“The Global Perspective – ISDA’s Views on the Legal and Regulatory Framework for the Russian Market in OTC Derivatives” Russian Derivatives Markets: Expecting the Breakthrough? MICEX, Moscow, Russia May 18, 2007 Dr Peter M Werner Policy Director pwerner@isda. org ISDA ® International Swaps and Derivatives Association, Inc.
ISDA’s Mission: To Encourage the Prudent and Efficient Development of the OTC / Privately Negotiated Derivatives Business – Harmonisation of market standards • By promoting practices conducive to the efficient conduct of business including the development and maintenance of derivatives documentation • Representing 780+ institutions from 53 countries active in the global markets in OTC derivatives • By promoting the development of sound risk management practices • By fostering high standards of commercial conduct • By advancing international public understanding of the business • By educating members and others on legislative, regulatory, legal, documentation, accounting, tax, operational, technological, and other issues • Products covered: All asset classes used as underlyings for OTC derivatives (cash or physically settled), from interest and FX/currency rates to equities, commodities, credit, developing products 2 ISDA ®
Risk reduction through close-out netting: Evidence All banks, 1998 -2006 • • 3 Bank for International Settlements, November 2006 – As of June 2006, total notional amount of all outstanding OTC derivatives was $369. 9 trillion – The total mark-to-market value of these outstanding OTC derivatives was $10. 1 trillion (2. 7% of notional amount). – After applying close-out netting, the total mark-to-market credit exposure was $2. 0 trillion (0. 5% of notional amount), a reduction of 80 percent. U. S. Department of the Treasury, Office of the Comptroller of the Currency, 4 th Quarter 2006 – For federally chartered U. S. banks, netting benefit as of December 30, 2006 was 83. 7 percent US banks, 1996 -2006 ISDA ®
Why Netting? Benefits for local banks and the local financial market • - strengthens the financial stability of banks, including local banks dealing with SMEs, protecting the deposits of all the bank's customers, including SMEs and households • - makes it easier for financial supervisors to manage a local bank getting into financial difficulties and decreases the likelihood of it tipping into insolvency as the result of a corporate default • - increases the resilience and stability of the local financial market by lowering systemic risk associated with corporate defaults in the OTC market (including financial derivatives, FX, commodities-related trades, repos, stock loans) Benefits for local companies • - lowers the cost of credit to SMEs because the credit risk premium is lower as the result of netting, which in turn helps them invest and grow • - increases the availability of credit to SMEs to the extent that banks are able to run credit lines to those customers on a net rather than gross basis, this increased access to funds also helping them to invest and grow or, during more difficult times, to maintain a reasonable funding position to weather the difficulties 4 ISDA ®
COUNTRY NETTING LEGISLATION AS OF FEBRUARY 2007 Anguilla Adopted Argentina Under Consideration Australia Adopted Austria Adopted Belgium Adopted Brazil Adopted British Virgin Islands Adopted Canada Adopted China Under Consideration The Czech Republic Adopted Denmark Adopted England * See Footnote Finland Adopted France Adopted Germany Adopted Greece Adopted Hungary Adopted Ireland Adopted Israel Adopted Italy Adopted Japan Adopted Luxembourg Adopted Malta Adopted Mauritius Under Consideration Mexico Adopted New Zealand Adopted Norway Adopted Poland Adopted Portugal Adopted Russia Adopted South Africa Adopted South Korea Adopted Spain Adopted Sweden Adopted Switzerland Adopted United States 5 Under Consideration Slovakia Adopted Footnote: England, Hong Kong, Singapore, Netherlands allow for close-out netting as a matter of general principles of law. No specific legislation had to be enacted. ISDA ®
Key Features of Efficient Netting Legislation : • Equal treatment for local and foreign law governed netting agreements • No interference with the contractual terms of the netting agreement • Equal treatment for all types of financial institutions (no matter if licenced under domestic, foreign or international laws and regulations) • Wide scope of counterparties eligible for the benefits of netting. No reasons to exclude corporates (eg insurance companies, energy or commodity firms, SPV, central and development banks, international organizations etc) • Wide scope of eligible transactions in order to adapt to product developments going forward 6 ISDA ®
Netting Legislation: Precedents • • France: Article L. 431 -7 of the Monetary and Financial Code, Sec 2 – Netting and Assignment of Claims allows for early termination and cash settlement of financial obligations resulting from transactions in financial instruments when at least one counterparty is a financial institution or investment service provider, a public law entity or municipality, clearing houses, non-resident entities with a status comparable to France or EU etc, provided these obligations are concluded under a master agreement according to its terms. Germany: Section 104 (2) of the Insolvency Code of Oct 5, 1994, as amended, provides a non-exclusive list of transactions (options etc), incl precious metal and other commodities, securities, all currencies, interest rates plus financial collateral arrangements as defined in Sec 1(17) Banking Law. Such transactions when subject to a master agreement can be netted according to its terms upon termination. 7 ISDA ®
Netting Legislation: Precedents • • 8 Hungary: Act CXX of 2001 on the Capital Markets (as amended on 10 June 2004) contains a definition of close-out netting, derivative transactions, repo and reverse repo transactions plus commodities. It amends the Bankruptcy Act to give effect to close-out netting and the single agreement concept. Furthermore, the EU Collateral Directive has been implemented in the meantime as well. Romania: Article 2 of Regulation No 31/2006 in connection with Article 2(1) No 12 of the Capital Markets Act defines derivatives in a generic way as options, futures, forwards, swaps and “any other derivative” contract relating to currencies, securities, interest rates, credit ratings, indices etc which may be settled physically or financially. Article 3 of Law No 278/2004 on Banking Insolvency as amended by Government Ordinance No 10/2004 on Bankruptcy of Credit Institutions) allows for the application of “bilateral netting” and also defines netting agreements. Article 2 of Government Ordinance No 9/2004 in connection with Law No 222/2004 implements the EU Collateral Directive and ensures equal treatment of title transfer and security interest collateral arrangements ISDA ®
Netting Legislation: Precedents • Brazil Article 30 of Provisional Measure 2192 -70/01 of August 24, 2001: “An agreement for netting and settlement of obligations within the National Financial System is hereby permissible, in the events and according to the rules laid down by the National Monetary Council. Paragraph 1. The netting and settlement arrangements in accordance with the terms and on the conditions set forth in the respective agreement shall not be affected by civil insolvency, debt rehabilitation, intervention, bankruptcy or extrajudicial liquidation of a party thereto, whereupon the final sentence of the main section of article 43 and item I of article 52, both of Decree-law No. 7661 of June 21, 1945, shall not apply. Paragraph 2. If, upon setoff of the amounts set out in the corresponding agreement, there is a credit balance in favor of the insolvent party, this balance shall be incorporated into the bankrupt estate, whereas any shortfall shall qualify as a credit against the insolvent party” • • 9 The scope of local and foreign counterparties as well as the range of eligible transactions are determined by way of decree issued by the Central Bank (Resolutions 2873/01 and 3039/02) BUT mandatory registration of all eligible OTC transactions with a designated exchange trading system. ISDA ®
Netting Legislation – Ireland Draft Bill Extract from Draft Markets in Financial Instruments and Miscellaneous Provisions Bill 2007 10. -Section 1 of the Netting of Financial Contracts Act 1995 is amended(a) by inserting the following after the definition of "the Companies Acts": " 'entity' includes (a) a natural or legal person, including a state or any international organisation duly established, (b) any subdivision or authenticating or other authority of a state or international organisation, and (c) an unincorporated body of persons; ", (b) by substituting the following for the definition of "financial contracts": " 'financial contracts' means one or more contracts consisting of one or more or a combination of the following: (a) interest-rate contracts which are one or more of- (i) single-currency interest rate swaps, (ii) basis swaps, (iii) forward-rate agreements, (iv) interest-rate futures, (v) interest-rate options, (vi) other contracts of a similar nature to those specified in any of subparagraphs (i) to (v), and (vii) contracts which are combinations of contracts referred to in subparagraphs (i) to (vi); (b) foreign-exchange contracts which are one or more of (i) cross-currency interest-rate swaps, (ii) spot foreign-exchange contracts, (iii) forward foreign-exchange contracts, (iv) currency futures, (v) currency options, (vi) other contracts of a similar nature to those specified in any of subparagraphs (i) to (v), and (vii) contracts which are combinations of contracts referred to in subparagraphs (i) to (vi); 10 ISDA ®
(c) contracts relating to, or which concern indices relating to, one or more of equities, bonds, gold, precious metals other than gold, and commodities other than precious metals, or a combination of them, which consist of one or more of (i) swaps, (ii) spot contracts, (iii) forward contracts, (iv) futures, (v) options, (vi) other contracts of a similar nature to those specified in any of subparagraphs (i) to (v), and (vii) contracts which are combinations of contracts referred to in subparagraphs (i) to (vi); (d) securities lending and securities borrowing contracts; (e) sale and repurchase agreements, including reverse repurchase agreements, in relation to securities; (f) buy and sell back agreements in relation to either or both securities and equities; (g) in relation to equities, (i) equities lending and equities borrowing contracts, and (ii) sale and repurchase agreements, including reverse repurchase agreements; (h) in relation to commodities, (i) commodity lending and commodity borrowing contracts, and (ii) sale and repurchase agreements, including reverse repurchase agreements; (i) contracts for either or both the assumption of and laying off of credit risk- (i) on loans, debt securities or other assets, or (ii) in relation to an entity, or other contracts of a similar nature; (j) any derivatives not otherwise encompassed by paragraphs (a) to (i) or paragraphs (k) to (o) concerning a reference item or index, whether cash-settled or physically settled, including- (i) swaps, (ii) spot contracts, (iii) forwards, (iv) futures, (v) options, and (vi) contracts for difference; 11 ISDA ®
12 (k) title transfer collateral arrangements; (l) any net amount due under a netting agreement or a master netting agreement; (m) agreements to buy or sell, clear or settle transactions in, or act as a depository for, any(i) financial asset, including, without limitation, any security (including any equity), currency, obligation evidencing debt (including a loan or deposit) and any negotiable or transferable instrument and any intangible asset, or (ii) commodity (including precious metal), energy or energy source; (n) contracts contained in points 4 to 7, 9 and 10 of Section C of Annex I to Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments; (o) any contract included by virtue of section 2; (p) contracts designated by regulations made under section 3. ", and (c) by substituting "agreement; " for "agreement. " in the definition of "party" and inserting the following after that definition: " 'reference item or index' means a reference item, rate or index relating to one or more of the following: (a) interest; (b) currencies; (c) securities (including equities); (d) commodities (including precious metals); (e) weather; (f) carbon or other emissions allowances; (g) bandwidth; (h) freight; (i) energy (including energy sources such as electricity, oil-related products, coal and gas); (j) credit risk on any entity or asset; (k) statistical data on economic conditions or any measure of economic risk or value; (l) market loss; (m) natural catastrophes; (n) real property; (o) renewable energy credits; (p) regulatory licences or quotas; (q) any factor not otherwise encompassed by paragraphs (a) to (p) which may impact on the business of an entity, regardless of whether it affects the business of a party to the relevant derivative. ". ISDA ®
ISDA’s current agenda for financial law reform • ISDA netting legislation initiatives • 2006 Model Netting Act and Memorandum on Implementation of Netting Legislation • ISDA proposal for a European instrument on close-out netting • European Collateral Directive – review of implementation • Hague Securities Convention • UNIDROIT Project on Intermediated Securities • UNCITRAL projects • Other financial law reform initiatives 13 ISDA ®
Model Netting Act • A model netting statute, prepared and published by ISDA - available from the ISDA website at http: //www. isda. org • Originally published in 1996, a revised version was published in 2002 • 2006 Model Netting Act published in March 2006 • Includes provisions relating to collateral and multibranch netting • Has influenced netting legislation in a number of countries, not necessarily adopted verbatim, but providing a set of basic principles and useful definitions to be incorporated into appropriate statutory form under local law • ISDA has also recently published a Memorandum on Netting Legislation (March 2006), with guidance for legislators on implementation of netting legislation, with particular attention to civil code jurisdictions 14 ISDA ®
ISDA Proposal for a European Instrument on Close-out Netting • Purpose: – to provide guidance to new EU member states that have not yet adopted netting legislation – to promote convergence of existing EU regimes for netting on a common set of core principles • Neither the 1994 Contractual Netting Directive nor Article 7 of the Financial Collateral Arrangements Directive establish a common set of core principles for close-out netting • EU Commission Securities Experts Group Report of May 2004 on the Financial Services Action Plan referred to need for minimum standards in this area • ISDA comment letter of 1 August 2005 on the EU Commission Green Paper on Financial Services Policy • ISDA comment letters of 3 April and 15 September 2006 to the EU Commission on implementation of the European Collateral Directive 15 ISDA ®
European Directive on Financial Collateral Arrangements • Now implemented in all 25 Member States • ISDA review of Collateral Directive implementation, including the implementation monitor on website • ISDA collateral opinions • Article 10: requirement for report by the Commission on implementation, due by 27 December 2006 • ISDA response of 3 April 2006 to the Commission’s questionnaire addressed to the private sector, and ISDA’s supplemental comments of 15 September 2006 16 ISDA ®
Implementation of the European Collateral Directive – key industry concerns • Scope, particularly in relation to the opt-out to exclude corporates • Clarification of what it means to “provide” financial collateral, particularly in relation to “control” of intangible claims • Differential implementation across the EU • Apparent lack of full implementation in one or more Member States • Article 7 and close-out netting • Article 9 and its relationship to the Hague Securities Convention 17 ISDA ®
Multiple Agreement Disorder (“MAD”) • Multiple Masters: 1. 2. 3. 4. 5. 6. Waste time Cost Money Invite documentation backlog Increase documentation risk (“Battle of the Forms”) Divert management attention Potentially increase credit risk (and capital costs) Solutions: Single Agreement concept (since 1987): ISDA Mater Agreement is the basis for 90+% of all global OTC derivatives transactions valued at USD 360 trillion (2006) 18 ISDA ®
Overview of ISDA Documentation • • ISDA Master Agreement Schedule Trade Confirmations Credit Support Documentation • User’s Guides • Legal Opinions from 50 jurisdictions 19 ISDA ®
Basic ISDA Agreement Structure ISDA Master Agreement plus Schedule • • Governs legal and credit relationship of parties Includes representations, events of default and covenants Incorporates Confirmations Schedule makes elections and changes to standard provisions Credit Support Documents u Offering protection against credit risk Short Form Confirmations u u u Incorporate Definitions Specify economic terms of each Transaction Include Transaction-specific modifications Long Form Confirmations u u Specify economic terms of each Transaction Include Transaction-specific modifications Definitions u 20 Contain standard terms and definitions for documenting particular types of Transactions ISDA ®
ISDA Agreement Structure (2007) Annexes Credit Support Documents: to reduce credit risk u 2001 Margin Supplement (incorporating 2001 Margin Provisions) u 1995 Credit Support Annex (Transfer-English law) u 1994 Credit Support Annex (New York law) u North American Power Annex Bridges u North American Gas Annex u 2002 Energy Agreement Bridge u GTMA Annex (UK Power) u 2001 Cross-Agreement Bridge u European Gas Annex u 1996 FRABBA Bridge u EU/US Emissions Allowance Annexes u 1996 BBAIRS Bridge u Global Physical Coal Annex 2002 Master Agreement 1995 Credit Support Deed (Security Interest-English law) Definitions: for use in documenting Transactions u 2006 Inflation Derivatives Definitions Confirmations u Long form confirmations Confirmations u Short form confirmations u ISDA ® Master confirmation agreements 2005 Commodity Definitions u 2003 Credit Derivatives Definitions 2002 Equity Derivatives Definitions u 2002 Master Agreement Protocol u u 1995 Credit Support Annex (Japanese law) 2006 Definitions u 1998 Euro Definitions u 1998 FX and Currency Option Definitions u 1997 Government Bond Option Definitions
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