter derivatives contracts held at current market prices, and therefore reflects the aggregated net risk position of market participants.

Inflation risk

This reflects the risk of inflation negatively affecting or undermining the future performance and real value of an investment.

Interest rate risk

This reflects the risk that arises from fluctuating interest rates which may affect a change in the value of an investment which is in some way based on such existing interest rates.

ISDA Master Agreement

This is the standard form boilerplate pre-printed documentation produced by the International Swaps and Derivatives Association, Inc. to document an over-the-counter derivatives transaction or transactions between two counterparties, with all such transactions under the agreement constituting a single agreement between the counterparties, and which generally may take the form of any of: (1) the 1987 ISDA Interest Rate and Currency Exchange Agreement; (2) the 1987 ISDA Interest Rate Swap Agreement; (3) the 1992 ISDA Master Agreement (Local Currency â&#x20AC;&#x201C; Single Jurisdiction); (4) the 1992 ISDA Master

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DEFINITION Agreement (Multicurrency â&#x20AC;&#x201C; Cross Border); (5) the 2002 ISDA Master Agreement; or (6) the ISDA/IIFM Tahawwut Master Agreement.

Legal risk

This may include the risk of financial or reputational loss which may arise for an entity, institution, or counterparty, in respect of defective transactions or documentation, unenforceable legal documentation, legal contractual disputes, or claims for liability that may be instigated against entities, institutions, or counterparties.

Liquidity risk

In financial markets this is the risk that any given asset or security cannot be sold due to an existing lack of liquidity (i.e. market demand or take-up) in the relevant market, i.e. lack of marketability of an investment.

Loss forecasting

This is the predicting of future losses based on historical data of past losses for a firm or entity, and typically using forecasting techniques such as net flow rates, vintage loss curves, and score distributions, or forecasting models such as Markov Chain Models.

Netting

This is usually the setting-off of the gross amount owed by counterparty A under all outstanding derivatives contracts, against the gross amount owed by counterparty B under all outstanding derivatives contracts between them, and with the net amount paid to the relevant counterparty which has the positive aggregated net amount outstanding.

Notional amounts

This is a pre-determined amount based on a set currency such as English Sterling or United States Dollars, which is used by counterparties to over-the-counter derivatives contracts as a sum by which periodically exchanged interest payments will be principally based on (i.e. calculated from), but which amount will actually never change hands throughout the term of the transaction.

Novation

The replacement of a single over-the-counter derivatives contract between a buyer and a seller, with two new over-the-counter derivatives contracts with the same terms, but with one contract between the central clearing counterparty and the buyer, and one contract between the central clearing counterparty and the seller.

Option

A financial contract in which the buyer agrees to pay the seller for the right, but not the obligation, to buy or sell the underlying asset(s) at a future specified time, or at any time before the future specified time, with a call option giving the holder the right to buy the underlying asset(s), and a put option giving the holder the right to sell the underlying asset(s).

Regulatory capital

See capital adequacy.

Reputational risk

This is the risk of loss to the reputation of a person, firm, or entity, that is typically measured in lost revenues or damage occasioned to shareholder value, and which results from negative public perceptions of said person, firm, or entity.

Risk-weightings

These refer to different risk weights allocated to different classes of assets or off-sheet balance exposures held by a bank or financial institution, and involves the assignment of a risk-weighting (in %)

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DEFINITION according to the stated level of risk associated with an asset or offsheet balance exposure, for example a risk-weighting of 0% for cash, a risk-weighting of 35% for claims secured by residential property, and a risk-weighting of 75% for retail products such as credit cards or loans held.

Sovereign risk

This is the risk that a nation as a sovereign entity will refuse to comply with the terms of any outstanding legal obligation entered into, such as a loan, resulting in a failure to make debt repayments, not honouring the terms of a loan agreement, or nullifying the terms of a loan agreement.

Stress testing

This usually involves statistical computer software which is designed and applied for use in artificially simulating the effects of different stressors on any given financial asset or liability portfolio, and which usually involves testing under normal and exceptional stressor conditions. These are transactions in which two parties to an over-the-counter derivatives contract agree to exchange periodic payments, usually over a set period of time, which are calculated by multiplication of an agreed "notional" amount of the transaction by a pre-agreed rate, price or index (examples include floating interest rates such as "LIBOR", or the "FTSE" index).

Swaps

Tear-up operations

These typically involve automated systems or processes such as 'TriOptima', which are applied to 'tear-up' or 'compress' all open overthe-counter derivatives portfolio positions held by all relevant over-thecounter market participants, in order to match up offsetting positions and to terminate those trades with a view to eliminating redundant overthe-counter contracts.

Value at Risk (VaR)

This is a statistical technique that is predominantly used within the fields of financial mathematics and risk management, to measure and quantify the risk of loss on a specific portfolio of financial assets for any given firm and for a pre-specified time frame.

175

For all blue entries see 'Definitions' section at the end.

176

OTC derivatives contracts are all derivatives contracts that are not standardised exchange-traded derivatives contracts. They are specifically labelled "over-the-counter" because of their ability to be individually negotiated and tailored to suit the specific needs of the counterparty, as if the counterparty is metaphorically obtaining the terms of the derivatives contract over the counter of the other counterparty. Whaley further explains that "Derivative contracts exist and, indeed, flourish because of trading costs and trading restrictions in the underlying asset market. Trading takes place for only two reasonsâ&#x20AC;&#x201C;hedging or speculating. Hedging reduces risk and hence reduces expected return; speculation increases risk and hence increases expected return. Managing risk and return can be accomplished in only two waysâ&#x20AC;&#x201C;by changing the amount of the asset being held or by taking a position in derivative contracts written on the underlying asset. When both strategies are feasible, trad-ing activity will tend to be concentrated in the lowest cost market, and the lowest cost market is usually the derivatives market. Sometimes, however, both strategies are not feasible. If an asset cannot be traded or if regulation limits the types of trades that can be placed, derivative contracts can ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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serve as an effective substitute." R.E. Whaley, Derivatives: Markets, Valuation, and Risk Management, (New Jersey: John Wiley & Sons, Inc.), p.10. 177

Pub.L. 111â&#x20AC;&#x201C;203, H.R. 4173.

178

179

R. Zepeda, "The ISDA Master Agreement 2012: A Missed Opportunity?" (2013) 28(8) Journal of International Banking Law and Regulation, pp.12-28.

180

A. Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (London: Strahan and T. Cadell, 1776); M. Friedman, Capitalism and Freedom: Fortieth Anniversary Edition (Chicago: University of Chicago Press, 2002); J.A. Schumpeter, Capitalism, Socialism and Democracy (Abingdon: Routledge Classics, 2010); and J. Fulcher, Capitalism: A Very Short Introduction (Oxford: Oxford University Publishing, 2004).

181

Van Deventer et al. note that "Risk management is the discipline that clearly shows management the risks and returns of every major strategic decision at both the institutional level and the transaction level. Moreover, the risk management discipline shows how to change strategy in order to bring the risk-return trade-off into line with the best long- and short-term interests of the institution." D.R. Van Deventer, K. Imai, and M. Mesler, Advanced Financial Risk Management: Tools & Techniques for Integrated Credit Risk and Interest Rate Risk Management, 2nd edition, (Singapore: John Wiley & Sons Singapore Pte. Ltd., 2013), p.5.

182

A. Tyagi, "Treasury and Risk Management Tope Financial Risks and Tools to Manage Them", (February 2013), Aberdeen Group, p.3.

183

In relation to collateral agreements, Field Fisher Waterhouse note that "The intrinsic value of swap transactions may vary from day to day as the markets fluctuate. It is increasingly common for parties to mark transactions to market on a regular basis and to seek to collateralise if their exposure passes certain thresholds. There are a number of reasons for this. In particular, a party may be motivated by a concern to maximise lines of credit from new or existing counterparties, to reduce credit risk, to reduce capital maintenance requirements or to meet regulatory concerns... There are a number of ways in which this can be done, and in an attempt to introduce market standardisation ISDA have produced four agreements intended to assist with the establishment of bilateral mark-to-market security arrangements." Field Fisher Waterhouse, 'Commentary on the ISDA Master Agreements' (February 2008) 1, p.4.

184

According to ISDA "This Agreement is used to document currency swaps and interest rate swaps in fifteen currencies (including US dollars). The Agreement does not incorporate the 1986 Code, but contains substantially identical provisions. The 1991 Definitions were developed for use with this Agreement." ISDA, "Publications", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 20 November 2013]. Harding adds that "This 1987 Agreement only covered interest rate and currency swaps. For currency swaps it covered 15 currencies. Addenda were issued in 1989 and 1990 to cover caps, floors, collars and options. The terms of these addenda were largely incorporated into the 1992 Agreement which updated the 1987 Agreement" (P. Harding, Mastering the ISDA Master Agreements (1992 and 2002), 2nd edition, (Harlow: Pearson Education Limited), p.19.

185

According to ISDA "This Agreement is used to document US dollar-denominated interest rate swaps. It is intended for use with the 1986 Code and incorporates the Code by reference. The 1992 ISDA Master Agreements were prepared to accommodate transactions that could be documented under the 1987 Agreements with their 1989 and 1990 Addenda, as well as other types of OTC derivatives." ISDA, "Publications", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 20 November 2013].

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ISDA also published the '1986 Code of Standard Wording', Assumptions, and Provisions for Swaps', and the '1987 ISDA User's Guide to the Standard Form Agreements' to aid market participants in their knowledge and understanding of how the 1987 Agreements functioned in practice. Kraw explains that "The ISDA code itself is not a contract, but only provides standard definitions and presumptions which apply unless expressly excluded. The existence of the code does not therefore eliminate the need for the parties to execute a contract which may incorporate, by reference, certain provisions of the ISDA code." E.M. Kwaw, Law and Practice of Offshore Banking and Finance, (CT, Westport: Quorum Books, 1996), p.185.

187

According to ISDA "This Agreement is used to document transactions between parties located in the same jurisdiction and transactions involving one currency. The Agreement is designed, among other things, to facilitate cross-product netting and may be used to document a wide variety of derivatives transactions. The 1992 Agreements were prepared to accommodate transactions that could be documented under the 1987 Agreements with their 1989 and 1990 Addenda." ISDA also prepared a User's Guide to assist in the understanding and use of this document. ISDA, "Publications", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 20 November 2013].

188

According to ISDA "This Agreement is used to document transactions between parties located in different jurisdictions and/or transactions involving different currencies. The Agreement is designed, among other things, to facilitate cross-product netting and may be used to document a variety of derivative transactions. The 1992 Agreements were prepared to accommodate transactions that could be documented under the 1987 Agreements with their 1989 and 1990 Addenda. ISDA also prepared a User's Guide to assist in the understanding and use of this document."

189

ISDA also subsequently published the 'User's Guide to the 1992 ISDA Master Agreement' to assist in the understanding and use of these documents.

190

E.M. Kwaw, Law and Practice of Offshore Banking and Finance, (CT, Westport: Quorum Books, 1996), p.185.

191

E.M. Kwaw, Law and Practice of Offshore Banking and Finance, (CT, Westport: Quorum Books, 1996), p.185. Kwaw (at p.185) notes that: "This reciprocity of obligations, to a large extent, influences the nature of the negotiations and resulting terms of swap agreements. For example, in a loan agreement, after the loan is made, the obligations that are left are those of the borrower, it is thus expedient to have rigorous provisions concerning events of default to protect the lender. In a swap agreement, events of default may to a large extent be reciprocal, so that both parties will take the benefit and the burden of the events of default."

192

See for example, B.J. Nalebuff and J.E. Stiglitz, " Information, Competition, and Markets", (1983) 73(2) The American Economic Review, Papers and Proceedings of the Ninety-Fifth Annual Meeting of the American Economic Association, pp. 278-283 and C. Shapiro and H.R. Varian, Information Rules: A Strategic Guide to the Network Economy, (Harvard Business School Press, 1998).

193

ABC, "Risk", <http://www.abc.org.uk/Products-Services/Product-Page/?tid=4256> [Accessed 20 November 2013].

194

Risk, "About Us" (2013) < http://www.risk.net/static/about-us> [Accessed 20 November 2013].

195

Risk, "About Us" (2013) < http://www.risk.net/static/about-us> [Accessed 20 November 2013].

196

BIS, "Statistical release OTC derivatives statistics at end-June 2013", (November 2013), Bank for International Settlements, Monetary and Economic Report, p.2.

197

For instance Harding explains that "With an ordinary loan, the lender lends money to the borrower at the start of the loan and the borrower has an obligation to repay the lender on an agreed date or dates. With an OTC derivatives transaction, this is less pre-dictable and market rate or price movements can change the roles of the parties several times during the life of a deal." (P. Harding,

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Mastering the ISDA Master Agreements (1992 and 2002), 2nd edition, (Harlow: Pearson Education Limited), p.25. 198

The International Monetary Fund add that typical counterparty risk mitigation practices also include the 'netting' of bilateral counterparty positions; the collateralisation of all the residual net exposures (i.e. the net exposure after amounts have been netted); and compression and tear-up operations that eliminate redundant contracts ( IMF, Global Financial Stability Report Meeting New Challenges to Stability and Building a Safer System, (April 2010), p.93.

199

ISDA, "ISDA Margin Survey 2013", (June 2013), International Swaps and Derivatives Association, p.2.

200

ISDA notes further that "Collateralization works best in those cases where the volume of activity is sufficient to warrant bearing the operational and procedural burdens associated with the sophisticated collateral process, provided that a legally enforceable claim can be established against collateral. Therefore, there are cases where it is simply more cost efficient or legally effective to rely on other methods of credit risk mitigation. Nonetheless, collateralization remains among the most widely used methods of mitigating counterparty credit risk in the OTC derivatives market, and market participants have increased their reliance on collateralization over the years." ISDA, "ISDA Margin Survey 2013", (June 2013), International Swaps and Derivatives Association, p.3.

201

ISDA, "ISDA Margin Survey 2013", (June 2013), International Swaps and Derivatives Association, p.2.

202

ISDA, "ISDA Margin Survey 2013", (June 2013), International Swaps and Derivatives Association, p.2.

203

J.P. Braithwaite, "Standard Form Contracts as Transnational Law: Evidence from the Derivatives Markets", (2012) 75(5) The Modern Law Review, pp.779-805, p.780.

204

P. Harding, Mastering the ISDA Master Agreements (1992 and 2002), 2nd edition, (Harlow: Pearson Education Limited), p.24.

205

Lomas v JFB Firth Rixson Inc [2010] EWHC 3372 (Ch) at [5] and [53] per Briggs J.

206

These are: (1) Interpretation; (2) Obligations; (3) Representations; (4) Agreements; (5) Events of Default and Termination Events; (6) Early Termination; (7) Transfer; (8) Contractual Currency; (9) Miscellaneous; (10) Offices; Multibranch Parties; (11) Expenses; (12) Notices; (13) Governing Law and Jurisdiction; and (14) Definitions.

207

This is split into six parts: (1) Part 1 – Termination Provisions; (2) Part 2 – Tax Representations; (3) Part 3 – Agreement to deliver Documents; (4) Part 4 – Miscellaneous; (5) Part 5 – Other Provisions; and (6) Part 6 – Foreign Exchange Transactions ad Currency Options.

208

Muscat notes that "A trade is usually agreed by a recorded telephone trade call which is considered to bind the entities of the dealers having made that call. It is standard practice, however, to confirm a trade in writing after the call. This is normally done two days after the trade date and is done by the exchange or countersignature of confirmations containing the complete terms of the transaction. At times a trade may need to be rebooked because through confirmations the dealers discover mistakes in the trade call." B. Muscat, "OTC Derivatives: Salient Practices and Developments Relating to Standard Market Documentation", (Spring 2009) No. 39 Bank of Valletta Review, pp.32-47, p.44.

209

According to ISDA "The 1994 ISDA Credit Support Annex allows parties to establish bilateral mark-tomarket security arrangements. This document serves as an Annex to the Schedule to the ISDA Master Agreement and is designed for use in transactions subject to New York law." ISDA, "ISDA Credit Support Documentation", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 22 November 2013].

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According to ISDA " The English Credit Support Annex allows parties to establish bilateral mark-tomarket arrangements under English law relying on transfer of title to collateral in the form of securities and/or cash and, in the event of default, inclusion of collateral values within the close-out netting provided by Section 6 of the ISDA Master Agreement. The English Credit Support Annex does not create a security interest, but instead relies on netting for its effectiveness. Like the New York Credit Support Annex, it is an Annex to the Schedule to the ISDA Master Agreement." ISDA Credit Support Documentation", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 22 November 2013].

211

According to ISDA "The 1995 ISDA Credit Support Deed allows parties to establish bilateral mark-tomarket collateral arrangements under English law relying on the creation of a formal security interest in collateral in the form of securities and/or cash. It is a stand-alone document (not an Annex to the Schedule), but is otherwise comparable to the 1994 ISDA Credit Support Annex for use with ISDA Master Agreements subject to New York law (which also relies on the creation of a formal security interest in the collateral)." ISDA Credit Support Documentation", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 22 November 2013].

212

According to ISDA: "The 1995 ISDA Credit Support Annex was prepared for use in documenting bilateral security and other credit support arrangements between counterparties for transactions documented under an ISDA Master Agreement for which the parties intend to use assets located in Japan as credit support. This Annex assumes that Japanese law will govern questions of perfection and priorities relating to posted collateral and is designed to provide documentation for parties wishing to minimize exposure to counterparties through collateral arrangements in respect of cash, deposit accounts, Japanese government bonds or other marketable securities situated in Japan. The structure and wording of this Annex were designed to conform to the 1994 ISDA Credit Support Annex in order to facilitate its use by those familiar with that Annex. Therefore, parties should generally refer to the User's Guide to the 1994 ISDA Credit Support Annex. The User's Guide to the Japanese Law Annex discusses the differences between the 1994 ISDA Credit Support Annex and the 1995 ISDA Japanese Annex." ISDA,"ISDA Credit Support Documentation", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 22 November 2013].

213

According to ISDA "The document reflects new netting, bankruptcy and securities clearing system legislation which were implemented in Japan after the 1995 ISDA Credit Support Annex (Security Interest - Japanese Law) was published. It is intended for use in documenting bilateral security and other credit support arrangements between counterparties for transactions documented under an ISDA Master Agreement for which the parties intend to use assets located in Japan as credit support. This Annex assumes that Japanese law will govern questions of perfection and priorities relating to posted collateral and is designed to provide documentation for parties wishing to minimize exposure to counterparties through collateral arrangements in respect of cash, deposit accounts, Japanese government bonds or other marketable securities situated in Japan. It is a stand-alone document (not an Annex to the Schedule)." ISDA,"ISDA Credit Support Documentation", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 22 November 2013].

214

According to ISDA "The English Standard Credit Support Annex allows parties to establish bilateral mark-to-market arrangements under English law relying on transfer of title to collateral in the form of securities and/or cash and, in the event of default, inclusion of collateral values within the close-out netting provided by Section 6 of the ISDA Master Agreement. The English Standard Credit Support Annex does not create a security interest, but instead relies on netting for its effectiveness. This alternative to the 1995 ISDA Credit Support Annex (Transfer ? English Law) further seeks to standardize market practice regarding embedded optionality in current Credit Support Annexes, promote the adoption of overnight index swap discounting for derivatives, and align the mechanics and economics of collateralization between the bilateral and cleared OTC derivative markets. This document, like the New York Credit Support Annex, is an Annex to the Schedule to the ISDA Master Agreement." ISDA,"ISDA Credit Support Documentation", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 22 November 2013].

215

According to ISDA "The 2013 Standard ISDA Credit Support Annex allows parties to establish bilateral mark-to-market security arrangements that create a homogeneous valuation framework, ÂŠ Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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reducing current barriers to novation and valuation disputes. This alternative to the 1994 ISDA Credit Support Annex seeks to standardize market practice regarding embedded optionality in current Credit Support Annexes, promote the adoption of overnight index swap discounting for derivatives, and align the mechanics and economics of collateralization between the bilateral and cleared OTC derivative markets. This document serves as an Annex to the Schedule to the ISDA Master Agreement and is designed for use in transactions subject to New York law." ISDA,"ISDA Credit Support Documentation", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 22 November 2013]. 216

For example: (1) the 1991, 2000, and 2006 ISDA Definitions; (2) the 1998 FX and Currency Option Definitions; (3) the 2003 ISDA Credit Derivatives Definitions; (4) the 2006 and 2008 ISDA Inflation Derivatives Definitions; and (5) the 2011 ISDA Equity Derivatives Definitions and Appendix.

217

For example: (1) the User's Guide to the 1992 ISDA Master Agreements; (2) the User's Guide to the 2002 ISDA Master Agreement; (3) the 2001 ISDA Cross-Agreement Bridge and Commentary; (4) the Explanatory Memorandum relating to the ISDA/IIFM Tahwwut Master Agreement; and (5) the 2013 ISDA Arbitration Guide.

218

For example The ISDA Standard Amendment Agreement â&#x20AC;&#x201C; 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Form (20 August 2013).

219

FATCA is the acronym for The US Foreign Account Tax Compliance Act (2010).

220

According to ISDA "The first protocol launched by ISDA was in 1998, the ISDA EMU Protocol which addressed contractual and legal certainty issues arising from the implementation of the European Monetary Union. This protocol and many others since 1998 have provided an efficient way of implementing industry standard contractual changes over a broad number of counterparties. The fundamental benefit to an adhering party to a protocol is that it eliminates the necessity for costly and time-consuming bilateral negotiations." ISDA, "About ISDA Protocols", <http://www2.isda.org/functional-areas/protocol-management/about-isda-protocols/> [Accessed 29 November 2013].

221

Muscat notes that "ISDA has sponsored legal opinions on a substantive number of jurisdictions worldwide regarding the applicability and enforceability of the netting provisions and collateral arrangements relating to the ISDA master agreements (all versions). If the parties to a master agreement intend to deviate from the wording contained in the standard agreements, it is recommended that they ensure that such changes do not render the legal opinion inapplicable or the netting provisions unenforceable". B. Muscat, "OTC Derivatives: Salient Practices and Developments Relating to Standard Market Documentation", (Spring 2009) No. 39 Bank of Valletta Review, pp.3247, pp.45-46.

222

For example the '2005 ISDA Collateral Guidelines', the 'Guidelines on Best Practices with respect to Cash Credit Support for Collateral Providers located in Canada' (ISDA Canadian Legal and Regulatory Affairs Committee, 4 May 2010), or the 'Best Practices for the OTC Derivative Collateral Electronic Margin Messaging Process' (15 February 2013).

223

P. Harding, Mastering the ISDA Master Agreements (1992 and 2002), 2nd edition, (Harlow: Pearson Education Limited), p.140. Harding notes (at p.140) that "The risks arises where economically simi-lar transactions are documented under different master agreements which may have varying valuation and termination provisions and produce different economic results on close-out."

224

Johnson comments that "Some changes are revolutionary, such as the complete revision of the calculation of early termination payments. Other changes reflect codifying market practice, such as the addition of a contractual set-off clause to the text of the 2002 Master Agreement itself. Finally, many changes were made to clarify and simplify the agreement such as the changes made to the payment netting provision." C.A. Johnson, The Guide to Using and Negotiating OTC Derivatives Documentation, (New York: Institutional Investor Books), p.54.

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[2009] EWHC 3386 (Comm).

226

[2009] EWHC 2656.

227

[2010] EWHC 3372 (Ch).

228

[2011] EWHC 718 (Ch).

229

[2011] EWHC 778 (Comm). See also: Pioneer Freight Futures Company Ltd (in liq) v TMT Asia Ltd [2011] EWHC 1888.

230

[2011] EWHC 692.

231

[2003] NSWSC 1169.

232

Case No. 08-13555 et seq. (JMP) (jointly administered).

233

ISDA, "ISDA Statement on Letter from Major Resolution Authorities", (6 November 2013), News Release, <http://www2.isda.org/news/isda-statement-on-letter-from-major-resolution-authorities> [Accessed 29 November 2013].

234

These are OTC derivatives trades which are executed by way of Confirmation and documented under an ISDA Master Agreement.

235

The netting provisions in the 2002 Master Agreement are very similar to those contained in the 1992 Agreement.

236

For example, section 1(c) of the 1992 Master Agreement states: "Single Agreement. All Transactions are entered into in reliance on the fact that this Master Agreement and all Confirmations form a single agreement between the parties (collectively referred to as this "Agreement"), and the parties would not otherwise enter into any Transactions."

237

Wood provides the following examples "A bank sets off a cross-claim for a loan owed to it by a depositor against the depositor's primary claim for a deposit owed by the bank. A defendant sets off, against the claimant-creditor, a cross-claim owed by the claimant to the defendant." P.R. Wood, SetOff and Netting, Derivatives, Clearing Systems, Volume 4, 2nd edition, (London: Sweet & Maxwell, 2007), para. [1-004].

238

These are stated to include any other amounts "payable by the Payee to the Payer (whether or not arising under this Agreement, matured or contingent and irrespective of currency, place of payment or place of booking of the obligation". It is also provided that "If an obligation is unascertained, X may in good faith estimate the obligation and set-off in respect of the estimate, subject to the relevant party accounting to the other when the obligation is ascertained" (ISDA Master Agreement 2002, section 6(f)).

239

In re: Lehman Brothers Inc, Case No. 08-01420 (JMP)(SIPA), United States Bankruptcy Court Southern District of New York.

240

These are contained in sections 6 (Early Termination) and 14 (Definitions) of the 1992 Master Agreement and section 6 (Early Termination; Close-Out Netting) of the 2002 Master Agreement.

241

ISDA, "Product Descriptions and Frequently Asked <http://www.isda.org/educat/faqs.html#32> [Accessed 29 November 2013].

242

M. Maizar, M. Jaquet, T. Spillmann, "Credit and counterparty risk: Why trade under an ISDA with a CSA? GesKR.

Questions",

205

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M. Maizar, M. Jaquet, T. Spillmann, "Credit and counterparty risk: Why trade under an ISDA with a CSA? GesKR.

244

Johnson states that "Under Loss, the non-Defaulting Party does not solicit quotations. Instead, the non-Defaulting Party itself in good faith makes the calculation of what its losses and costs would be if it were in-the-money, or any gains if it were out-of-the-money with respect to the relevant Transactions. If the non-Defaulting Party were in-the-money, the non-Defaulting Party is damaged because it will not receive its future payment obligations. If the non-Defaulting Party were out-of-themoney, it would have a gain because it would no longer be required to make future payments to the Defaulting Party under the ISDA Master Agreement. The net present value of the gain of the nonDefaulting Party (as calculated by the non-Defaulting Party) would be paid to the Defaulting Party on the Early Termination Date." C.A. Johnson, The Guide to Using and Negotiating OTC Derivatives Documentation, (New York: Institutional Investor Books), p.84. Weeber et al. further note that "When a party, as calculation agent, applies the loss method, its goals are to secure (1) an accurate valuation that includes all economic costs of replacement, (2) a calculation obtained in a "commercially reasonable" process and (3) a method that can withstand attack in future litigation", P. Weeber, M.E. Hoffman, and E.S. Robson, "Market Practices for Settling Derivatives in Bankruptcy: Part I", (October 2009), American Bankruptcy Institute Journal, Vol. XXVIII.

245

Field Fisher Waterhouse state that basically Market Quotation "involves the gathering of quotations for replacing the Transactions from leading dealers in the relevant market", but that if Market Quotation "cannot operate for any reason, for example if too few "Reference Market-makers" provide a quote, or if calculation on this basis would not (in the reasonable belief of the party making the determination) produce a commercially reasonable result", the Loss method will be used as a fall back. Field Fisher Waterhouse, 'Commentary on the ISDA Master Agreements' (February 2008) 1, p.12. Johnson adds that "The goal of Market Quotation is to preserve for the non-Defaulting Party the economic equivalent of any payment or delivery under the termi-nated transactions. Although the Reference Market-Maker does not actually enter into replacement transactions with the nonDefaulting Party, Market Quotation is generally thought to more accurately reflect market conditions because of the quotations received from independ-ent third parties." C.A. Johnson, The Guide to Using and Negotiating OTC Derivatives Documentation, (New York: Institutional Investor Books), p.84.

246

Johnson notes that the new Close-Out Amount melds the methodologies for calculating damages under the Market Quotation and Loss methods, as the party entitled to make the calculation (the Determining Party), calculates the mount of its losses, gains, costs, or gains under the then prevailing circumstances, in order to replace or provide the 'economic equivalent' of the material terms of the terminated transactions. It is noted that the Determining Party is entitled to rely on a much wider range of sources to determine the Close-Out Amount, including market quotations from third parties, relevant market data supplied by third parties. The Determining Party is also allowed to rely on internal quotations or market data, but only if this data is used in the regular course of conducting its business for the valuation of similar transactions, and only if the Determining Party believes in good faith that quotations or market data are not readily available or would produce a result that would not satisfy those standards. C.A. Johnson, The Guide to Using and Negotiating OTC Derivatives Documentation, (New York: Institutional Investor Books), pp.88-89.

247

D.L. Mengle, "Close-Out Netting and Risk Management in Over-the-Counter Derivatives", (1 June 2010), International Swaps and Derivatives Association and Fordham University, <http://ssrn.com/abstract=1619480> [Accessed 27 November 2013], p.1.

248

249

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R.R. Bliss and G.G. Kaufman, "Derivatives and systemic risk: Netting, collateral, and closeout", (2006) 2 Journal of Financial Stability, pp.55-70, p.60.

251

R.R. Bliss and G.G. Kaufman, "Derivatives and systemic risk: Netting, collateral, and closeout", (2006) 2 Journal of Financial Stability, pp.55-70, p.68.

252

Section 5(b)(v) of the 2002 Master Agreement specifies that this includes where "X consolidates or amalgamates with, or merges with or into, or transfers all or substantially all its assets (or any substantial part of the assets comprising the business conducted by X as of the date of this Master Agreement) to, or reorganises, reincorporates or reconstitutes into or as, another entity". It also includes the direct or indirect acquisition of beneficial ownership of X, as well as any substantial change in the capital structure of X.

253

Section 5(b)(iv) of the 1992 Master Agreement and section 5(b)(v) of the 2002 Master Agreement.

254

ISDA states that the 2005 Guidelines are intended to: (1) Document the state of collateral management practice at the end of 2004; (2) Discuss the nature and mechanics of collateralization, including the key legal foundations; (3) Describe the interaction of the collateral management function with other areas of the firm; (4) Identify the benefits and risks of collateralization; and (5) Outline current trends and possible future developments in collateral management. ISDA also states that the topics addressed include: (1) Collateral as a Risk Management Tool; (2) Collateral Management Function; (3) Documentation for Collateral; (4) Margin Call Process; (5) Managing Collateral Assets; and (6) Trends in Collateral Management. ISDA, "ISDA Credit Support Documentation", <http://www.isda.org/publications/isdacredit-users.aspx#marg> [Accessed 28 November 2013].

255

ISDA, "Global Derivatives: More Change Ahead", (19 April 2013), pp.5 and 9.

256

Section 2(d) of the 1992 Master Agreement and section 2(d) of the 2002 Master Agreement.

257

Section 3 of the 1992 Master Agreement and section 3 of the 2002 Master Agreement.

258

Section 14 (Definitions: "Default Rate") of the 1992 Master Agreement and section 9(h) of the 2002 Master Agreement.

259

Section 13 of the 1992 Master Agreement and section 13 of the 2002 Master Agreement.

260

Section 14 of the 1992 Master Agreement and section 14 of the 2002 Master Agreement.

261

S. Das, "In the Matter of Lehman Brothers – Part 1: Breaking Up is Hard To Do", (15 November 2011), <http://www.economonitor.com/blog/2011/11/in-the-matter-of-lehman-brothers-%E2%80%93part-1-breaking-up-is-hard-to-do/> [Accessed 1 December 2013].

262

A. Sakoui, "Lehman unwinding creates a blueprint", (21 September 2010), Financial Times.

263

264

265

E. Parker and A. McGarry, "The ISDA Master Agreement and CSA: close-out weaknesses exposed in the banking crisis and suggestions for change" (January 2009) Butterworths Journal of International Banking and Financial Law, pp.16-19, p.16.

266

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ISDA, "Non-Cleared OTC Derivatives: Their Importance to the Global Economy", (March 2013), p.4.

268

ISDA, "About ISDA", <http://www2.isda.org/about-isda> [Accessed 28 November 2013]. ISDA also notes "These members include a broad range of OTC derivatives market participants including corporations, investment managers, government and supranational entities, insurance companies, energy and commodities firms, and international and regional banks. In addition to market participants, members also include key components of the derivatives market infrastructure including exchanges, clearinghouses and repositories, as well as law firms, accounting firms and other service providers."

269

P. Harding, Mastering the ISDA Master Agreements (1992 and 2002), 2nd edition, (Harlow: Pearson Education Limited), p.19.

270

C.A. Johnson, The Guide to Using and Negotiating OTC Derivatives Documentation, (New York: Institutional Investor Books), p.7.

271

For example, ISDA's latest conference schedule includes the following: (1) Implementing EU Derivatives Regulation (3 December 2013, London); (2) Transaction Reporting Conference DoddFrank and EMIR Requirements (4 December 2013, London); (3) Extraterritoriality in International Derivatives Regulation (5 December, New York); (4) Swap Execution Facilities: The Evolution of OTC Trading (10 December, New York); (5) U.S. and European Swap Regulations Who They Apply to and How They Are Addressed by ISDA Protocols and ISDA Amend by Markit (16 January 2014, Singapore); (6) Extraterritoriality in International Derivatives Regulation (20 January 2014, Tokyo); (7) Transaction Reporting Conference Dodd-Frank and EMIR Requirements (21 January, London); (8) ISDA/FOA Client Cleared OTC Derivatives Addendum (28 January 2014, London); (9) ISDA 29th Annual General Meeting (April 8-10, 2014) (8 April 2014, Munich). ISDA, "ISDA Conference Schedule", (2013), <http://www2.isda.org/conference/> [Accessed 28 November 2013]. ISDA also notes that it holds more than 120 conferences around the world on documentation, clearing, collateral, data and reporting, risk management, and related issues, with over 5,000 market participants attending ISDA held events in 2013. ISDA, "Global Derivatives: More Change Ahead", (19 April 2013), p11.

272

"netalytics makes conducting your netting analysis simple. A joint venture with ISDA, netalytics provides a standard colour-coded report with answers to 14 key netting questions for each jurisdiction covered by an ISDA netting opinion. Features include a compare function, version control and source hyperlinks. Reports are quickly updated to reflect new or updated opinions published by ISDA, plus the alert function delivers details of these updates directly to your inbox to ensure you're always on top of developments." derivativeservices, (2013) <http://www.derivativeservices.com/products/derivatives/netalytics#/products/derivatives/netalytics/> [Accessed 28 November 2013].

273

"CSAnalytics puts the answers to collateral questions at your fingertips. CSAnalytics covers every ISDA collateral opinion, examining the enforceability of each collateral document. The answers to each question illustrate three fact patterns, identifying exactly what the opinion says based on the location of your counterparty/collateral. The compare function enables you to compare answers across jurisdictions, perhaps focusing on one credit support document or a specific fact pattern. With links to the underlying opinion in each question, collateral analysis has never been so easy." derivativeservices, (2013) <http://www.derivativeservices.com/products/derivatives/netalytics#/products/derivatives/CSAnalytics/ > [Accessed 28 November 2013].

274

For example: (1) ISDA ECP Guarantor Keepwell Terms (19 April 2013) (Set of provisions to allow ECP guarantors to provide a “keepwell” to other guarantors that need such support to also qualify as eligible contract participants); (2) ISDA Exclusionary Terms and Keepwell Terms Advisory Note (19 April 2013); (The purpose of the ISDA Exclusionary Terms and the ISDA Keepwell Terms is to provide contractual terms that may be easily inserted into transaction documentation to address issues relating to guarantees by parties that may be non-ECPs. The ISDA Exclusionary Terms and Keepwell Terms can be used individually or in combination for these situations); and (3) ISDA Non© Copyright 2017 | Storm-7 Consulting | All Rights Reserved

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ECP Guarantor Exclusionary Terms (19 April 2013) (Set of provisions to ensure that any guaranty provided in a document excludes the guaranty of swap obligations by a guarantor who is not an eligible contract participant). 275

See: ISDA, "Amicus Briefs", (2013) <http://www2.isda.org/functional-areas/legal-anddocumentation/amicus-briefs/page/2> [Accessed 28 November 2013].

276

United States Court of Appeals, Second Circuit, October 9, 2013.

277

Judgment of the English Court of Appeal, April 3, 2012.

278

United States District Court, Southern District of New York. July 15, 2010.

279

US Bankruptcy Court – Southern District of NY. July 5, 2005.

280

ISDA, "Eurozone Contingency Planning", (2013) <http://www2.isda.org/functional-areas/legal-anddocumentation/eurozone-contingency-planning/> [Accessed 28 November 2013].

281

ISDA, "Mission Statement", (2013), <http://www2.isda.org/about-isda/mission-statement/>, [Accessed 28 November 2013].

282

This is stated to mean "Providing standardized documentation globally to ensure legal certainty and maximum risk reduction through netting and collateralization".

283

This is stated to mean "Promoting infrastructure that supports an orderly and reliable marketplace as well as transparency to regulators".

284

This is stated to mean "Enhancing counterparty and market risk practices and advancing the effective use of central clearing facilities and trade repositories".

285

This is stated to mean "Representing the derivatives industry through public policy, ISDA governance, ISDA services, education and communication".

286

ISDA, "Strategy Statement", (2013), <http://www2.isda.org/about-isda/mission-statement/> [Accessed 28 November 2013].

287

See: <http://www.derivsdocu.com/> [Accessed 28 November 2013].

288

For example see: P.C. Harding, Mastering the ISDA Master Agreements: A Practical Guide for Negotiation, 3rd edition, (Harlow: Pearson Education Limited, 2010); S.P. Bender, Negotiating Skills for the ISDA Master Agreement: The Essential Playbook for Over-the-Counter Derivatives, (Financial Times/Prentice Hall, 2011); and G. Reiner, ISDA Master Agreement, (Beck CH, 2013).

289

ISDA notes that: "The ISDA/IIFM Tahawwut Master Agreement is a global master agreement for transactions in Islamic derivatives. The document provides the first standard contract document for cross-border transactions in Shariah-compliant derivatives. Like the ISDA 2002 Master Agreement on which it is based, the ISDA/IIFM Tahawwut Master Agreement is a multiproduct framework agreement. The document has been drafted with a view to documenting commodity murabaha-based Islamic profit-rate and currency swaps." ISDA, "ISDA Master Agreement", <http://www.isda.org/publications/isdamasteragrmnt.aspx> [Accessed 28 November 2013].

290

See: ISDA, "IIFM and ISDA Launch Tahawwut (Hedging) Master Agreement", (1 March 2010), <http://www.isda.org/media/press/2010/press030110.html> [Accessed 28 November 2013].

291

ISO, ISO 31000:2009, Risk management – Principles and guidelines, (2009), International Organization for Standardization.

292

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ISDA, "Global Derivatives: More Change Ahead", (19 April 2013), p.2

294

P.R. Wood, Set-Off and Netting, Derivatives, Clearing Systems, Volume 4, 2nd edition, (London: Sweet & Maxwell, 2007), para. [12-003].

295

It should also be noted that the ISDA Master Agreement has been officially translated into other languages for educational purposes, including: (1) Brazilian Portuguese; (2) Chinese; (3) French; (4) Indonesian; (5) Greek; (6) Japanese; (7) Korean; (8) Russian; (9) Spanish; and (10) Vietnamese language versions.

210