In a DerivSource Spotlight article, Sapient Global Markets explores some of the key impacts regulatory reforms will have on the documentation of OTC derivatives.
While much has been written about the effects on trading desks or how mandatory clearing for derivative products will be affected under the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and the European Market Infrastructure Regulation (EMIR), there has been little discussion of the impact on the documentation of OTC derivatives. This is understandable, given the fact that the documentation needs to reflect changes to trading and infrastructure and is therefore perceived as somewhat secondary. However, it is important to remember the role documentation played in the financial crises and consider the impact of the impending regulation on documentation.
One of the main purposes of contractual documentation is to put the parties’ intentions in writing with certainty, adding the necessary detail to ensure they have managed the various risks related to a transaction that may arise following the occurrence of certain events. The details cover certain market, trading, operational and legal risks—fine points that traders are unlikely to have addressed in their entirety, as well as compliance issues. It is apparent that the documentation follows on from the financial transactions and the way in which these take place. It is also clear from the Dodd-Frank Act and EMIR that the mode of trading and operating is evolving, in which case the documentation will significantly change as well. Given the strong desire to simplify and standardize the trading and settlement of transactions, it is likely that their documentation will simplify and also become more standardized.
The Dangers of Complexity and the Move to Simplification
The last few years have clearly demonstrated the dangers of complexity in the capital markets, which arose from the demand by investors for ever more complex products with higher yields. As the products increased in complexity, so did the documentation seeking to detail the contractual obligations evolving alongside the products. The structures often involved a multitude of jurisdictions as the transactions became increasingly cross-border in nature. This resulted in a significant increase in document complexity, due to the need to deal with issues arising from the multiple applicable sets of laws and regulations.
A key driver for regulators is to simplify products and their documentation. The latter is important in order to provide greater transparency and allow investors to better understand the products and the risks associated with them, thereby improving valuation and risk management processes in the market.
Regulators have already taken major steps to force the market to standardize trade documentation. In the US, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) have proposed rules that will regulate the clauses that are inserted into swap confirmations under the Dodd-Frank Act. The proposed rules set forth requirements for how to document the swap trading relationship between swap dealers, major swap participants and their counterparties. The commissions have proposed that the swap trading relationship documentation includes a written agreement by the parties on terms relating to payment obligations, netting of payments, events of default or other termination events, netting of obligations upon termination, transfer of rights and obligations, governing law, valuation and dispute resolution procedures.
The commissions are encouraging market participants to adopt standardized confirmation templates and standardized master confirmation agreements which will comply with the new regulations once finalized. Until the rules have been determined by global regulators, the industry and market are preparing for oncoming regulations by trying to standardize current documentation to help with the transition process. An example of this is the recent release of the Futures Industry Association (FIA)-International Swap Derivatives Association (ISDA) Cleared Derivatives Execution agreement. In the European Union, current rules regarding standardization requirements have not yet been proposed. The Markets in Financial Instruments Directive (MiFID), however, is expected to focus on developing a more comprehensive level of document standardization and to push participants to increase use of electronic confirmation systems.
The move to mandatory clearing of trades does not include structured trades. However, these trades are the most complex of the structures with documentation that is amongst the most impenetrable to an investor. Regulators are ensuring that such transactions will incur high capital charges and be forced away from banks to funds. Therefore, it is likely that the amount of complex documentation within banks will be reduced.
Does Standardization Really Result in Better and Simpler Working Documentation?
The majority of OTC derivatives are currently documented under the architecture developed by ISDA. Financial institutions and end users understand this architecture and how to utilize it to manage their commercial and legal risks. A number of its key provisions have also been tested through market events and in litigation, providing an opportunity for the market to refine documentation to a position where there is a good degree of legal and operational certainty. Challenges, such as close-out netting and set-off on insolvency, have been dealt with through the documentation architecture and industry legal opinions. This familiar architecture will have to be amended and/or replaced with documentation befitting the new trading model demanded by proposed regulation. There have been contrasting views between the US and Europe as to whether the correct approach is to move to a more “futures style” of documentation, rather than the current specific OTC derivatives approach—with the former being strongly favored in the US.
The new documentation may aim to simplify, however, until the documentation has been tested in times of stress and proven to work in contractual disputes, it will not be clear that true simplification has been successfully achieved while resulting in documentation that works for the industry.
Clearing Documentation—a Path to Standardization and Simplification
The end user and the clearing member may use an annex to the ISDA Master Agreement to apply to cleared transactions. This annex would deal with certain key clearing provisions, such as margin, events of default, termination events and portability of trades. The annex would override the terms of the original ISDA Master Agreement for cleared transactions.
Alternatively, the parties may use a futures customer agreement as the primary agreement, attaching an annex to deal specifically with cleared OTC trades. Such agreements generally provide for wide discretions in favor of the dealer (for example, the margining terms and imposition of position limits). Therefore, end users may ultimately find themselves having futures clearing agreement provisions, which are generally more onerous (particularly in their default provisions), applying to their OTC transactions. With respect to client clearing, there is currently no clear consensus as to whether to document for clearing on a principal or agency model basis. The question of whether a clearinghouse operates on an agency basis or a principal-to-principal basis is important for end users to consider as part of their risk analysis before choosing clearing platforms.
Under the agency model, the end user faces the clearinghouse directly, because, although the clearing member may appear to be a party to the trade, it is not the true legal counterparty. In this instance, the clearing member acts as the agent of the client and therefore acts on behalf of the client with the clearing house.
In contrast, under the principal model, the end user directly faces the clearing member and the clearing member will directly face the clearinghouse. In this case, there are two identical back-to- back transactions among the three parties and no direct relationship between the client and the clearing house. This latter model adds to the complexity of the documentation significantly, since this lack of direct relationship between the client and clearing house means the client does not directly benefit from dealing with an entity (the clearing house) that has been crafted not to fail by its very design. As a result, a number of legal constructs and contractual provisions need to be added into the documentation to address this issue.
Note that the documentation needs to be further amended to take into account both the clearinghouse rules and the underlying documentation between the clearing member and the end user.
Incorporating clearinghouse rules into documentation between the end user and the clearing member changes the documentation for OTC trades. In theory, parties have a large amount of freedom to document OTC trades within the ISDA architecture and include their own bespoke terms—which does nothing to promote documentation standardization or simplification. The inclusion of clearinghouse rules introduces a certain forced rigidity.
Typically, clearinghouse rules are generally nonnegotiable and provide significant discretions in favor of the clearinghouses, such as margin amounts and the collateral it is willing to accept. The terms between the end user and the clearing member, however, are likely to be negotiable in many areas and the clearing member will be likely to seek wide discretions in its favor.
The mismatch that can result between the two sets of back to- back documentation does not aid either standardization or simplification. For example, while margin terms are dictated in part by the clearinghouse rules, a clearing member may seek a wide discretion to require additional margin from the end user. This is generally the case under futures customer agreements (the rationale of the clearing member being that it places greater risk on the end user than it does on the clearing house). It is also likely to apply to clearing arrangements which use the ISDA Master Agreement with a deemed (or mandatorily amended) Credit Support Annex (CSA). Collateral requirements under the deemed CSA generally provide for the clearinghouse minimum margin amount plus an additional buffer amount (typically characterized as Independent Amount).
CCPs can generally change their rules unilaterally—without requiring consent from the clearing member. Therefore, to analyze the documentation fully, end users (who will ultimately be affected by such unilateral changes in CCP rules whether one is using a principal or agency operating model) must also review the relevant clearinghouse rules. These rules are likely to have an ongoing impact on the underlying documentation between the end user and the clearing member, since the clearing member will undoubtedly want to ensure any mismatch between the terms of the documentation it has in place with the CCP on one side and the end user on the other is appropriately managed.
Is Documentation for Clearing Really Simplified?
Although documentation for a particular CCP will be standardized, there will be a variance between CCP documentation forms, due to different clearinghouse rules, product coverage, jurisdictional considerations and the fact that some clearing houses will use a principal model, while others will use an agency model.
Given that a CCP is likely to have coverage based on particular products and jurisdictions, it is likely that an institution will need to deal with many forms of documentation as they enter into trades via numerous CCPs. This will result in a large number of standardized forms that will be required by a particular institution. Parties will continue to use their existing ISDA Master Agreements for non-cleared trades, further adding to the documentation that will have to be maintained.
In the end, the structure of documentation that an end user will enter into will depend on a variety of factors. These include the extent to which the clearing platform adopts a futures clearing approach, whether an OTC contract is exchanged for a futures trade before being submitted for clearing and whether the contract remains an OTC contract during the clearing process.
Document Proliferation – At Least in the Short Term
There will be a transition period in which there will likely be a proliferation of documentation. On top of all of these new standard forms that will have to be maintained, financial institutions will need to put amendment agreements in place to modify existing client documentation. For instance, clients will now have both “clearing” and “non clearing” documentation with financial institutions (the latter for trades prior to their acceptance by the clearing house or transactions that are not eligible for clearing). Market participants already struggle to manage their documentation and find it difficult to report on the contractual provisions contained in documentation with accuracy and in a timely manner—hence the numerous document portfolio reviews undertaken over the last few years searching for certain “toxic” clauses, such as rating downgrade triggers. With such an impending proliferation of documentation, concern in the market is prompting the development of processes and systems to improve documentation management.
Coping with the Change
The legislation will result in a wide range of new regulations that will increase the complexity and burden of compliance for most market participants. Some will be updating existing documentation and procedures while others will be creating completely new infrastructures to comply with emerging regulations. Many non-financial end users of derivatives may now have to comply with the new Dodd- Frank Act in the US. Therefore, they will be making major strides to catch up to the standardization that may already exist with other market participants. In the coming months, there will be updates to existing universal templates, master agreements and protocols, as well as new documentation for certain asset classes moving towards standardization. In order to manage this, there will likely be a greater uptake in document generation and assembly systems. This will be the case for both transactional documentation (such as trade confirmations for which the uptake of such systems is already very good) and relationship-level documentation (e.g., master agreements governing such trade confirmations).
The number of in-house legal departments that still rely on shared folders to store important documents is of concern. There is often little policy around how such documents are to be stored and it was no surprise that in the wake of the Lehman crisis, many firms were simply unable to locate important documents and emails in a number of cases. The new regulations are likely to encourage greater use of enterprise content management systems to help manage the certain increase (at least in the short-term) in documentation and facilitate documentation portfolio searches for reporting purposes. Such systems improve the ability to conduct regulatory and internal audits, as well as provide a framework for document retention policies to be easily implemented. This will help simplify recordkeeping and the work required to respond to the introduction of complex regulation. Additionally, the implementation of a document workflow on top of such systems allows market participants to quickly prove their adherence to the long list of demands that will be placed on them by regulators.
Sophisticated search and data extraction document systems are also being leveraged to help prepare for the impact of new regulations on documentation. For example, many institutions are developing such systems to ensure they can identify the transactions and legal agreements affected by regulations and can then easily amend the terms of the documentation to comply with regulators. This process is more efficient than undergoing large documentation portfolio review exercises.
The Changing Face of Documentation
The new regulatory reality is coming and it will certainly affect operations, including the documentation process and the approach taken to contract lifecycle management. With the move to mandatory clearing, documentation will become more standardized over time. However, it won’t necessarily be easier to successfully manage the documentation process without a very careful review of the requirements placed on market participants and the development of appropriate processes and systems to cope with the changing face of documentation.
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