Current Legal Issues Affecting Central Banks, Volume IV.

22A. The Significance of the International Foreign Exchange Master Agreement

Robert Effros
Published Date:
April 1997
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This chapter addresses how the new master netting agreements for foreign exchange can help to reduce systemic risk. It provides some information about the development of these master netting agreements and the variety of possibilities for their use, as well as a view of how the market is working to solve these problems. Market participants need to be able to net now and to have enforceable bilateral netting agreements in place as soon as possible. The subject of bilateral contracts between private participants in the markets will therefore be addressed in this chapter. The major agreement that will be focused on is the agreement for foreign exchange netting, called the International Foreign Exchange Master Agreement (IFEMA).1

The genesis of IFEMA was through the Foreign Exchange Committee, which is sponsored by the Federal Reserve Bank of New York but is independent of it, and the British Bankers’ Association. In each jurisdiction, the agreements were developed by the private sector; however, the central banks and the banking supervisory agencies in each jurisdiction were advised of the developments in the private sector.

Characteristics of the Foreign Exchange Market

The foreign exchange market is a global, well-established market. In comparison with derivatives, foreign exchange transactions take place in many more centers. The foreign exchange market is also older; foreign exchange has existed practically since the beginning of time.

Yet, over the years, the characteristics of the foreign exchange market have changed. Foreign exchange, initially at least, was used as a medium of exchange for goods and, ultimately, investments. However, it can now also be used as a medium for speculation and the hedging of risks in one currency or another. Initially, many of the participants in the markets were banks, central banks, and parties that needed foreign exchange in connection with international trade. More recently, because of increased interest in foreign exchange as a medium of investment, there are many new participants in these markets, including corporations and different types of pooled investment vehicles. Hedge funds are important players in the financial markets and have made large investments in various foreign currencies.

Documentation in the Foreign Exchange Market

Documentation practice in the foreign exchange market has evolved very rapidly in the past few years. In the past, because of the somewhat straightforward nature of foreign exchange as a medium of trade, people who transacted foreign exchange dealt in confirmations, which were often the sole piece of documentation for spot (current delivery) and short-dated forward transactions, particularly between dealers. Confirmations for these transactions show the parties to the transaction, the amount of currencies to be exchanged and the rate of exchange, the trade date, and the value (settlement) date. Confirmations also often contain delivery instructions. Because of the large volume of transactions entered into by foreign exchange dealers, the confirmation process is usually automated; although all parties include the same information in confirmations, as noted above, there is no standard format, except for messages sent over an electronic system, such as the Society for Worldwide Interbank Financial Telecommunication (SWIFT).

Netting Methods

In the beginning of the 1980s, market participants looking for ways in which to reduce settlement risk decided to apply portfolio management techniques. The concept of portfolio management emphasizes the portfolio of obligations that one counterparty owes to the other counterparty rather than the individual transactions. This concept was attractive to market participants, who were beginning to realize that parties active in the market would have a number of different transactions with each other, some of which would settle on the same date. Informal practices thus developed within the back offices (the operations systems of financial institutions) to settle these same-day payments on a net basis. At this point, the lawyers were not involved. The process was very simple: if one participant owed another a number of payments in U.S. dollars totaling, say, $5,000, and if the second participant owed the first a number of payments in deutsche mark totaling, say, DM 3,000, they would agree that the first participant would make only one payment, the net of all dollar payments, while the second would make one payment, the net of all deutsche mark payments.

Many participants employ netting methods to reduce risk. There are various methods of netting. First, in payments netting, payments between counterparties are netted so that only one payment in each currency is made for each value date. Second, in netting by novation, a new foreign exchange transaction entered into by counterparties for settlement on a particular value date is netted against any existing obligations to receive or deliver currencies for such value date; new obligations to receive or deliver the currencies involved are created by contract novation. Like payments netting, only one payment per currency is made by the parties on each value date. Before the adoption of the 1994 amendments to the Basle Capital Accord, netting by novation was the only form of netting recognized to reduce the capital exposure of banks.2 A third method of netting is setoff. In foreign exchange options transactions, setting off one option against another, similar option terminates in whole or part the original option. Setting off foreign exchange options is analogous to the process of netting by novation foreign exchange transactions in the cash market. A final method of netting is close-out netting. Upon the occurrence of an event of default, the non-defaulting party has the right to close out all open transactions, convert them to the non-defaulting party’s base currency, mark them to market, and net the resulting amounts, which will then become a payment owed either to or by the defaulting party. Limited two-way payments are not an accepted practice in the foreign exchange market.

Master Agreements

Market participants realized that it was necessary to deal with the problem of a counterparty defaulting on forward foreign exchange transactions. Because transactions settle on different value dates, the challenge was to apply what the traders do on a daily basis in managing their portfolios, namely, to attach a present value to a stream of payment obligations on a forward basis, even though those payments will be due in the future, so that there is one marked-to-market valuation due to or from one party or the other.

These concepts have become incorporated in documentation that is known in many types of trading as master agreements. They are master agreements because they represent a number of individual transactions that are all subsumed under one contract. Agreements for spot and forward foreign exchange transactions, as well as for foreign exchange options, generally follow the same structure. An agreement covering spot and forward foreign exchange transactions deals with the terms of the transactions, confirmations, netting by novation, and settlements. An agreement covering foreign exchange options deals with the terms of the option, the payment of premium, confirmations, exercise of options, settlement, and setoff. Both spot and forward foreign exchange agreements and foreign exchange options agreements contain events of default that give the non-defaulting party the right to close out and net down open transactions.

Several foreign exchange master agreements have been established to date. In 1985, the Foreign Exchange Committee Foreign Exchange Netting and Close-Out Master Agreement was prepared. Another was the Worldwide Foreign Exchange Netting and Close-Out Agreement (the FXNET Agreement). FXNET is an automated trade comparison-and-matching system that facilitates the process of netting by novation. The FXNET Agreement also contains close-out provisions relating to foreign exchange transactions between counterparties in a local market. A FXNET Global Foreign Exchange Netting and Close-Out Agreement has been developed for parties that do not subscribe to the automated system. In 1992, the International Currency Options Market (ICOM) Master Agreement for Foreign Exchange Options was developed under the sponsorship of the Foreign Exchange Committee and the British Bankers’ Association.3 The ICOM Master Agreement reflects current market practice in the foreign exchange options market and provides a standard agreement for this market. In 1992, also, the International Swap Dealers Association (ISDA) Master Agreement was promulgated.4 The ISDA Master Agreement can be used with ISDA foreign exchange definitions. Additionally, many participants amend their ISDA Master Agreement schedules to include specific foreign exchange market practice provisions, including netting by novation for spot and forward foreign exchange transactions, setoffs for foreign exchange options, and confirmation procedures. Finally, in 1993, the International Foreign Exchange Master Agreement (IFEMA) for spot and forward foreign exchange transactions came into being. IFEMA, which is the focus of this chapter, follows the general format of the 1985 Foreign Exchange Netting and Close-Out Master Agreement and reflects current market practice for spot and forward foreign exchange transactions.5

All these contracts state that the parties enter into the agreements with the intention of having only one contractual relationship, but with a number of different payments obligations. Moreover, the agreements make clear that this is the only reason that they enter into the relationship.

Legal Recognition and Enforceability of Netting Agreements

In the case of default by a party, the master agreement concept and the close-out provisions of foreign exchange agreements permit the non-defaulting party to close out open positions without the risk of “cherry-picking” by a trustee or other representative of the defaulting party’s estate. Cherry-picking is the practice followed by trustees in bankruptcy or other representatives of the estate of affirming those transactions that are of value to the bankrupt estate and disaffirming those transactions that are without value. If a master agreement is in effect, however, the non-defaulting party has a claim so that the trustee or representative of the bankrupt estate should recognize the portfolio of transactions.

In the United States, the Federal Deposit Insurance Corporation Improvement Act6 provides that otherwise enforceable netting contracts between financial institutions (broker-dealers, depository institutions, future commision merchants, and other institutions, as determined by the Federal Reserve) are to be given effect notwithstanding any stay, injunction, or other order of any court or administrative agency.7

The Federal Reserve released in 1995 its Regulation EE under the netting contract provisions of the Federal Deposit Insurance Corporation Investment Act.8 Regulation EE expands the definition of financial institution to satisfy both a qualitative and a quantitative test.9 Under the qualitative test, the entity represents that it will engage in financial contracts as a counterparty on both sides of one or more financial markets.10 Under the quantitative test, the entity must have possessed on any day during the previous 15-month period either (i) financial contracts of a gross dollar value of $1 billion in notional principal amount outstanding or (ii) total gross marked-to-market positions of at least $100 million in financial contracts with counterparties that are not affiliates.11 The Federal Reserve has stated that the test can apply to both U.S. and non-U.S. entities. The term “financial contract” includes foreign exchange spot, forward, and options contracts, as well as swaps, repurchase contracts, securities contracts, and the like.12

Initially, as noted above, only netting by novation qualified for reduction of exposure for bank capital adequacy purposes.13 The Basle Committee on Banking Supervision then amended the Basle Capital Accord so that netting, including close-out netting, is now recognized for capital adequacy purposes, subject to three considerations.14 First, the netting agreement must create a single, enforceable obligation, so that, upon the happening of an event of default, including an event of default resulting from the insolvency of the counterparty, a non-defaulting party can close out and liquidate open positions, resulting in one payment made by one party to the other party. Second, the bank must have written, reasoned legal opinions as to the enforceability of the netting agreement in all jurisdictions that have a connection to the transactions under the agreement. Third, the bank must have a process in place to ensure that legal issues involving netting are kept under review to keep up with changes in the law.

In the United States, the Federal Reserve has amended its risk-based capital guidelines to recognize the risk-reducing benefits of netting agreements15 and to implement the recommendations of the proposal of the Basle Committee on Banking Supervision addressed above. The Federal Reserve requires that the banking organization have the written, reasoned legal opinions described above, which conclude to a “high degree of certainty that the netting contract will survive a legal challenge in any applicable jurisdiction.”16 The opinions may be prepared either by an outside law firm or by in-house counsel. The netting agreement and opinion (and translations into English, if necessary) have to be available for inspection by the Federal Reserve.17 The Federal Reserve has the discretion to disqualify contracts from netting treatment if the contracts or legal opinions do not meet the requirements set out in the guidelines.18

Multibranch Issues

In multibranch situations, a banking firm will need to have opinions in the country of jurisdiction of the two counterparties, as well as opinions in all jurisdictions in which the banking firms are doing business through branches. Essentially, three-dimensional opinions will be needed. A two-dimensional opinion says that netting is enforceable under the laws of that jurisdiction, while a three-dimensional opinion says that netting is enforceable not only under the laws of that jurisdiction but also across jurisdictions. In the event of the insolvency of a branch, there is no impediment to claiming a net amount at the head office level if a three-dimensional opinion has been received.

The issue of master agreements involving parties that trade in multiple jurisdictions might thus be called the multibranch question. Many participants, particularly banks, make foreign exchange transactions from both their head offices and their branches worldwide. In order to satisfy the Basle Capital Accord standards for the recognition of close-out netting, a bank is required to obtain legal opinions that the master agreement is enforceable in bankruptcy under the laws of the jurisdiction whose law governs the agreement, the jurisdictions where the head offices of the parties are located, and the jurisdictions where branches subject to the agreement are located. For banks headquartered in the United States, it is likely that, for an agreement subject to U.S. law, a U.S. court would recognize a provision netting the outstanding transactions of the head office and branches; this is a question that needs to be asked of counsel in each jurisdiction covered by a multibranch agreement. Many jurisdictions recognize netting at the head office level. In other jurisdictions, the law of that jurisdiction may require that the non-defaulting party pay the defaulting party’s branch for transactions involving the branch where the branch was owed money.

In these circumstances, participants may respond in a number of ways. They may opt to (i) transact only in jurisdictions where there is legal certainty that the netting agreement is enforceable in bankruptcy; (ii) enter into separate agreements for each jurisdiction or pair of branches; or (iii) use a severability clause in the master agreement that would permit netting across pairs of branches only if the non-defaulting party determined that the netting was legally enforceable.

For example, bank A and bank B may sign an IFEMA that lists as designated offices the head office of each bank, which is in jurisdiction X, (for example, the United States). Bank B will also trade out of branches in jurisdiction Y and jurisdiction Z. Bank A will trade only in the United States, jurisdiction X. Suppose that three foreign exchange transactions are outstanding, as shown in Figure 1.

Figure 1.

In the first transaction, on a marked-to-market basis (meaning that present value is applied), bank B owes bank A 10 units of currency, as of today. In the second transaction, bank B’s office in jurisdiction Y owes bank A 5 currency units. In the third transaction, between bank A in jurisdiction X and the branch of bank B in jurisdiction Z, bank A owes bank B 5 currency units. So, from bank A’s standpoint, for the three transactions on a marked-to-market basis, bank B owes bank A 10 currency units, for a total of 15, while bank A owes bank B 5 currency units. If the netting agreement were totally effective in all jurisdictions, bank B should owe a net amount of 10 currency units to bank A.

However, it is not known exactly whether the above example could actually happen. The Bank of Credit and Commerce International (BCCI) is an important example of a financial institution that was dealing in many jurisdictions and became insolvent. If on a net basis, bank A has 10 currency units of assets of bank B and wants to set those off against the amounts that bank B owes it, bank A should be concerned that, because of the bankruptcy regime in jurisdiction Z, it may have to pay bank B for those transactions that are booked in the branch without receiving payment for the other transactions owed it by bank B.

The problem is the uncertainty about whether the bankruptcy regime in each country will be the same. The BCCI case showed that there are two different types of bankruptcy regimes, the local and the universal. Under the local bankruptcy regime, the branch of the foreign bank can be liquidated as though it were a separate entity. Therefore, the representative in jurisdiction Z of the branch of bank B would treat this obligation from bank A as a separate obligation, which could not be netted at the head office level. Other jurisdictions follow a universal approach, under which the representatives of the bankrupt estate in jurisdiction Y would assemble assets and liabilities and, ultimately, turn them over to the liquidator in the head office’s jurisdiction of country X. As a result, legal counsel and banking organizations need to ask to what extent bankruptcy issues on a three-dimensional basis can affect the calculation of the ultimate amounts payable under netting agreements.

Financial Intermediaries

A second issue involves dealing with financial intermediaries. A participant in the foreign exchange market should analyze carefully the identity of its counterparty. It is a principle of common law that an agent acting on behalf of an undisclosed principal is a party to the transaction.19 In addition, “[u]nless otherwise agreed, a person purporting to make a contract with another for a partially disclosed principal is also a party to the contract.”20 A participant dealing with an intermediary should require the intermediary to identify its principal. The participant should do due diligence on the creditworthiness of the principal and on the authority of the principal to enter into transactions and to delegate this authority to the intermediary. The intermediary should provide promptly an allocation of transactions by principal if the transaction is done as a block trade. For example, suppose bank A is dealing with a hedge fund. The hedge fund is represented by party X, an agent to the hedge fund. In order to know exactly who is a credit risk, bank A will have to do an analysis on two levels. First, it will have to determine whether the hedge fund is properly incorporated and has the power to contract to buy and sell foreign exchange. There may be an issue of ultra vires if the hedge fund is not authorized to contract for foreign exchange transactions. Second, party X is the intermediary; in this example, bank A never directly transacts with the hedge fund, but with its intermediary, party X. Therefore, in addition to checking the power of the hedge fund, bank A must also check the delegation of authority by the hedge fund to party X enabling it to deal with bank A.

In the market, if one does not know the identity of the counterparty, one does not sufficiently understand the risks involved in dealing with an agent in foreign exchange or any type of traded product.

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