After many months, the European ISDA cleared derivatives addendum is near completion. This agreement, which is a template to be used to document the relationship between the customer and clearing member for clearing derivatives via a central counterparty (CCP), is complicated, and the negotiations have been fraught with delays.
Too complex
“I think a real issue is the complexity of [the Addendum]. It will not be easy to use, even for those with dedicated resource. It will mean firms have to take really detailed legal advice on whether the document does what it is meant to do,” said Jane Lowe, Director, Markets, for the Investment Management Association (IMA). “It is a tough read, even for lawyers in our members who specialise in this area. They are struggling.”
Linking the document to the ISDA master agreement is one reason why this document has become so complex, said Lowe.
An ISDA master agreement is the master contract used for OTC derivatives contracts and is designed to cover bilateral terms between two parties. Using the ISDA master agreement as the underlying contract for the ISDA cleared derivatives Addendum presents challenges because it does not reflect the relationship dynamics and counterparty exposures of a central cleared contract, where for instance, a broker is intermediating the trade rather than being the sole principal to it. The Addendum must somehow support the dynamic of the relationships and exposures in a CCP environment because the underlying contract does not.
“The complexity is also a response to the fact that the fundamental change in role is very hard to deal with. They’ve added more and more definitions and circumstances to try to deal with this [role difference] and it has just got out of hand,” said Lowe. “It is getting more and more complicated with every single change so that it is now about 70 pages, which makes it a massively complex agreement to put on top of an already complex master agreement.”
A lawyer close to the Addendum negotiating process agrees that some find the agreement complex however, this is not avoidable given the nature of the contract.
“It is a common theme in terms of people saying you could make this much more simple but actually I think it is quite difficult to make this simpler and still fit for purpose,” said the lawyer who also disagrees that the complexity is due to the master agreement foundation.
Paring down the Addendum would be problematic because so many of the elements of the document are interlinked making it is difficult to include one and not the other, said the lawyer. For instance, the rights of clients on a clearing member default and the rights of clients to move transactions are inherently interlinked as are the conditions supporting both, explained the lawyer.
Also, debate has ensued over the volume of conditions including in the document. The modification clause, for instance, has been one area of contention. There is the potential for changes to be made to the transaction between the clearing member and CCP, which would impact the clearing member as intermediary between client and CCP if corresponding changes were not also made between to the transaction between the clearing member and client. There has been much debate on the conditionality involved in the clearing members discretion in respect to what should happen in those circumstances.
Close out
The closeout clause in the ISDA cleared derivatives Addendum has been the focal point of much negotiation in recent months and is identified by many as the main cause of the delay in finalising the standard agreement.
“[The closeout agreement] is really balancing the point at which the clearing member, in the event of a default of a client, can closeout using individual line items versus being able to use macro hedges,” explains a broker source. “So, what the discussion is really about is under what circumstances can a clearing member do [a macro hedge] and under what rights.”
The closeout clause refers to the closeout scenario where in the event of a client default, the broker then has the client’s portfolio of assets and must replace that risk to ensure the bank’s own security. The way a broker can replace this risk and ‘closeout’ the client’s portfolio of assets is to either execute offsetting trades or put on a large macro hedge to immediately manage the risk and follow up by going through the trades in more detail over a period of days, if necessary. The former process provides greater transparency in the valuation of the client’s portfolio and thus the clients are keen for brokers to use this method where possible. However, the clearing members want the flexibility to conduct macro hedges when deemed appropriate, such as when managing large portfolios of trades.
The level of flexibility for brokers was at the heart of the discussion with closeouts, agrees a second lawyer familiar with the negotiations.
“I think one of the major sticking points in the UK and Europe has been the sell-side representatives have been reluctant to recognise or hardwire, any preference for doing offsetting trades even with all the caveats and qualifications that were built in the US Addendum, and they really want the flexibility to do whatever they think is appropriate at the time of default,“ said the second lawyer.
Regional differences
The US version of the FIA-ISDA cleared derivatives Addendum, published in September 2012, offers a precedent for the European version. Many participants question why the European version didn’t simply mirror this already agreed US version, especially as a compromise on the closeout clause was established in this contract.
The second lawyer explains: “In the FIA Addendum [in the US] there was a great deal of discussion over many months on how should a cleared swap portfolio be liquidated and valued in the event of a default. The compromise people came to was that the clearing member should seek to closeout the position by putting on offsetting positions with the same clearinghouse in order to flatten the position, if offsetting transactions are reasonably available and would produce a reasonable result.”
The crux of the issues lies in the extent to which the European market participants should be renegotiating the US Addendum.
“The reason why the Addendum has to be renegotiated in terms of the language is that we need to support the pluralities of clearing here in Europe. So, we do need to [renegotiate the language] but we have been trying to make sure that, as much as possible, it is in line with the US Addendum,“ the broker explains.
A key regional difference is that the clearing models in Europe, namely the principle-to-principle model where the clearing member is facing the clearinghouse, differs from the US agency model where the clearing member acts as a go between agent. The difference between the two models accounts for some of the divergent treatment of the closeout clause in Europe compared to what has already been agreed in the US Addendum.
“Although the clearing members want to make it as riskless as possible and closer to an agency arrangement, the fact is legally they are sitting in the middle between the clearinghouse and the client, which they don’t do in the US and that makes for a lot of differences,” explains David Geen, General Counsel, ISDA. For example, this difference means that a firm will have to consider the reallocation of certain risks in the European Addendum whereas in the US this is simply not an issue, he added.
While acknowledging the differences, it is also seen by some that the brokers, at least in the first draft of the Addendum, were giving more weight to these variations than was necessary to support certain favourable clauses.
“I think people feel the difference in the model is being cited as a pretext for getting a different result in Europe that would give the clearing member greater flexibility to do what they want to do,” said the second lawyer.
The first draft of the European Addendum did seem to be based on the US version but with the brokers having ‘cherry picked’ which clauses were favourable to them from the agency model in the US, agrees a buy-side source. “For one provision, the sell side reason for including the new clause is that this is a principle-to-principle relationship and so requires the additional term and conversely, where it is more beneficial for them to just pass things on, they will pick the agency style clause”, the buy-side source explained.
Buy-side Stamp of Approval
Despite the misgivings during the process, the Addendum is nearly finished, including the closeout agreements as concessions have been made.
“I think people have realised they need to compromise,” Geen said. “It may not work for everyone, but the thing that people have to understand is that people can negotiate away from this; it’s just a template.“ There are many elements of the Addendum, as in an ISDA master agreement, that signatories can make elections, switch off clauses or opt in or out. So, there are various ways the documents can be negotiated further.
Despite this, some in the buy-side community are concerned that they won’t have the power to negotiate this contract, which they don’t necessarily view as fair. Creating a standard document is always difficult because both sides need to agree that the document is a good starting point. There is little support for the Addendum from the buy side so far, said Lowe.
She said: “The aim of a standard or model document of this kind is that although it will not be perfect for everyone, it should provide a good place to start from. People can then make some changes to suit themselves and negotiate on these. And I think the problem is that people are not yet happy with it [the Addendum] as a starting point. There is also significant concern that clearing brokers may try to impose it nonetheless and many buy side firms won’t have enough clout to say no.”
The difficulty is that the buy-side represents a wide spectrum of financial organisations ranging from large to medium sized and small boutique, regional fund managers. The smaller asset managers do not have the same negotiating powers of the larger institutions and are going to be driven to use the standard Addendum. The sell-side will be able to push it stating that the document has been approved by the buy side when in actual fact, not all types of institutions were able to make any inroads into the Addendum as it was negotiated in the ISDA committee, the second buy-side source noted.
“My concern is that the document will be promoted as having the badge of being endorsed by the buy side but the people who are purportedly endorsing aren’t going to use it in its standard form,” said a second buy-side source.
What alternative do buy-side firms have if they choose not to use the addendum? They can create their own client clearing agreements but they then will have to negotiate them with each clearing member and CCP in question representing a multiplicity of contract negotiations.
The first lawyer points out that the Addendum is there to provide the buy-side with a starting point to avoid the complexity and hassle of managing multiple contracts. “What the Addendum will deliver to them is a single starting point that can be negotiated with clearing members for each CCP on a standard basis. Now they may move away from the standard but it will still be from one common starting point. And given the time scale we are potentially looking at, that can only be a good thing.”
Other firms however, have moved ahead of the Addendum. For example, Insight Investments has led the way by creating its own standard client clearing agreement to be used by all clearing members. This has reduced the need to negotiate multiple versions of contracts but not all firms will have the wherewithal to do this, which means other buy-side firms will need to rely on the Addendum for client clearing.
Where do we go from here?
One of the big questions is how involved the buy side has been in the development of the Addendum, which is being negotiated within an ISDA committee. “I would say the buy-side is properly represented [in the ISDA committee] and a good range of buy side institutions – hedge funds and asset managers, whose concerns are different but same in the sense that they want a good deal from the clearing members,” said Geen. In the ISDA committee, the number of buy-side institutions is greater than dealers. There are about a dozen dealer firms and there are probably 20 buy-side firms or more, he added.
“It has taken a while because we’ve had different views among buy side and sell side but what that means is that when we publish something it has been thoroughly vetted,” said Geen.
The other issue is whether the Addendum which is meant to be a market model to support market participants as they prepare for CCP clearing, has fallen short of its goal. Lowe said: ” I don’t think [the Addendum] actually achieves what its aiming to do, which is to fill a documentation gap for 2 to 3 years during implementation, because it is not easy to use, nor is it clear how well it implements the EMIR protections and obligations.”
The IMA is considering conducting a survey of member firms to establish how the association can best support its members with the Addendum going forward.
The first lawyer warns one Addendum is better than none. The lawyer said: “The ultimate aim was to get people to focus on a single document. Now people might not be overjoyed with what that single document looks like – they might think it’s too complex or overly engineered but the reality is they could have been facing a document that is overly complex and overly engineered six times over rather than one time over.”
The Addendum is expected to be finalised sometime in May 2013.
*This article has recently been updated.
