10 Upper Bank Street, London, E14 5JJ
Switchboard: +44 (0)20 7006 1000Fax: +44 (0)20 7006 5555
This section describes the standard market over-the-counter (OTC) derivatives documentation currently available for documenting some of the risk management instruments described previously.
The standard OTC hedging documentation currently available falls broadly into two categories: multi-product documentation; and product-specific documentation, and takes the form of master agreements under which a number of transactions can be documented. Users of these master agreements benefit not only from the ease of documenting multiple transactions under a single agreement but also from an ability under the laws of many countries to net exposures under those transactions.
Principal in the production of standard market multi-product derivatives documentation is the International Swaps and Derivatives Association, Inc. (ISDA), which was established in 1985 by representatives of international banks, companies and other business organisations. The central documents published by ISDA are the two 1992 Master Agreements – the multicurrency cross border master agreement and the local currency single jurisdiction master agreement – (the former being the more commonly used) – and the 2002 version of the multicurrency cross border master agreement (see for updates here).
Changes have been made to reflect members’ experiences in using the documents and changes in market practice over the intervening decade. There are no plans to publish a 2002 version of the local currency single jurisdiction master agreement.
As will be seen below, the cross border master agreement purports to cover an almost unlimited range of derivatives transactions. For this reason, it is considerably longer and more complex than product-specific documentation. ISDA documentation has grown organically over the last few decades.
ISDA has published detailed sets of definitions, which include forms of trade confirmation, covering different categories of derivatives products (for example the 1998 FX and Currency Option Definitions; the 2002 Equity Derivatives Definitions; the 2011 Equity Derivatives Definitions; the 2003 Credit Derivatives Definitions; the 2005 Commodity Definitions; the 2008 Inflation Derivatives Definitions; the 2006 Fund Derivatives Definitions and the 2007 Property Index Derivatives Definitions), as well as a detailed set of general definitions (the most recent version of which is the 2006 ISDA Definitions).
ISDA updates these sets of definitions from time to time to include new types of transactions and to reflect current market practice. For example, a May 2003 Supplement, a 2005 Matrix Supplement, a 2005 Monoline Supplement and a July 2009 Supplement to the 2003 ISDA Credit Derivatives Definitions are available as well as the IDSA 2014 Credit Derivatives Definitions (discussed below) and the 2011 ISDA Equity Derivatives Definitions revise, expand and restructure the earlier 2002 ISDA Equity Derivatives Definitions (although at this stage, most participants continue to use the 2002 definitions). These definitions may be expressly incorporated into an ISDA master agreement or a trade confirmation (more usually the latter); they are of particular use in drafting confirmations for the various types of products traded, and for providing agreed terms and fallbacks for unexpected events. To assist market participants, ISDA has also published User‘s Guides to its master agreements and to some sets of definitions. It is, however, fair to say that the documents comprise a formidable body for the uninitiated, notwithstanding the guides, which are not intended as a substitute for taking legal advice.
ISDA has also published a series of documents to enable parties to put in place collateral, or margin, arrangements. Currently, the most commonly used English law versions of these are the 1995 ISDA Credit Support Annex (which uses a title transfer method of collateralising obligations) and the 1995 ISDA Credit Support Deed (which uses a security interest method).
ISDA has also published the 2001 Margin Provisions, which include both title transfer and security interest approaches within one document for use as appropriate with common operational provisions. However, at this stage, the 2001 Margin Provisions have not been widely adopted.
In 2013 ISDA published the 2013 ISDA Standard Credit Support Annex which is designed to further standardise market practice and align the mechanics and economics of collateralisation between the bilateral and cleared OTC derivatives markets (we discuss central counterparty clearing of OTC derivatives further below).
Most recently, ISDA published the 2014 ISDA Credit Derivatives Definitions, which are a complete revision of the 2003 ISDA Credit Derivatives Definitions. The 2014 ISDA Credit Derivatives Definitions introduce several new terms for credit default swaps, including a new credit event for certain financial reference entities which will be triggered by a government initiated bail-in; a provision for the delivery of the proceeds of bailed-in debt or a restructured reference obligation in lieu of the original obligation; more delineation between senior and subordinated credit default swaps; an expansion of the types of assets that may be delivered by way of settlement for sovereign credit default swaps; and the adoption of a standardised reference obligation across all market-standard credit default swap transactions on the same reference entity and seniority level. The 2014 ISDA Credit Derivatives Definitions are scheduled to be adopted by the market in September 2014 and ISDA will produce a protocol that will enable market participants to apply the new definitions to certain existing transactions, thereby eliminating distinctions between those existing transactions and new transactions entered into on the 2014 ISDA Credit Derivatives Definitions.
So far as the development of product-specific OTC derivatives documentation is concerned, the role of the British Bankers’ Association (BBA) has been central. The BBA published (amongst others) the FRABBA terms in 1985 for use with forward rate agreements, the International Currency Options Market (ICOM) Terms and Agreement (together with guides to both) in 1997 for use in respect of currency option transactions, and the International Foreign Exchange Master Agreement (IFEMA) and the IFEMA Terms (together with guides to both) in 1997 for use with foreign exchange spot and forward transactions.
The BBA also published the 1997 Foreign Exchange and Options Master Agreement (FEOMA) which parties may use to document foreign exchange spot and forward transactions as well as foreign exchange options. The FEOMA is an amalgamation of the IFEMA and the ICOM.
The Foreign Exchange Committee, together with the BBA, more recently published the 2005 International Foreign Exchange and Currency Option Master Agreement (IFXCO) which updates the ICOM, IFEMA and FEOMA by incorporating terms from the 1998 FX and Currency Option Definitions published by ISDA, EMTA (the trade association for the emerging markets) and the Foreign Exchange Committee, as well as recommendations of the Global Documentation Steering Committee.
In co-operation with the BBA, and modelled closely on earlier versions of the IFEMA and ICOM documents, the London Bullion Market Association (LBMA) in 1994 published the IBMA for use with spot, forward and option transactions in gold and silver. The FRABBA, ICOM, IFEMA, FEOMA, and IBMA are described in greater detail later in this section. Please note that the ICOM, IFEMA, FEOMA and IFXCO are now primarily sponsored by the Foreign Exchange Committee and can be obtained from the Financial Markets Lawyers Group website. (here)
The ISDA master agreements set out standard terms and conditions applicable to parties’ transactions, together with a schedule. The schedule gives the parties the ability to adjust the master agreement to their requirements by completing blanks, selecting alternative operative provisions and amending the master agreement where appropriate. The local currency master agreement is intended to be used where both counterparties are in the same jurisdiction and no international issues need to be addressed.
The local currency master agreement, therefore, omits international provisions found in the cross border master agreement such as those covering withholding tax and other tax matters, contractual currency and jurisdiction. The first time a transaction is to be entered into between two parties, they are likely to negotiate the terms of the schedule and then execute the master agreement. It is, however, important to remember that the master agreement should ideally be entered into before the parties enter into any transaction. Each transaction entered into between two parties is generally concluded by the parties on the telephone and evidenced by a written “confirmation” which specifies the terms of the transaction and which is customarily prepared by one party and sent by telex/facsimile/electronic message system to the other party.
The recipient party will then notify the first party either of any disagreement with any of the specified terms or of its agreement with such terms. Once a confirmation is in agreed form, it constitutes a supplement to, and is governed by, the master agreement. It is intended that all transactions entered into under the terms of the master agreement shall constitute a single agreement between the parties.
A key benefit of a master agreement is that parties can substantially reduce their credit exposure to one another as it is generally possible, subject to relevant insolvency laws, upon the occurrence of an Event of Default or Termination Event (as defined) to terminate all transactions simultaneously and net the termination gains (derived from profitable transactions) against the termination losses (derived from loss-making transactions). This is called close-out netting. Netting provisions also apply during the lifetime of an agreement to a transaction where payments due from one party to the other and vice versa are in the same currency and are due for payment on the same date. This is called payment netting. In order for these payment netting provisions to apply in respect of two or more transactions governed by their ISDA master agreement, the parties must make an election in the schedule or in a confirmation (see below).
The 1992 and 2002 master agreements were updates of two master agreements published in 1987 and cover numerous types of swap including interest rate swaps, basis swaps, forward rate swaps, commodity swaps, commodity options, equity swaps, equity index swaps, foreign exchange transactions, interest rate floors, caps and collars, currency swaps, credit derivatives, return swaps and so on. It should be noted that the term “transaction” as used in the 1992 and 2002 master agreements imposes no apparent limitation on the types of transaction which may be traded under them. Companies which signed the 1987 version should consider replacing it with a later version if, for example:
- they wish to transact some of the newer types of financial instruments;
- settlement is to be by way of delivery (delivery not being catered for in the 1987 version); or
- their 1987 document did not provide for payment of a close-out sum to a defaulting party.
There are some other significant differences between the 2002 and 1992 agreements.
One of the most significant changes is to the calculation method used when transactions are terminated following an event of default or termination event. This new methodology is intended to address some of the weaknesses of the previous methodology, which came to light during periods of market stress in the late 1990s. The aim is to offer greater flexibility, and yet less uncertainty, when determining, using fair and commercial practices, a close-out amount based on reproducing the economic equivalent of material terms of terminating transactions. Also, a new termination event based on force majeure or act of state has been included. Other changes, of which there are many, reflect developments in market practice and amendments that were commonly made to the 1992 master agreement. ISDA has also published an amendment agreement and a protocol whereby the close out calculation provisions in a 1992 master agreement can be replaced with the 2002 master agreement calculation provisions, if the parties so wish.
As a final point, it should always be borne in mind that the generic master agreements need to be used with a degree of caution; certain provisions may need to be added or modified in relation to a particular transaction or for particular counterparties. An outline of the more important issues is discussed in the following section. Some issues to be considered when completing a schedule to an ISDA master agreement (which is generally divided into five parts although, of course, additional parts may be added) are summarised below – and some differences between the 1992 and 2002 master agreements are noted.
This deals with early termination provisions. The parties can negotiate which types of defaults by which group members will result in the termination of which transactions. They can also decide whether certain insolvency-related events will, subject to relevant insolvency laws, automatically terminate transactions without any action being taken by either party; the intended advantage of such an arrangement is to try to ensure that the termination rights of the non-defaulting party may be exercised prior to the onset of any insolvency regime which may apply to the other party.
Depending upon the jurisdiction concerned, this may not be necessary or advantageous, (or even effective), and the decision to adopt such a provision must, therefore, be weighed against the disadvantage of termination occurring without either party being aware of the fact. This may mean that the non-defaulting party continues to make payments after termination at a time when the relevant market could be adversely moving. The parties may also specify any additional termination events that they consider necessary, for example, relating to change of ownership. Finally, in this part of the 1992 schedule the parties can also choose both how the termination payments will be calculated (“market quotation” or “loss”) and how the payments will be made (the “First Method” or the “Second Method”).
The first set of options is unlikely to lead to a significant difference in amount but if the proposed transactions are not regularly traded then the second choice, “loss”, would be more appropriate. In the 2002 master agreement elements of “market quotation” and “loss” have been combined into a single calculation method so no election is needed. The difference between the second set of options is principally that the First Method will not require the non-defaulting party to make any payment to the defaulting party even where the application of the measure of payment provisions shows that there is a net sum due from the non-defaulting party. In practice, the Second Method (full two-way payments) is invariably selected, not solely on the basis of fairness, but also because the selection of the First Method will result in banks and securities firms receiving disadvantageous treatment in terms of their regulatory capital requirements and also in some jurisdictions “First Method” may not be enforceable. In the 2002 master agreement, all payments are made using Second Method approach (although this terminology is now redundant) and, again, no election is needed.
This deals with withholding tax and whether the parties can pay amounts without a withholding tax obligation and receive amounts “gross”. The tax representations relate solely to withholding tax and do not address other tax questions such as value added tax, capital gains tax, stamp duty reserve tax or stamp duty. The tax representations of the payee are expressed to be made at all times, while those of the payer are only made on the date upon which a transaction is entered into. A UK party should also consider whether payments that it makes under transactions can be deductible expenses for the purposes of calculation of its UK corporation tax liability. The tax treatment of payments in the UK under derivatives transactions is complicated and companies should always seek specific advice on the tax implications of such transactions before entering into them.
This deals with the information that each party agrees to supply to the other. This will frequently include tax treaty forms, documents and certificates for the purposes of obtaining double tax treaty relief. Other documents a party may request include copies of constitutive documents, board resolutions, signing authority, specimen signatures and other corporate authorisations.
It is best practice in all circumstances for a party to a master agreement to verify that its counterparty has the requisite power and capacity to enter into the transactions covered by the agreement and such documents can help in the assessment of this; the constitutive documents of any counterparty (in particular the objects clause of a corporate counterparty) should be examined carefully to ensure that the counterparty has requisite capacity to transact all the product types intended to be entered into by the parties and, where appropriate, to provide collateral. When dealing with overseas counterparties or overseas credit support providers, local legal opinions may be considered necessary in confirming a party’s capacity to enter into the master agreement and transactions under it or to provide credit support.
Additional documentation evidencing due authorisation may be required from counterparties which are, for example, building societies, municipalities, funds, charities or insurance companies and these should be considered on a case-by-case basis where applicable. Parties entering into master agreements with such types of counterparties should seek legal advice as to what types of authorisations and other comfort are needed. In addition, as mentioned below, extra representations as to capacity may need to be inserted into the transactional documentation. It should be noted that if a counterparty does not have the requisite power to enter into the master agreement, the master agreement and all transactions thereunder may be held to be ultra vires and void, notwithstanding the inclusion of extra representations.
This is a group of miscellaneous provisions. If one of the parties is to enter into transactions out of different offices/branches, these should be specified and the tax consequences considered. In relation to this, there is an important provision regarding obligations of these offices and branches being equivalent to those of the home office. This would be the case under English law but is not necessarily so in other jurisdictions. There is also a provision in this part relating to payment netting. The terms of the master agreement provide for payments in the same currency in respect of the same single transaction which are payable on the same date to be netted. The schedule enables parties to amend this provision to apply to any specific or all transactions and, if required, to apply from a specified date. By amending this provision the parties can facilitate cross-product netting.
However, because of a lack of operation capability, many parties are unable to agree to netting, particularly across more than one transaction. Particular caution should be exercised in completing this part of the 1992 schedule since, as mentioned above, a close reading will reveal that the dis-application of a certain provision contained in the master agreement has the counter-intuitive effect of applying these netting provisions to all transactions between the parties (the drafting in the 2002 version has been simplified).
Part 4 is also the place where any credit support documents (e.g. guarantees, comfort letters, security documents) should be specified together with the name of the party granting the support. Also, the governing law is specified here. In addition, the 2002 schedule includes the text of ISDA’s Relationship Between Parties’ representation (in which parties represent that they have taken independent decisions to enter into transactions, that they are not acting in a fiduciary capacity, and so on) and a consent to telephone recording of conversations, both of which were commonly added to Part 5 of the 1992 schedule.
This Part (“Other Provisions”) appears in blank to allow any extra provision required by the parties to be set out. Such provisions may include:
- additional events of default, e.g. that the down-grading of a party’s credit rating constitutes an event of default;
- additional representations and/or covenants where one of the parties is, for example, a foreign company, a building society or an insurance company, or to cover a situation where one of the parties is acting as agent and not as principal – a “no agency” representation has been included in the 2002 master agreement at section 3(g) which can be applied or dis-applied in Part 4 of the 2002 schedule;
- in the case of the 1992 schedule, a set-off clause to allow (at the option of the non-defaulting party) set-off of a party’s termination payment and monies owed by the other party under other agreements – a set-off provision in these terms is included in the 2002 master agreement itself at section 6(f);
- escrow provisions to address potential problems arising from time differences between the places to which each party makes payments (i.e. one party could make a payment at the time it is obliged to do so in the relevant time zone but then fail to receive payment due to it from the other party); in this situation provision can be made for a third party to hold payments “in escrow” and only release a payment when it has received the corresponding payment from the other party; and
- provisions to address a situation where one party is consistently the buyer of an option or interest rate cap or floor; in this case the buyer’s obligations are met at the start of the transaction by the payment of a premium and, therefore, it may be considered appropriate to limit the events of default so that they generally do not apply to the buyer once it has paid all premiums due to the other party.
ISDA has launched various documentation projects since the Lehman Brothers insolvency in September 2008, addressing some of the lessons learned in the crisis and also responding to calls from EU and US regulators for greater transparency and standardisation in the derivatives market.
Notably, ISDA’s Close-Out Amount Protocol permits parties to agree up front that in the event of a counterparty default they will use close-out amount valuation methodology to value trades. Close-out amount valuation, which was introduced in the 2002 master agreement, differs from the market quotation approach in that it allows participants more flexibility in valuation where market quotations may be difficult to obtain.
ISDA has also been incorporating (or “hardwiring”) into its standard credit default swap documentation provisions for the auction settlement of contracts after a default or other credit event on a company referenced in credit default swap transactions. A new ISDA Determinations Committee makes binding determinations on issues such as whether a credit event has occurred, whether an auction will be held and whether a particular obligation is deliverable.
These developments, coupled with the changes in market practice that support standard coupons for credit default swaps, are intended to introduce greater certainty to transactional, operational and risk considerations for the treatment of credit default swaps.
ISDA is actively involved in helping generate access to central counterparty clearing for privately negotiated derivatives and published Common Principles for Give-Up Agreements for Central Clearing in November 2009 and, most recently, the ISDA/FOA Client Cleared OTC Derivatives Addendum (central counterparty clearing, and the Addendum, are discussed further below).
Further, March 2010 saw the launch by the International Islamic Financial Market (IIFM) and ISDA of the ISDA/IIFM Tahawwut (Hedging) Master Agreement, a breakthrough in Islamic finance and risk management. The agreement marks the introduction of the first globally standardised documentation for privately negotiated Islamic hedging products.
These terms, which were introduced by the BBA in 1985 for use with forward rate agreements, are primarily intended for use by banks in the London inter-bank market. Where a non-bank uses FRABBA terms they may need to be amended. For example, section 1.3 provides “it is understood that both parties have entered into this forward rate agreement in accordance with normal banking practice”.
Certain additional representations may be required, e.g. as to capacity and the tax position (as the tax representation is only given on the date the forward agreement is entered into and is not repeated thereafter). Also, where a forward rate agreement is cross border certain amendments may be necessary. The termination provisions of FRABBA terms are also considered by some not to be comprehensive. For example, illegality does not trigger termination of an agreement. The consequences of termination operate on a general indemnity basis.
ICOM, IFEMA, FEOMA, IFXCO and IBMA
These documents, as mentioned above, were published by the BBA (in the case of ICOM, IFEMA, FEOMA and IFXCO) and by the LBMA (in the case of the IBMA) in respect of currency options, spot and forward currency transactions and bullion spot, forward and option transactions, respectively.
The ICOM, IFEMA and FEOMA come with a schedule in which the parties may specify matters such as the scope of the Agreement, offices through which transactions made under the document may be entered into, the offices in respect of which the netting provisions contained in the documents will apply, payment instructions, netting provisions, threshold amount, additional Events of Default, election in respect of automatic termination, governing law, consent to jurisdiction, agent for service of process and certain additional regulatory representations.
The IFEMA and FEOMA schedules also provide for election in respect of cash settlement of FX transactions. The IBMA schedule is more limited and enables the parties to specify matters such as offices in respect of which netting provisions contained in the agreement will apply, and the trigger amount in respect of cross-default provisions contained in the document.
The key provisions found in the ICOM, IFEMA, FEOMA and IBMA include settlement and novation netting provisions, close-out and liquidation provisions, force majeure provisions and (in the case of the ICOM, FEOMA and IBMA) detailed provisions relating to the exercise (including automatic exercise) of the settlement and netting of options. The tax provisions (including VAT provisions in respect of bullion) contained in these documents are in a standard form and therefore do not normally need to be negotiated on a case-by-case basis, although they should be considered from a tax perspective.
The IFXCO is an update of the ICOM, IFEMA and FEOMA. The IFXCO contains provisions recommended by the Global Documentation Steering Committee as part of its efforts to improve and co-ordinate all types of master agreement for derivatives transactions in response to the Long-Term Capital Management insolvency in 1998, including changes to provisions for cross-default, involuntary bankruptcy default, adequate assurances, force majeure, default notices and bankruptcy events of default. The IFXCO also incorporates the terms of the 1998 ISDA FX and Currency Option Definitions. The IFXCO has an Adherence Agreement instead of a Schedule, although the two documents have much the same effect. In contrast to the FRABBA terms, the ICOM, IFEMA, FEOMA, IFXCO and IBMA are designed for use by companies and thus do not require specific amendment in this regard.
Where no executed master agreement exists, there are ICOM, IFEMA, FEOMA and IBMA “terms” which seek to reflect the standard market practice for currency options, foreign exchange and bullion transactions as the case may be. Each document, by its terms, purports to apply to all transactions between two parties falling within the scope of the document, even where the parties have not executed the document.
The document will only apply automatically in this way if the parties have not executed another appropriate master agreement and if one of the parties is acting through an office located in the UK. Since the terms are not specifically negotiated they contain certain fall-back positions in respect of matters which would otherwise be expressly agreed (such as the trigger amount for cross-default purposes). The application of each of the ICOM, IFEMA, FEOMA and IBMA in the form of “terms” provides a useful fall back where transactions are, for example, executed before a master agreement has been put in place.
However, it is probably the case that a considered and negotiated master agreement, rather than the terms, will be more likely to achieve the desired result in most cases.
EMIR and central counterparty clearing of OTC derivatives
Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (EMIR), which has direct effect in this jurisdiction, imposes a range of obligations on parties to OTC derivatives contracts – in some cases, irrespective of whether a party is a financial counterparty (FC) or a non-financial counterparty (NFC). Consequently, one of the effects of EMIR is that entities that were previously unregulated in relation to their derivatives transactions (e.g. many corporates) will now have to comply with all applicable EMIR obligations.
At the time of writing, a number of those obligations are now effective (e.g. risk mitigation obligations in relation to timely confirmations, dispute resolution, portfolio reconciliation, portfolio compression and reporting). The headline EMIR obligation that all standardised OTC derivatives between certain parties (broadly, FCs and NFCs that have exceeded the clearing threshold) should be cleared through central counterparties is now expected to be introduced from spring 2016 beginning with certain classes of interest rate swaps. The EMIR obligation that non-cleared trades should be appropriately collateralised is now expected to be introduced from autumn 2015, subject to certain phase-in provisions. Similar regulatory changes are being implemented in the United States and internationally to enable fulfilment of G20 commitments.
Unsurprisingly, this regulatory change will have an impact on documentation for both non-cleared and cleared OTC derivatives. The precise details will depend on the classification of the parties and, in relation to clearing, the choice of clearing member/dealer and CCP.
A number of CCPs are starting to offer buy-side access for credit, interest rates and FX clearing, and have developed or are developing their own standard form documentation. In addition, ISDA and FIA Europe (previously known as the Futures and Options Association (FOA)) have published a template (the ISDA/FOA Client Cleared Derivatives Addendum) for use by cleared swaps market participants to document the relationship between a clearing member and its client for purposes of clearing OTC derivatives transactions across CCPs. ISDA has also been developing a number of protocols and forms of agreement to assist parties with their EMIR compliance more generally. These include the ISDA 2013 EMIR NFC Representation Protocol, the ISDA 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol and the ISDA EMIR Timely Confirmation Amendment Agreement Form.