Current Legal Issues Affecting Central Banks, Volume IV.

23A. Over-the-Counter Derivatives

Robert Effros
Published Date:
April 1997
  • ShareShare
Show Summary Details

If one has been following the financial news in the United States recently, one could well have the impression that a specter is haunting the world’s financial markets: over-the-counter derivatives activity, also known in shorthand as OTC derivatives. In future years, people will look back on the current concerns and come to the conclusion that the markets were to a great extent afraid of the complex and unknown. This chapter analyzes what OTC derivatives are, their uses, and a technique for managing credit risk for OTC derivatives known as netting.

Defining OTC Derivatives Transactions

The label “OTC derivatives” encompasses a wide variety of instruments. In essence, an OTC derivative is a nonstandardized financial instrument that does not trade through any particular exchange or clearinghouse; hence, the name “over the counter.” Because they are not standardized, OTC derivatives can be customized to fit the particular needs of the “consumer” of the OTC derivative. This consumer is often called an end user. The interests of end users of OTC derivatives are represented by The End-Users of Derivatives Association. OTC derivatives are often tailored to satisfy the very specific demands of end users.

End users enter into OTC derivatives for a variety of reasons. The standard use for an OTC derivative is “hedging.” One of the simplest OTC derivatives products is a “currency swap.” A currency swap is a simple exchange of cash flows between a dealer of OTC derivatives and an end user. If an end user is expecting to receive future payments in another currency, a currency swap will “hedge” the end user against changes in that currency, thereby eliminating the currency risk. For this type of end user, a decision not to hedge can be a form of speculation.1 Basic swaps can also be used to hedge interest rate risk. In this instance, an end user that has obligations attached to a floating interest rate, such as the London interbank offered rate, can exchange them for a more predictable flow—a fixed rate.

These examples of hedging through swap transactions constitute some of the most basic hedges that are created with OTC derivatives. More complex risk management is also possible. For example, equity derivatives can be used to hedge certain equity risks. If an entity holds a block of stock and wants to avoid the volatility inherent in the stock without selling it, the return on the stock can be swapped for a series of fixed cash flows. In this way, an end user can in essence cash out the present value of the expected returns on an equity while avoiding a sale of stock, which might have unwanted tax or securities law consequences or might be restricted otherwise

The demand for OTC derivatives has steadily grown. However, the size of the market is hard to measure. One possible measure is simply notional amount. Notional amount, however, grossly overstates the true credit risk generated by OTC derivatives activity and the true economic impact of the transactions. The notional principal amount outstanding of swaps increased from $867 billion in 1987 to $3,872 billion in 1991.2 In fact, the replacement costs—the market values of derivatives transactions—for all OTC derivatives tend to be about 2-3 percent of the gross notional amount.

An illustration of the changing market value of a derivatives transaction is helpful. At the start of a basic interest rate swap, the replacement cost (the market value) will be zero because, by definition, each of the cash flows being “swapped” is worth the same amount at the start of the transaction. The market price of the floating rate, therefore, equals the market price for the fixed rate. However, interest rates will change over time, and the floating rate that would be swapped for an equivalent fixed rate will change. As a result, the original contract will become valuable to one party, the party “in the money”; the contract will become a liability for the other party, the party “out of the money.” The present value of the amount that these parties are in or out of the money will be the market value of the swap. When people speak of “marking to market,” they are referring to the calculation of this number, which also represents the credit risk, or replacement cost, for the in-the-money party.

Benefits and Risks of OTC Derivatives Transactions

The size of the market suggests that a large number of end users find significant benefits from OTC derivatives transactions. Why is this so? What utility is created by this market? Empirically, the size of the market would seem to speak for itself. Analytically, a number of explanations have been advanced concerning the utility of OTC derivatives. Some explanations point to an increased volatility in interest and exchange rates over the past two decades. Observers suggest that events such as the collapse of the Bretton Woods system of fixed parities and the inflation of the late 1970s have created large costs for multinational firms through increased volatility. It is possible, therefore, that OTC derivatives are valuable because they ameliorate these significant costs.

Most regulators and observers appear to approve of hedging. After all, the word “hedging” has a nice, safe ring to it. However, certain uses for OTC derivatives, although believed by some observers to be good and to add value, are seen by other observers as the dark side of derivatives activity. For example, OTC derivatives allow speculation on a particular currency or interest rate at relatively low transactions costs. It is thus cheaper to enter into a swap with cash flows tied to the return of the Standard & Poor’s 500 Index than it is to actually buy 500 different equities. On balance, it appears that lower transactions costs for certain forms of investment are a net good to society. It is undeniable that lower transactions costs make it cheaper to speculate, but they also make it cheaper to hedge and cheaper to invest.

Leverage is another issue that has concerned some observers. Customized derivatives can be used to achieve high levels of leverage—the perils and benefits of which have been known for some time. If someone is willing to extend the credit—at a price, of course—there appears to be no harm as a general matter in allowing an entity to utilize that credit through an OTC derivatives transaction. After all, credit and leverage are essential parts of market capitalism. Of course, as the Group of Thirty report on derivatives recommended, it is important that management understand the risks that it is taking.3 As some well-known companies in the United States have recently discovered—or claim to have recently discovered—an OTC derivatives transaction can be a highly leveraged proposition. Every end user needs to formulate clear policies on the appropriate use of derivatives. Bad policies can always be avoided; violations of policy, however, are more difficult to avoid.

Another concern of certain regulators and observers is credit risk. If a party to an OTC derivatives transaction that is out of the money falls into insolvency, the other party will lose the economic value of the transaction. Some fear that, if a money center bank were depending on a counterparty that fell into insolvency, a “domino effect” could result, with one default triggering other defaults in a cascading fashion.4

There are things that can be done, however, to reduce credit risk. One method is netting. The basic question is whether exposures between two counterparties to a bilateral derivatives transaction master agreement should be netted against each other. If an OTC derivatives dealer has entered into a single transaction with an end user, the dealer’s credit risk in the event of the insolvency of the end user is easy to understand. However, if the dealer has entered into a series of derivatives transactions with another party (documented, one hopes, under a single master agreement, such as the 1992 International Swaps and Derivatives Association (ISDA) Master Agreement), the dealer’s credit risk is more complex. Upon bankruptcy, three things could happen to the group of derivatives transactions: (i) they all could be continued; (ii) they all could be terminated; or (iii) the derivatives transactions favorable to the insolvent party could be continued while the rest are terminated. In the OTC derivatives business, this third possibility is called cherry-picking.

The bankruptcy question is an important one for two closely related reasons. First, the answer to the question is crucial if one is to perform realistic assessments of credit risk. Such assessments of credit risk allow a bank to judge the riskiness of its portfolio of assets and liabilities. Second, the answer is important if one is to accurately assess the amount of capital that an OTC derivatives dealer should set aside. Although all OTC derivatives dealers need to understand this issue, it becomes one of particular concern to OTC derivatives dealers regulated as banks. National banking regulators and the Basle Committee on Banking Supervision have been grappling with this question for some time.

ISDA Master Agreement

At the center of the ISDA agreement structure is the 1992 version of the master agreement.5 This document sets out the master agreement structure and incorporates the individual confirmations that spell out the specific terms of each individual transaction. The document includes representations, events of default, termination events, and covenants, and it specifies early termination provisions. The confirmations, which differ according to the form of the transaction, all become part of the master agreement. Also, the document contains a number of definitions that facilitate the creation of confirmations for individual transactions. With this structure, one-page confirmations can be used for a variety of products, including rate swaps, basis swaps, foreign exchange transactions, rate caps and floors, currency swaps, equity derivatives, commodity derivatives, and other derivatives transactions. Finally, ISDA completed work on the 1994 Credit Support Annex,6 which allows the market value of the netted transactions to be collateralized. This document allows counterparties to (i) net their exposure with each other and then (ii) collateralize the single net exposure. As a result, after netting and upon proper collateralization, both counterparties’ net exposure will be zero.

Why Does Netting Work?

The 1992 ISDA Master Agreement states that the parties have entered or will enter into one or more transactions with each other from time to time and will execute and exchange a document or other confirming evidence (each document a “confirmation”) setting forth the particular terms of each transaction. It also states that the parties enter into transactions in reliance on the fact that each 1992 ISDA Master Agreement and confirmations relating thereto form a single agreement.

In the event of a default-based termination, the 1992 ISDA Master Agreement allows a lump-sum amount (reflecting the positive or negative values of all transactions) to be calculated in connection with an early termination date (commonly referred to as “close-out netting”). The agreement contains two alternatives for calculating this lump-sum amount upon early termination, which the parties elect at the time that they enter into a master agreement. The lump-sum amount calculated during close-out netting is the netted total of all the transactions entered into pursuant to the master agreement.

If the 1992 ISDA Master Agreement is enforceable in bankruptcy, the exposures of differing OTC derivatives transactions will in essence be set off against each other upon the bankruptcy of one of the counterparties. Hence, if the netting provisions of the 1992 ISDA Master Agreement are enforceable, a series of OTC derivatives transactions entered into under such an agreement only generates the credit risk of the net of these transactions. However, if netting were not enforceable, the credit risk would be the sum of all the out-of-the-money transactions, typically a much higher figure than the net. Consequently, depending on whether netting is enforceable, a series of OTC derivatives transactions between the same two counterparties could create widely different credit exposures.

The Group of Thirty report gave a very clear recommendation regarding documenting and netting. As Recommendation 13 states:

Dealers and end users are encouraged to use one master agreement as widely as possible with each counterparty to document existing and future derivatives transactions, including foreign exchange forwards and options. Master agreements should provide for payments netting and close-out netting, using a full two-way payments approach.7

Why? The explanation is simple; the commentary on the above recommendation notes that

  • [a] single master agreement that documents transactions between two parties creates the greatest legal certainty that credit exposure will be netted. The use of multiple master agreements between two parties introduces the risk of “cherry-picking” among master agreements (rather than among individual transactions); and the risk that the right to set off amounts due under different master agreements might be delayed.8

The rationale is incontrovertible. The commentary also asserts that “there is substantial scope for reducing credit risk by including foreign exchange forwards and options under master agreements along with other derivatives transactions.”9

There has been a fair amount of discussion over whether the Basle Committee on Banking Supervision should apply netting to the risk-based capital guidelines. In April 1993, the Basle Committee on Banking Supervision released The Supervisory Recognition of Netting for Capital Adequacy Purposes.10 In this consultative proposal, the Basle Committee on Banking Supervision accepted that netting should be recognized for risk-based capital adequacy purposes. It wrote that “the 1988 Capital Accord should be revised to recognize, in addition to netting by novation, other forms of bilateral netting of credit exposures to the extent that such arrangements are effective under relevant laws. . . .”11

The release left open the question of whether netting should be applied to the “add-on.” The add-on is an extra capital charge required by the 1988 Basle Capital Accord.12 The purpose of the add-on apparently is to provide a cushion in the event of market movements that might change the value of exposures and, hence, change the level of credit risk during the period from one mark to the next. ISDA believes that there is convincing evidence that netting reduces the chance that market movements will increase credit risk for a portfolio of OTC derivatives. If this is indeed the case, the logic of the add-on calculation would suggest that netting, if enforceable, should reduce add-on requirements as well.

For risk-based capital purposes, the question becomes, To what degree is netting enforceable under relevant laws? Part of the good news is that a number of recent statutory developments have explicitly guaranteed the enforceability of netting in the laws that regulate some of the world’s largest economies and most sophisticated financial centers.

In the United States, changes to the U.S. Bankruptcy Code addressed netting with respect to counterparties that were corporations,13 while amendments to the Federal Deposit Insurance Act in the form of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, a law aimed at the savings and loan industry,14 and provisions of the Federal Deposit Insurance Corporation Improvement Act15 have addressed netting with respect to financial institutions whose insolvencies are not governed by the U.S. Bankruptcy Code.

In France, legislation was directed at the netting of debts and claims related to certain markets that are either (i) specifically regulated or (ii) governed by a framework agreement complying with general principles of standard framework agreements governing the relationship between the two parties, at least one of which is a qualified institution.16 By “qualified institution,” the French Parliament meant a French bank, credit, or insurance institution or a foreign entity that was subject to analogous regulation in its home country.

Legislation explicitly permitting netting has also been passed in Canada,17 Belgium,18 Germany,19 and Switzerland.20 Over half of the Group of Ten (G-10) countries have passed statutes enforcing netting.

In other countries, explicit statutory guidance is sometimes lacking, but the ISDA has spent considerable time and effort attempting to document the extent to which netting under the ISDA Master Agreement is enforceable “under relevant laws.” To this end, the ISDA solicited legal opinions from legal counsel in all 11 of the G-10 countries with respect the enforceability of netting under the ISDA Master Agreement.

There are some obstacles to these legal opinions in countries where the law does not explicitly address netting. This situation arises because the relevant laws were enacted before the genesis and growth of the OTC derivatives market, and because there are no cases on point. If there are no cases and precedents directly on point in a country, these opinions are reasoned opinions, that is, they operate from analogy and logic. The ISDA has now finalized legal opinions from all the countries represented on the Basle Committee on Banking Supervision.

One example of a country where netting became well established even without legislation is England. On November 23, 1993, the Financial Law Panel, which is sponsored jointly by the City of London and the Bank of England, issued a guidance notice entitled “Netting of Counterparty Exposure.” The purpose of the guidance notice was to provide a clear statement of what is widely agreed by lawyers to be the basic rule of English law: close-out netting for OTC derivatives transactions is a form of setoff that is enforceable in England. This conclusion was confirmed by 23 leading London law firms.

Enforceability of Netting

What can be concluded about the G-10 world and the enforceability of netting? In brief, throughout the countries represented on the Basle Committee on Banking Supervision, netting is the law. If a party to an OTC derivatives transaction is organized in one of the 11 G-10 countries, the counterparty can terminate its OTC transactions upon bankruptcy, and close-out netting, as embodied in the ISDA Master Agreements, will be enforced.

Multibranch Netting

The basic question of multibranch netting is, What happens when a bank enters into OTC derivatives transactions under a master agreement through several of its branches in different countries? Upon insolvency of the bank, will the assets and liabilities of a given branch be treated together with the rest of the bank, or will the local regulators attempt to deal with the local branch separately? In the United States, this separate approach is known as ring fencing.

Section 10(a) of the 1992 ISDA Master Agreement provides for multi-branch netting. At this juncture, the legal opinions gathered do not speak to the issue of multibranch netting; they all address the question of bilateral close-out netting. Nonetheless, the ISDA is not aware of any precedent indicating that officials administering bank insolvencies in G-10 countries would not honor a master agreement with such a provision. Although bankruptcy law in many countries gives the right to assume, reject, or assign executory contracts in bankruptcy, apparently no bankruptcy law permits the amendment of a contract. Therefore, as a matter of contract and insolvency law, it is not apparent how the multi-branch provision could be removed from the master agreement. Hence, it is likely that legal opinions would generally confirm that master agreements can create enforceable multibranch netting. If uncertainties exist in some countries, owing to the discretionary powers of banking regulators or other officials overseeing bank insolvencies, clear statements that such powers would be exercised to support the enforceability of multibranch netting arrangements would resolve any doubts.

Until recently, there was a degree of uncertainty concerning the enforceability of a multibranch master agreement that includes branches organized under the laws of the state of New York. New York historically has taken the approach of ring fencing branches chartered under New York law that are placed in receivership by the New York State Banking Superintendent. In July 1993, however, New York adopted legislation21 sponsored by the State of New York Banking Department that addresses the treatment of “qualified financial contracts],” including OTC derivatives, entered into by a New York branch or agency of a non-U.S. bank that is placed in receivership by the New York State Banking Superintendent. Under the new New York law, qualified financial contracts are not terminated automatically upon the Superintendent’s taking of possession of a New York branch or agency, and the Superintendent will not assume or repudiate such contracts documented under multi-branch master agreements. Instead, the home country regulator of the foreign bank will be allowed to assume or repudiate the multibranch master agreement, and counterparties will be allowed to terminate such agreements in accordance with their terms. This type of legislation provides important legal certainty, and it is to be hoped that similar legislation or rules, if required, will follow in other jurisdictions.

    Other Resources Citing This Publication