Reforms in US and European high-risk transactions, including financial derivatives, requires familiarity with a long line of requirements and documents. What does one need to know before entering a derivative transaction?
The over-the-counter (OTC – transactions that are not made within the stock exchange) financial derivatives transaction market is huge and was multiplied by ten over the past 15 years. The transactions are not only in very high nominal amount but also, because they can be made synthetically (i.e. without the need to actually hold the base asset) involve a very high risk.
United States legislation known as the "Dodd-Frank reform" (after the Congressmen who initiated this legislation) which president Obama signed into force in July 2010, applies limitation on financial institutions on the use of their own capital for high-risk transactions, including financial derivatives. The purpose of this reform was, inter alia, to reduce the credit risks borne by financial institutions when trading OTC derivative transactions and to increase the transparency in this market. The reform applies certain restrictions such as a demand for clearing in central clearinghouses, collateral requirements and reporting obligations.
In 2012 a set of elaborated rules for implementation of the Dodd-Frank reform were published and such apply (as previous American reforms such as the FATCA or prohibition on certain transaction types clearing or the payment of bribes in foreign countries) not only to American financial institutions but also to non-American entities that transact with American entities. This is done via a prohibition on transactions by Americans entities with any entity that does not conform with the rules.
In the first half of 2012 similar rules were set also in European market. Such rules knows as the European Markets and Infrastructure Regulation (EMIR) commenced entering into force in 2013. The EMIR reform also applies a demand for clearing in central clearinghouses, collateral requirements and reporting obligations.
OTC derivatives transactions, as opposed to stock exchange transactions, are not subject to a centralized set of rules but are subject to the consent of the parties. To increase the standardization of the market a number of form agreements were created, the dominant of which is the form master agreement prepared by ISDA – the International Swaps and Derivatives Association - in 1987, as amended several times since. Currently new agreements are executed under the 2002 ISDA Master Agreement template. Execution of an ISDA Master Agreement form agreement applies such agreement to all existing transactions between the parties at the time of execution and any future transactions.
Over the years, ISDA formulated a long list of appendices to the Master Agreement to regulate various issues, including many definitions used by the parties to such agreements and regulation of credit exposure of the parties to each other.
The Master Agreement template purpose is to regulate many complex legal issues, such as the ability to treat all transactions as a single transaction, the ability to calculate the exposure on a net basis (an important issue especially in light of the capital adequacy rules applicable to financial institutions), method of closing transactions in case of default and limitation of credit exposure, carried out through an annex to the agreement.
In the beginning of 2006, Israel passed the Transactions in Financial Assets Law of 2006 that set the ground for Israeli financial institutions to act based on the ISDA Master Agreement templates without the apprehension that such will not be enforced in Israel.
Although negotiation of an ISDA Master Agreement based agreement is limited to filling and amending the different annexes to the agreement, managing such negotiations not only requires expertise in the field, but may also be time consuming. In order to conform to regulatory changes, such as entry into force of the Dodd-Frank and EMIR reforms, ISDA published protocols that parties to the agreements are required to adopt in order to amend the agreements to which they are signatories.
We note that with the implementation of the EMIR reform, in order to trade with a European financial institution one is required to identify itself using an alphanumeric 20 symbols ID known as a Legal Entity Identifier (LEI) which several dozen entities worldwide were authorized to issue. An entity that is a signatory of an ISDA Master Agreement based agreement with a European entity or intends to trade with such should obtain such ID as promptly as practical.
The EMIR reform is primarily intended, as stated, to minimize the risks of the OTC derivatives trade and increase transparency. The EMIR sets three main requirements on all participants in the derivatives market:
• Reporting Obligation – An obligation to report all terms of the transaction to a trade database as of the entry into force of the regulations.
• Clearing Obligation – a central clearing obligation of certain derivatives transactions at a central clearinghouse which is to be involved in any derivatives transaction. The central clearinghouse will act as the buyer vis-à-vis the seller and vice versa. The central clearinghouse is an entity subject stringent regulation. One of the functions of such central clearinghouse is to assess the risk each of the involved parties bear.
• Reducing Risk of Other Transactions – Methods to mitigate the risk of financial derivatives that are not subject to a central clearing obligation by which one may also assess the risks involved ad approve such.
Finally, while ISDA Master Agreement based agreements may seem simple, they are complex documents and it is important to be well acquainted with them and have them drafted by a legal expert specializing in such field. Additionally, many complex transactions are conducted by what appears to be a short and simple termsheet referring to external documents. It is vital to demand to receive all such external documents and ensure that these are not documents based, in whole or in part, on ISDA documents. If any of such do, it is important that an ISDA legal expert will review the whole transaction as it may be influenced by the drafting of such documents and sometimes an ISDA Master Agreement need be executed before entering into the transaction.