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Guy Dempsey, Of Counsel at Katten Muchin Rosenman LLP, and Carolyn Jackson, partner at Katten Muchin Rosenman UK LLP, and both P.R.I.M.E. Finance experts, discuss the impact of the coronavirus (COVID-19) on OTC derivatives, including which OTC derivatives are most affected by the pandemic, whether market disruption or other circumstances could become Force Majeure events, defensive measures market participants should be taking and how derivatives regulators are responding.
The coronavirus (COVID-19) pandemic has already affected the derivatives market in many ways and will continue to cause disruption for the foreseeable future. With respect to over-the-counter (OTC) derivatives, market participants must conduct thorough reviews of the terms of their master agreements and transactions, with particular focus on operational and ‘dark-side’ provisions (ie, Termination Events and Events of Default) of the ISDA Master Agreement (ISDA) and other industry standard documentation. Those reviews should look at potential problems for both the market participant and its counterparties. To avoid inadvertent defaults, market participants should also be evaluating their operational ability to make and receive payments and deliveries under current conditions and, if necessary, take steps to ensure that ability is maintained if conditions worsen.
The OTC derivatives most affected by the pandemic are those that involve payments calculated by reference to prices of assets traded on exchanges and similar platforms. The ISDA definitions for products like equity, commodity and credit derivatives contain specific disruption events that can be triggered by trading interruptions in the relevant markets caused by the pandemic. Some of these have already occurred due to the recent high volatility and downward spiral of equity and certain commodity prices.
The equity market is particularly susceptible to actions such as trading halts imposed on exchanges/trading venues by their existing rules (such as circuit-breakers) or regulatory intervention, such as the recent short selling restrictions imposed across various European countries. Due to the impact of COVID-19, Level 1 circuit breakers have been triggered on four separate occasions in the US on the opening of trading on 9, 12, 16 and 19 March. Circuit-breakers have also been triggered on other exchanges, such as Brazil, Japan, India, South Korea and Thailand during this COVID-19 pandemic. Market participants, not just in the US or UK, but globally should consider how the derivative or the underlying asset that they are trading could be halted by volatile swings in the market.
Triggered disruption events may result in the application of delayed or substituted valuation, pricing or settlement mechanics of the derivative contract. For instance, under the 2002 ISDA Equity Derivatives Definitions, highly volatile prices caused by COVID-19 could constitute a market disruption event and fall within the definition of a trading disruption, ie, derivatives of listed shares may have fluctuated beyond the limits set by an exchange and so in accordance with the exchange’s policy and ISDA instrument, exchanges may suspend or limit the trading of the underlying asset (shares), and/or any derivative of such asset.
Certain market events can impact derivatives of any asset class. A recent example is China declaring on short notice an additional public holiday. The unscheduled holiday raised questions surrounding the applicable business day conventions, payment dates and interest accruals over the extended holiday period. Depending on the date that a market closure announcement, whether for an additional public holiday or otherwise is made, parties may not be able to strictly comply with certain contractual terms.
Given that the COVID-19 pandemic is spreading, market participants may consider the impact that a national government action will have on local market participants, and as a result, we may see a psychological shift in market participants to a more cautious approach to trading any derivative asset class as they look to fully comprehend decisions made by governments on short notice, and in some instances, with indecisive timeframes (such as extensions to existing lockdown periods).
Fundamentally, market participants should be aware that the disruption may take many forms. Possible mismatches between valuation dates, payment dates and delivery dates, may in turn affect calculation periods, which truly means that any derivative of any asset class can be affected by this COVID-19 pandemic.
The 2002 ISDA, but not the 1992 ISDA, includes Force Majeure as a Termination Event and not as an Event of Default, as it is generally regarded as a no-fault occurrence, permitting the Termination of some or all of the outstanding Transactions by either party. Many market participants, however, have amended their 1992 ISDA to include Force Majeure either as part of the original negotiation or through adherence to the ISDA Illegality/Force Majeure Protocol.
For Force Majeure to apply, either a ‘force majeure’ or an ‘act of state’ must have occurred. Additionally, it must be either ‘impossible’ or ‘impracticable’ for the relevant office to make or receive payments or deliveries, which are extremely difficult standards to meet. If a party cannot make or receive payments or deliveries because they would be in violation of law, the standard could possibly be met. The use of Force Majeure as a defence to performance might be undermined, however, if a party has sub-standard business continuity arrangements that contribute to its non-performance.
A Force Majeure Event in regards to a Transaction requires a waiting period of up to eight days before a termination notice can be served, whereas no waiting period is required for a Force Majeure Event termination in regards to a Credit Support Document. Note, however, that market participants using an English law title-transfer CSA will not be able to allege Force Majeure in relation to a Credit Support Document as such a CSA is a ‘Transaction’ and not a Credit Support Document under the ISDA.
If counterparties have used a 1992 ISDA and have not incorporated a Force Majeure provision as discussed above, they should review their documentation to check if they added a provision regarding ‘Impossibility’ as discussed in the ISDA Users Guide to the 1992 Master. Unlike Force Majeure, Impossibility cannot be established by demonstrating impracticability.
Market participants with English law governed 1992 contracts with no Force Majeure or Impossibility provisions, can look to common law principles such as frustration. Frustration requires an event (which cannot have been foreseen) to have occurred after the contract was entered into which makes it impossible or illegal to perform. Satisfying the conditions of frustration as with Force Majeure and Impossibility, has a very high hurdle.
Force Majeure, Impossibility and Frustration are very fact specific and complex areas of the law.
There are three main adverse effects that can be caused by excessive market volatility.
First, a party subject to daily margin requirements may face significant margin calls due to losses in the party’s economic position. Failure to meet those collateral demands can result in termination of all outstanding derivative contracts. Parties will want to look to their agreements to evaluate any default provisions to make margin calls, which will differ under the English title vs the English law Deed and NY CSA, as the former is a ‘Transaction’ under the ISDA, whereas the latter are ‘Credit Support Documents’.
Second, parties who are subject to financial covenants, additional termination events tied to financial deterioration (such as net asset value reduction triggers and ratings downgrade events) can find themselves facing potential termination of their swaps due to deterioration of their overall economic position. Some parties might even have termination events tied to material adverse changes in their financial conditions or prospects.
Third, a counterparty may obtain termination rights due to cross-defaults and to problems with a party’s Specified Entities and/or Credit Support Providers. Similarly, the early termination of a derivative for an event of default may in turn cause defaults under other agreements.
All market participants should examine their trading document to identify their current exposure under financial covenants and custom termination events and events of default. Special attention should be given to provisions requiring notice to the counterparty of adverse events.
Participants concerned about counterparty defaults should review their policies and procedures for terminating ISDA agreements. All contracts governed by NY law include an implied duty to act reasonably and in good faith in enforcing the agreement.
The pandemic may give rise to some novel issues with respect to routine matters involved in terminations, especially as the ISDA does not permit notices under Sections 5 (Events of Default and Termination Events) and 6 (Early Termination) to be sent by email. For instance, consider how the giving of a default notice might be affected by enforced closing of business and remote working. Can you effectively serve a notice on a business if no one is there? Additionally, even if it might be possible in an agreement to serve such notice by fax (under the 2002 ISDA only) rather than by courier, since contact details can be updated by notice, rather than by agreement between the two parties, how can you be sure that the relevant fax numbers or other contract details are up to date?
In the United States, the CFTC has been very active in providing specific relief to market participants in response to issues caused by the COVID-19 pandemic. CFTC Chairman Heath P. Tarbert and his directors have proved themselves willing to move quickly to alleviate unexpected problems such as the challenge of meeting record-keeping and telephone recording obligations when employees are working from home.
In the EU, the European regulators and the competent authorities, while in general not providing guidance directly on OTC derivatives, have been issuing legislation and providing guidance on financial matters more broadly, especially to ensure the orderly functioning of the markets, which will in turn have an impact on the OTC derivatives market.
One such measure is the 16 March 2020 decision by the European Securities and Markets Authority (ESMA) temporarily requiring the holders of net short positions in shares traded on an EU regulated market to notify the relevant national competent authority if the position reaches or exceeds 0.1% of the issued share capital. Relatedly, ESMA has introduced delays to the new tick-size regime for systematic internalisers under the Market in Financial Instruments Regulation (600/2014). ESMA has acknowledged the current difficulty for ensuring the recording of telephone conversations under the revised Markets in Financial Instruments Directive (2014/65/EU), while reminding participants any failure in recording should be restored as soon as possible. ESMA has extended the 13 April 2020 reporting and registration deadlines under the Securities Financing Transactions Regulation to 13 July 2020.
The Financial Conduct Authority (FCA) did, however, issue a statement on 25 March 2020, that market participants should continue to assume that the transition date from LIBOR will remain 1 January 2022. The FCA conceded that there may need to be some flexibility regarding compliance with interim transition milestones, but stressed that firms should prepare to be in compliance by the end of 2021. The FCA has also indicated its support of the ESMA actions above, although unlike the competent authorities in Austria, Belgium, France, Greece, Italy and Spain, the FCA has not issued any temporary short selling prohibitions.
Ultimately, it remains to be seen whether the pandemic will have a delaying effect on less imminent compliance dates for Phase 5 for initial margin (Scheduled for September 1) and LIBOR replacement (despite the FCA’s announcement discussed above). A major consideration with respect to those issues is that any changes in timing will require significant global coordination.
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Emma is head of the Banking and Finance team and the Finance Group at LexisNexis®UK.
Emma has wide-ranging experience in derivatives and capital markets with a particular emphasis on credit derivatives and structured products. Emma qualified as a solicitor with Allen & Overy LLP, working in the derivatives and structured finance teams in both their London and Paris offices before gaining experience with Deutsche Bank AG (advising the foreign exchange prime brokerage desk) and Crédit Agricole CIB (advising the fixed income and derivatives desk) before joining LexisNexis®.
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