DRS’ Michael Beaton explores how the use of long-form confirmations may change as a result of a recently published IOSCO consultation paper.
Some practitioners consider a long-form confirmation to be a confirmation that sets out, in full, all the terms and provisions applicable to a transaction [1] (Type 1). Others consider a long-form confirmation to be one which deems an underlying ISDA Master Agreement to exist in circumstances where an actual ISDA Master Agreement has not been executed (Type 2). Either way, the use of long-form confirmations has a long-established history. Although the extent of their use has declined in recent years as a result of increased focus on risk management, the desire to take advantage of trading opportunities means that the practice of trading ahead of legal documentation is still not extinct. This is particularly the case with respect to shorter dated transactions and certain asset classes, such as FX.
However, this situation may be about to change. On 17 September 2014, the International Organization for Securities Commission (IOSCO) published a consultation paper on “Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives”. The policies detailed within the consultation apply to financial entities and systemically important non-financial entities that engage in non-centrally cleared OTC derivatives. The risk mitigation techniques themselves will be familiar to readers of EMIR and the Dodd-Frank Act and address:
• Trading Relationship Documentation
• Trade Confirmations
• Valuations
• Trade Reconciliation
• Portfolio Compression; and
• Dispute Resolution.
On the subject of the confirmation of derivative transactions, the consultation paper states that “in the case of one-off transactions, trading relationship documentation could take the form of a trade confirmation that includes all material rights and obligations of the counterparties to the non-centrally cleared OTC derivatives transaction, which have been agreed between them”. In other words, it is possible to use a long-form confirmation on a one-off basis. Although the execution of multiple “Type 1” long-form confirmations risks a loss of netting benefit, presumably, IOSCO is primarily concerned about the risks associated with executing multiple “Type 2” long-form confirmations. Whilst deeming an underlying ISDA Master Agreement to exist, long-form confirmations of this type typically do not document any of the elections that are made within the schedule to the ISDA Master Agreement and which assist in managing risk, such as the identity of specified entities, cross-default thresholds and applicability of Automatic Early Termination. Viewed from this perspective, IOSCO’s position is an understandable attempt to enhance legal certainty.
The consultation paper seems to imply that, where two or more transactions between counterparties exist, a long-form confirmation should not be used. In these circumstances, written trading relationship documentation should be executed prior to or contemporaneously with the execution of the non-cleared derivatives transaction. No distinction is made between short-dated or long-dated transactions or between asset classes. This may require some firms to revisit existing practices around the documentation of derivatives transactions. The industry has until only 17 October 2014 to respond to the consultation so, whilst not yet over, the days of the long-form confirmation are certainly numbered.
