Graham Bryant, Associate General Counsel in ISDA’s London office, talks to Bob Currie about the design and benefits of the Association’s digital framework for terminating a portfolio of derivatives transactions
In 2024, the International Swaps and Derivatives Association (ISDA) published a digital framework that can help market participants to prepare for potential termination of collateralised derivatives contracts.
The ISDA Close-out Framework is a decision-tree that helps firms to navigate the close-out of derivatives portfolios contracted under an ISDA Master Agreement. The decision-tree evaluates the rights available to parties under ISDA trading and collateral documentation, taking into account the possible application of a statutory or contractual stay (or both of these) – which could temporarily suspend early termination rights and remedies under derivatives contracts during a bank resolution process.
The framework also guides participants through potential claims over collateral posted under initial margin (IM) and variation margin (VM) credit support annexes (CSAs) and custodian agreements.
Challenges with closing out OTC derivatives contracts
Bryant explains that the ISDA Close-out Framework was introduced in response to feedback from ISDA members in the aftermath of the March 2023 failure of Signature Bank and Silicon Valley Bank in the US, and the merger of UBS and Credit Suisse.
Member firms indicated that the challenge of closing out OTC derivatives contracts has become substantially more complex in light of reforms introduced in responding to the global financial crisis. In 2011, the G20 introduced margin requirements on non-centrally cleared derivatives to this reform programme and called upon the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) to develop consistent global standards for these margin requirements.
From a legal perspective, a major change has been the need under these BCBS-IOSCO rules for certain counterparties in non-cleared derivatives relationships to exchange IM and to segregate this IM with a third-party custodian. These BCBS-IOSCO requirements were introduced on a phased basis, dependent on the size of a firm’s portfolio of uncleared derivatives (or aggregate average notional amount, AANA), from September 2016.
A second important consideration in managing the close-out process is the potential application of contractual or statutory stays. These will apply to bank resolution regimes, introduced in the aftermath of the global finance crisis. The ISDA Close-out Framework includes high-level analysis on how a stay may be triggered, the length of this stay, which contractual rights might be affected, and any creditor safeguards that may apply under bank resolution regimes in the US and Europe.
While normal insolvency proceedings may apply in most cases, some banks are too large and systemically important to manage their liquidation through a standard liquidation procedure. These resolution tools are designed to protect financial stability, minimising risk of contamination (a ‘domino effect’) across the financial system and wider economy. These also enable resolution authorities to distribute losses to the bank’s shareholders and creditors (‘bail in’), rather than the financial burden falling on to the public authorities and, ultimately, onto taxpayers (‘bail out’).
A ‘resolution stay’ is a temporary suspension or prohibition – often for 48 hours – of any termination rights and remedies, enabling the resolution authority to step in for this period and attempt to provide orderly resolution.
ISDA has been involved in industry efforts to ensure cross-border contractual recognition of resolution stays, reducing the risk that a third-country court may fail to recognise the application of the resolution stay and may cut over the actions of the resolution authority during the period that the resolution stay is active.
In doing so, ISDA has established a resolution stay protocol, which provides a standardised template through which firms can adapt their documentation to contractually recognise the cross-border application of bank resolution regimes, thereby strengthening the likelihood that the terms of a resolution stay will be recognised and upheld by a third-country court.
Learning from bank failures
DerivSource asked Bryant to expand on the primary lessons that ISDA members have learnt from the close-out of SVB and Signature Bank, along with the near collapse of Credit Suisse and its subsequent take over by UBS.
One, he responds, is the sheer volume of documentation that may be involved in closing out these bank failures and the significant variation in documentation across the parties involved. ISDA has published an industry-standard account control agreement (ACA) template, but many custodians have continued to use their own bespoke ACA documentation in providing segregated custodial services for IM.
The ISDA IM CSA includes a number of elections for counterparties to tailor certain provisions, including selection of the regulatory regimes applicable to the trading relationship. It also allows counterparties to make choices on what will constitute an enforcement event, the methodology to be used to calculate the IM amount, the types of collateral that are permitted as IM and many other issues. In addition, there are provisions allowing the parties to agree how the ISDA IM CSA (which is a bilateral agreement entered into between the trading parties) will interact with the ACA (which is signed by the custodian, as well as both trading parties).
This presents a complex contractual landscape to navigate and one that can become particularly challenging under stress conditions. “While this is by no means unmanageable, it does dictate that counterparties need to work through these complexities in advance and to ensure they are well prepared for a possible default of their derivatives counterparties,” explains Bryant.
Coordinating internal business functions with legal, ops and risk teams
The ISDA Close-out Framework is intended to be a preparatory resource to help firms to coordinate internal business functions and legal, operational and risk management teams, as well as relationships with third-party service providers and financial infrastructure.
To facilitate this analysis, ISDA’s has developed a decision tree to help counterparties work through the close-out process. The association has simplified this challenge, focusing on two potential default events – bankruptcy and failure to pay – as a proxy to work through the close-out provisions of the ISDA Master Agreement.
The analysis also examines return of collateral and collateral enforcement, particularly regarding segregated IM.
The goal is to help firms to ensure that each party is prepared effectively and to work through default mechanics and collateral enforcement provisions in ISDA documentation, beginning with the ISDA Master Agreement.
In providing feedback to ISDA, member firms highlighted that enforcement procedures over IM claims have been untested since they were introduced. Consequently, it has been important to work through potential default scenarios and to identify areas for further evaluation and revision ahead of these being applied in a default scenario.
Commenting on the timing of the release, Bryant suggests that after the collapse of SVB and Signature Bank, and the near collapse of Credit Suisse, it has taken time to gather feedback from market participants, develop this into a process flow and integrate this real-world experience into the ISDA Close-out Framework. ISDA has worked closely with an external software development company to code the framework and push this out for user testing and validation. The publication of the framework in June 2024 represented the culmination of 15 months of planning, development and testing work.
Looking ahead, Bryant suggests the ISDA Close-out Framework will soon be complemented by the release of the ISDA Notices Hub. The ISDA Notices Hub will provide a fast and secure online mechanism for delivery of critical termination-related notices under ISDA Master Agreements. ISDA indicates this will enable firms to maintain control over their contractual positions, even when traditional communication mechanisms are difficult to employ – for example, during wartime or extreme health events.
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