Derivatives Regulation

Overview

The so-called over-the-counter derivatives market is significant.  The value of derivative transactions runs to trillions of euros and dollars, etc., many times the value of the entire economy of the world.  They represent a mechanism for risk management and exchange of payment profiles in terms of risk and credit exposure.

Derivatives have been criticised for their apparent part in accentuating the financial crisis.  Certain investors and funds invest directly in derivatives unconnected with specific risk management.  The effective of derivatives can be to greatly amplify risk and reward.

ISDA Agreement

The principal ISDA agreements are the  1992 ISDA Master Agreement (Multicurrency/Cross Border) agreement (1992) and the  ISDA Master Agreement 2002.

The ISDA documents govern the vast majority of derivative transactions.  They are pre-printed documents with a number of specific forms dealing with the particular transactions which can be adapted to the circumstances.  There is a schedule by which amendments can be made to the general terms.

Typically, credit institutions or other financial market participants may have exposure to each other under  ISDA Agreements.  A key feature of the ISDA structure is the provision for netting out in the event of default.

This allows parties in the circumstances to terminate some or all of their trades so that only the net amount due is payable.  This reduces the risk of insolvency to the net amount outstanding between them.  This reduces considerably the insolvency risk which would otherwise apply.

The ISDA is usually governed by the English and Wales law or the law of New York State. The ISDA documents are understood to be enforceable in key jurisdictions which must commonly participate in international finance through the ISDA Agreement.

Collateral

Collateral may be given in support of the swap obligations.  ISDA has prepared credit support documentation to allow the provision of collateral and margin in respect of mutual obligations. Alternatively, counterparties may simply enter traditional security arrangements by way of mortgage, guarantee, debenture etc.

The Transfer Credit Support Annex provides for the transfer of title to the collateral without providing for a security interest.  The value of collateral transferred is factored into any close-out in the event of a default.  Security operates by way of title transfer and seeks to avoid the requirement for registration.  It is repurchased on termination of the security.

EU Regulation

The European Market Infrastructure Regulation is an EU framework providing for obligations on the part of entities using derivative contracts.  It is implemented through technical standards evolved by the European Securities and Markets Authority.

The Regulation divides entities using derivatives into financial counterparties, which are generally banks, insurance companies and investment firms, funds etc. and non-financial counterparties.  Non-financial counterparties are divided into two categories depending on whether their derivatives relate to assets in excess of certain thresholds, referred to as clearing thresholds.

The Regulation provides for the conduct of business and prudential standards, both for trade repositories and central counterpart clearing houses, which are authorised or recognised by the European Securities and Markets Authority.

• Entities must report details of trades in exchange-traded or over-the-counter derivative contracts to the trade repositories.
• They must keep records regarding entry and modification of all exchange trade and over-the-counter derivative contracts.

Mandatory Risk Mitigation

There is a provision for risk mitigation practices in respect of over-the-counter contracts not cleared through a central counterparty clearinghouse.  This includes provision for confirmation of the terms of non-cleared derivative transactions and reconciliation of portfolios.  There must be pre-agreed arrangements prior to entering non-cleared over-the-counter derivative transactions to reconcile terms of contracts and eliminate discrepancies.

Compression of portfolios in non-cleared over-the-counter derivative contracts is applicable where there are more than 500 non-cleared derivative contracts outstanding with a counterparty.  Dispute Resolution Mechanisms are incorporated in the contracts.

There is provision for

• Daily mark-to-mark valuations of exchange-traded and over-the-counter derivative contracts.  These are applicable to the financial counterparties and above-threshold non-financial counterparty parties.
• Accurate, timely and appropriate segregated exchange of collateral in relation to over-the-counter derivative transactions where thresholds have been exceeded.  They apply to financial counterparties and above-threshold non-financial counterparties,
• Clearing of over-the-counter derivative transactions entered where the gross notional value of the contract exceeds the clearing threshold for the applicable asset class.