The recently published FIA-ISDA cleared derivatives execution agreement is the industry’s first attempt to regulate the relationship between parties entering trades for central clearing. Documentation Risk Solutions’ managing director Michael Beaton explains the structure of this new legal agreement.
On 14 June 2011, the Futures Industry Association (FIA) and the International Swaps and Derivatives Association (ISDA) jointly published the first draft of the FIA-ISDA Cleared Derivatives Execution Agreement (CDEA).
The transactions underlying any CDEA will continue to be governed by the relevant contractual terms (e.g. the ISDA Master Agreement in the case of OTC derivatives transaction). The purpose of the CDEA is to act as a template for use by counterparties in documenting the process surrounding the submission, acceptance and rejection of certain transactions that are intended to be cleared. The document is very much a first draft, which the authors recognise may not be necessary or appropriate in all circumstances and which is likely to be modified and/or superseded as regulations develop with respect to central counterparty clearing.
Please note that the CDEA makes reference to many deadlines drafted in the alternative. In the interests of clearly explaining the general principles underpinning the CDEA, many of these deadlines have been simplified. Readers should refer to the CDEA itself for additional detail.
Application
The CDEA applies to both Over-the-Counter (OTC) derivatives trades and to trades executed via a multilateral or other trading facility (“Derivative Transactions”) which are to be cleared via a “Clearing Organisation”. However, it does not apply to futures, options and other derivatives that are executed on or subject to the rules of a designated market or regulated foreign board of trade.
Parties
The counterparties to Derivatives Transactions are specified as “Party A” and “Party B”. If one of those parties is a swap dealer, that party should be specified as “Party A”. There is also the option to make the clearing members of Party A and/or Party B parties to the CDEA.
Submission of Derivatives Transactions
As soon as practicable, but in any event within 30 minutes of execution, Party A must electronically submit the details of the relevant Derivative Transaction(s) to an agreed trade submission system. As soon as practicable after receiving Party A’s submission, but in any event within two hours, Party B must either affirm, reject, or deny knowledge of the relevant Derivatives Transaction (unless the submission took place within three hours of the latest time for which trades can be submitted for clearing on a particular day, in which case the deadline for affirmation, rejection or denial is 9:00 am local time on the following business day).
Rejection of Derivatives Transactions by Party B
If Party B rejects a Derivatives Transaction, Party A and Party B will consult in an effort to resolve any issues within an agreed timeframe. If the consultation proves unsuccessful, the CDEA will no longer govern the disputed transaction.
Acceptance of Derivatives Transactions by the relevant Clearing Organisation
Upon acceptance of a Derivatives Transaction for clearing by the applicable clearing organisation, each of Party A and Party B shall be deemed to have entered into separate cleared Derivatives Transactions governed by the applicable agreement that each has with its respective Clearing Member (unless Party A and/or Party B are already clearing members of the relevant clearing organisation) and each shall have no further rights or obligations to the other with respect to the relevant Derivatives Transaction.
Derivative Transactions Not Accepted For Clearing
The CDEA specifies a number of options (referred to as “fallbacks”) which are available to the parties in the event that:
(a) A party’s Clearing Member has not accepted the Derivatives Transaction, generally speaking, within 90 minutes of the time at which Party B affirmed the relevant trade, or
(b) A Clearing Organisation rejects or otherwise has not accepted a Derivatives Transaction prior to, generally speaking, the period starting one hour before the latest time at which a Derivatives Transaction may be submitted to the Clearing Organisation for clearing on the same day.
Fallbacks
Unless otherwise agreed, Party A will consider the fallbacks in the order set out below and elect, in its sole discretion, one of the fallbacks to apply. Party A must provide notice of its election to Party B as soon as practicable, and in any event, on or prior to the latest time in relation to which a trade can be submitted to a Clearing Organisation for clearing on the business day following the day on which the relevant trade was executed.
The fallback options available to Party A are to:
(a) Accept the relevant trade as a cleared Derivative Transaction by Party A or an affiliate of Party A (if a Clearing Member);
(b) Accept the relevant trade as a bilateral Derivative Transaction (in which case it will no longer be subject to the CDEA); or
(c) Terminate the Derivative Transaction.
Termination of Derivative Transactions
Party A may elect to terminate the relevant Derivative Transaction(s) or will been deemed to have elected to terminate them if it has not made an election prior to the latest time on which a transaction could be submitted for clearing on the business day following the day on which the relevant Derivative Transaction was executed.
On any termination (whether deemed or actual) one party will pay to the other an Early Termination Amount (“ETA”) pursuant to Section 6(e) of a 2002 ISDA Master Agreement which will be deemed to exist between the parties and based on the following assumptions:
(a) The date of the election (or deemed election) to terminate is the “Early Termination Date”;
(b) The Early Termination Date arose as a result of an Additional Termination Event with respect to which the relevant Derivative Transaction is the sole “Affected Transaction”;
(c) The “material terms” for the purposes of the “Close Out Amount” within the 2002 ISDA Master Agreement shall include the fact that such Derivatives Transaction was to be cleared;
(d) The “Termination Currency” is USD;
(e) New York law governs the deemed ISDA Master Agreement; and
(f) The “Affected Party” is to be identified in accordance with the rules specified below.
Identification of the “Affected Party”
The significance of identifying the “Affected Party” is that it is the Non-affected Party which calculates the ETA. However, under the CDEA, if the party determining the ETA fails to do so in a timely manner (and in any event by the end of the fifth Local Business Day after the Early Termination Date), then the ETA shall be determined by the other party.
The “Affected Party” shall be Party A if a Derivative Transaction fails to clear because:
• Party A fails to submit the Derivatives Transaction for affirmation/rejection or otherwise breaches its obligations towards Party B;
The “Affected Party” shall be Party B if a Derivative Transaction fails to clear because:
• Party B fails to affirm/reject a Derivatives Transaction or otherwise breaches its obligations towards Party A;
A Party will also be the “Affected Party” if a Derivative Transaction fails to clear because:
• Its Clearing Member rejects the Derivative Transaction for clearing, including, without limitation, because the Party in question has violated a position or credit limit imposed by its Clearing Member; or
• The Clearing Organisation of which its Clearing Member is a member rejects the Derivative Transaction because its Clearing Member has violated a position or credit limit imposed by the Clearing Organisation.
If a Derivatives Transaction fails to clear because a Clearing Organisation rejects a Derivatives Transaction for clearing for any other reason, there is effectively no “Affected Party”. In these circumstances, Party A shall be the “Determining Party” for the purposes of determining the “Close-Out Amount” under the deemed 2002 ISDA Master Agreement and shall determine the ETA at mid-market prices.
Clearing Member Annexes
There are two optional annexes to the CDEA. Broadly speaking, if elected, each annex requires a party’s Clearing Member to clear, within specified timeframes, such party’s transactions provided that they comply with certain parameters set down within a “Limits Notice” which details:
(a) Permitted transaction types;
(b) Position/credit limits; and
(c) Other additional provisions.
A Party’s Clearing Member can only revise or terminate a Limits Notice by notice to the other party to the CDEA (with a copy to its own client). Furthermore, any revision or termination of a Limits Notice will not affect Derivatives Transactions entered into prior to the effectiveness of the notice to revise or terminate.
If the Clearing Member of a party (the “Relevant Party”):
(a) fails to accept a Derivatives Transaction which is eligible for clearing or which it has otherwise agreed to accept, or if the relevant Clearing Organisation rejects a Derivatives Transaction for clearing because the Relevant Party’s Clearing Member has violated a position or credit limit; and
(b) the trades in question are ultimately terminated; and
(c) an ETA is payable by the Relevant Party
then the Relevant Party and its Clearing Member shall have joint and several liability for such payment.
If the Relevant Party does not make payment within three Local Business Days of the due date, the Relevant Party’s Clearing Member shall make payment within one Local Business Day following demand from the other Party. Where the Relevant Party makes payment, its Clearing Member shall, unless otherwise agreed, reimburse the Relevant Party within one Local Business Day following demand. Upon payment, the Relevant Party or its Clearing Member shall be released from all payments and obligations to the other Party with respect to the relevant Derivatives Transaction.
If the ETA is payable by the Party which is not the Relevant Party, then, unless otherwise agreed, that Party shall have sole liability for such payment.
Conclusion
The CDEA represents a first attempt to document and allocate the risks associated with the transfer of trades from a non-cleared environment to a cleared environment. It is likely to be subject to significant amendment in the future but is nonetheless a useful starting point for market participants looking to address these issues. However, it remains to be seen whether this is an approach that will be adopted and developed by regulators, so its ultimate utility remains uncertain.
