Documentation of Over-the-Counter Derivatives

Tan Sin Liang explains the complex documentation involved in over-the-counter derivatives transactions.

Meaning of Over-the-Counter Derivatives Transaction

A derivatives transaction ('derivatives') may be defined as a bilateral contract involving the exchange of cash flows whose value is derived, as the name suggests, directly from the value of an underlying asset, security, price, reference rate or index. There are four basic elements in a derivative, viz a bilateral contract, a contract for the exchange of cash flow (not a loan or borrowing), an underlying (eg reference rate, index) and the value of the derivative which is derived directly from the value of the underlying. For example, the value of a forward foreign exchange is derived directly from the value of the underlying currencies.

All derivatives are traded in an exchange ('exchange traded derivatives') or over-the-counter ('OTC derivatives'). OTC derivatives are not traded in an exchange but are contracted directly between the two contracting parties ('counterparties'). This article will focus only on OTC derivatives because the accompanying documentation and other risks are more complex.

ISDA Documentation of Derivatives

Most of the derivatives in the global derivatives market are documented under the International Swaps and Derivatives Association (ISDA) documentation. ISDA documentation is highly complex and technical. Unlike other legal documentation, the ISDA documentation of derivatives involves a mosaic of documents. Hence, it may be helpful to have an overview of the ISDA documentation architecture (see Figure A).

ISDA Master Agreement

At the heart of the ISDA documentation is the ISDA Master Agreement ('Master Agreement'). As its name suggests, it is a 'master' agreement. Once signed, it governs all past and future individual transactions entered into between the parties. Hence, the Master Agreement must be negotiated with care and prudence. The types of derivatives that may be documented under the Master Agreements are rate swaps, basis swaps, forward rates, commodity swaps, commodity options, equity/equity index swaps, equity/equity index options, bond options, interest rate options, foreign exchange, caps, floors, collars, swaptions, currency swaps, cross currency swaps, currency options, credit derivatives and combinations of the above.

There are two Master Agreements, viz the 'Multicurrency - Cross Border Master Agreement' and the 'Local Currency - Single Jurisdiction Master Agreement'. The difference between the documents is that the former is used where the parties are from different jurisdictions and the transactions are likely to involve more than one currency, whereas the latter is meant for contracting parties from the same jurisdiction and the transactions are likely to involve only the local currency.

The Master Agreement consists of the standard terms ('Standard Terms') (pages 1-18) and the Schedule. The Standard Terms include provisions relating to interpretation, conditions precedent, netting, withholding tax, representation, undertakings, events of default, termination events, early termination, governing law, just to name a few. Although these are 'standard' terms and conditions, they are meant to be negotiated and customised to suit both parties. Many of the Standard Terms are cross-referenced to the Schedule to allow the parties to customise the agreement. This includes making certain elections and amendments of the Standard Terms. Hence, the Master Agreement provides great flexibility in documenting derivatives.

It should also be noted that the Master Agreement is an open-ended agreement with no fixed term. If the parties want to end their relationship (eg one party defaults), they can either formally terminate the Master Agreement or they just do not enter into any further deals with each other in future. It is worth noting that the rights and obligations of the parties to a derivatives contract are mutual (since it is a contract for the exchange of payments). Hence, in negotiating a Master Agreement, it may not be prudent to adopt a 'cavalier' approach because what Party A imposes on its counterparty may 'backfire' on Party A if it defaults (unless both parties have agreed to a 'one-way' agreement in favour of Party A because of its superior credit rating).

The Schedule

The Schedule is an integral part of the Master Agreement. It is used to customise the Master Agreement by amending the Standard Terms and specifying certain details for the Standard Terms. For instance, the Threshold Amount for the Cross Default clause in section 5(a)(vi) of the Master Agreement is specified in Part 1(C) of the Schedule. Since all the negotiation of the Master Agreement is documented here, it is also the most contentious part of the ISDA documentation. Contrary to the notion that documenting the Master Agreement is merely 'filling in the blanks', its negotiation and documentation is more like a game of chess. It requires negotiation skill, precision drafting and experience to anticipate a 'move' by your 'opponent'. How good an agreement a legal counsel can negotiate for his client would also, in part, depend on the relative credit rating of the client. The negotiation of the Schedule typically takes weeks, months or sometimes (based on the writer's own experience) even more than a year. It is also challenging that some jurisdictions (eg Malaysia) even impose a 'two months rule' to sign the Master Agreement (ie to finalise the Schedule).

Confirmations

A derivatives transaction is typically initiated by a party over the phone. The oral terms of the transaction are documented in a Confirmation by the initiating party (or the counterparty) and forwarded to the other party for its acceptance. According to market practice, the latter is expected to respond within 48 hours ('exchange of Confirmation'). Again, the parties may not always finalise the Confirmation within 48 hours. The writer has personally advised on Confirmations which were finalised after a few months.

Each Confirmation represents a derivatives transaction. The ISDA has provided several 'standard' Confirmations (ranging from 'plain vanilla' derivatives such as interest rate swaps, FX currency swaps, equity swaps, etc, to complex Confirmations such as credit derivatives swaps). For 'structured' deals (non-standard transactions), the standard ISDA Confirmations will not fit, hence the parties will have to 'tailor make' the Confirmation for this particular transaction. A Confirmation consists of mainly economic and financial payment terms. It is typically brief (usually two to three pages), hence it is sometimes referred to as a 'ticket'. However, for complex derivatives (such as credit derivatives), the Confirmation can be as long as 19 pages or more. All Confirmations form part of the Schedule, which in turn forms part of the Master Agreement. Hence, whilst a Confirmation contains mainly the economic and financial payment terms, the legal aspects of the Confirmation are governed by the Master Agreement via the Schedule. It is useful, in documenting OTC derivatives, to appreciate this concept of a 'document within a document', which is the foundation of ISDA documentation architecture (see Figure B).

When transactions are documented in a mosaic of documents, conflict of interpretation is inevitable. Section 1(b) of the Master Agreement resolves this conflict under its 'inconsistency rule'. For instance, if the Schedule conflicts with the Master Agreement, the Schedule shall prevail. On the other hand, if the Confirmation conflicts with the Schedule or the Master Agreement, the Confirmation will prevail. Based on this 'inconsistency rule', the parties can use a Confirmation to override the Master Agreement for that particular transaction by making the specific modification in the Confirmation. This, again, demonstrates the flexibility of ISDA documentation. Nothing is cast in stone.

ISDA adopts the 'menu' approach in documenting Confirmations. Each party, subject to the agreement of the other, elects a 'menu' of electives provided in the Confirmation as the terms of the transaction. It is important to note that a wrong choice of the electives may expose a party to certain risks. For instance, in an interest rate Confirmation, the payment dates are subject to 'Business Day Convention'. If Party A chooses 'Preceding Business Day Convention' while Party B chooses 'Following Business Day Convention', Party A is potentially exposed to a settlement risk because of the time differential.

ISDA Definitions

Market practice dictates that the size of the Confirmation document is reduced to a 'ticket' size to enable the traders to negotiate the transactions efficiently. This is achieved by adopting the various relevant ISDA Definitions into the Confirmation document (see Figure B), hence dispensing with the need for lengthy explanation of the various technical terms used in the Confirmation. Each of these technical terms are defined in the relevant ISDA Definitions. Hence, for instance, if the parties enter into an interest rate swap or a currency swap, they would incorporate the 2000 ISDA Definitions (which is 120 pages long and supersedes the 1991 ISDA Definitions and the 1998 Supplement) in the Confirmation. If the parties enter into a commodity derivatives transaction, they would adopt the 1993 Commodity Derivatives Definitions.

Altogether, there are nine ISDA Definitions booklets which apply to nine different classes of derivatives. These definitions are highly technical and esoteric. They define the technical terms, but they do not explain the terms. In other words, these do not constitute a 'dictionary'. To make documenting derivatives even more challenging, there are various 'interpretation rules' in the definitions under which a party is deemed or presumed to have made a certain election in failing to make an election ('default choice' or 'fallback'). For instance, if a party fails to elect a Business Day Convention for its payment dates, it is deemed to have elected the Modified Business Day Convention. These default choices may or may not be favourable to the party who may have left it blank out of its own (or its lawyers') ignorance of these 'interpretation rules', as it may cause the party to suffer a settlement risk.

ISDA Credit Support Documentation

So far, we have discussed the documentation of derivatives without collaterals. Such transactions may be acceptable between two counterparties with the same credit rating (eg two international banks with an 'AAA' rating). However, a 'AAA' bank may need to enter into various derivatives with a 'BBB+' bank for hedging purposes. But the 'AAA' bank would be hesitant to enter into derivatives with a 'BBB+' bank because of counterparty risk (the latter is more likely to default since it is financially weaker). One way to overcome the counterparty risk is through collateralisation.

Most of the cross-border collateralisation of derivatives transactions are documented under the ISDA Credit Support Documents. The most common collateral documents adopted in the derivatives market are the Credit Support Annex governed by New York law ('New York Annex'), the Credit Support Deed ('English Deed') and the Credit Support Annex ('English Annex'); the last two documents are governed by English law. The Credit Support Annex governed by Japanese law ('Japanese Annex') is used mainly when one of the parties is a Japanese party. There are basically two routes of collateralisation, viz 'security interest' and 'outright transfer'. The New York Annex, English Deed and the Japanese Annex adopt the 'security interest' form of collateralisation whilst the English Annex adopts the 'outright transfer' route. Which ISDA Credit Support Document should one choose? If the parties prefer to secure the collaterals as a first priority legal charge or mortgage, they should adopt the 'security interest' documentation. This form of collateralisation benefits the collateral giver because of its 'equity of redemption' rights. On the other hand, if the parties want the advantage of dealing with the collaterals at hand (eg rehypothecate, sale), thereby enhancing liquidity, they should adopt the 'outright transfer' documentation ('English Annex'). This benefits the collateral receiver because it owns the collateral, hence it can deal with it.

Each of these ISDA Credit Support Documents are, like the Master Agreement, divided into the standard terms and the Schedule. These Credit Support Documents are 'master' agreements governing every collateral transaction between the parties. These documents are incorporated as part of the Master Agreement because they are a part of the Schedule (with the exception of the English Deed, which is a 'stand alone document') (see Figure B).

The ISDA Credit Support documentation contemplates a 'two way' collateralisation. In other words, either party may, at any given time, be the collateral giver or the collateral receiver because of the mutual rights and obligations under a derivatives contract (which is, as explained earlier, a contract for the exchange of cash flows). The underlying rationale is that whichever party suffers an 'exposure' (ie value of the collaterals at hand is less than the market-to-market value, which fluctuates from day to day or even hour to hour, of the derivatives transaction in its favour ('in-the-money')), the other party must transfer sufficient collateral to remove the exposure. As a simple illustration, if, on day 'T1', Party A is exposed to Party B (US$10m), Party B will have to transfer USD10m worth of collaterals to Party A on T1 . However, if, on day T1 + 30, the situation is reversed, Party A will have to transfer US$10m collaterals to Party B. Incidentally, the type and quality of assets used in derivatives are highly 'liquid' and 'stable' assets such as the G7 cash (eg United States Dollars, British Sterling, etc) and US Treasury Bonds/Notes. As the result of the recent Asian economic crisis, it is not uncommon today to see 'one way' collateral documentation. Under this form of unilateral collateralisation, the inferior credit rated party (typically a local bank) will provide the collateral whilst the superior credit rated party (typically an international investment bank) does not provide collateral.

Summary

Derivatives transactions are notoriously subject to a variety of risks such as credit or counterparty risk, market risk, settlement risk, operational risk (remember Nick Leeson?), liquidity risk, systemic risk and legal risk. There are a variety of legal risks (which is beyond the scope of this article) and not least of all, documentation risk. It is hoped that the above discussion will have given some indication how such documentation risk in relation to derivatives can arise.