The International Swaps and Derivatives Association (ISDA) finally published its long-awaited new equity derivatives definitions on 8 July 2011 (2011 Definitions).
As the end-product of a 17-month-long process involving consultation with more than 60 international buy-side and sell-side market participants, the 2011 Definitions marks a significant milestone for the derivative industry's commitment to standardise equity derivatives contracts, increase automation and electronic confirmations and enhance transparency.
The 2011 Definitions is also significant for its marked departure from the existing 2002 ISDA Equity Definitions. In contrast with the more rigid approach under the 2002 Definitions, the 2011 Definitions adopts a toolkit approach that takes into account market developments and provides more flexibility for new products to be efficiently documented going forward.
Some of the key features of the 2011 Definitions are summarised below.
New documentation structure
The 2011 Definitions comprises four key documents: the 2011 definitions booklet (the so-called "Main Book"), the Appendix, an ISDA Transaction Matrix and a short-form Transaction Supplement.
The Main Book contains core definitions and operative provisions which parties can incorporate into their confirmations for a broad range of equity derivatives trades. In addition, it provides a wide selection of additional terms and provisions which the parties can selectively use as building blocks for their transactions.
The Appendix to the Main Book will contain tables setting out a range of combinations for definitions, elections, and methodologies from the Main Book according to particular types of equity derivatives transactions. Currently, ISDA has only published the template of the Appendix, but its intention is to subsequently populate the template with workable combinations of terms and provisions. These combinations will then be defined and used in the ISDA Transaction Matrices and Supplements (see below). The Appendix is likely to be subject to frequent amendments and restatements as the 2011 Definitions becomes increasingly used.
ISDA Transaction Matrices
At the core of the new documentation structure is a series of Transaction Matrices that will set out standardised terms for equity derivatives contracts traded across the globe.
Currently, many of the product group elections under the 2002 Definitions are made under a lengthy Master Confirmation Agreement (MCA). With the introduction of the Transaction Matrices, transactions will be able to be governed by brief standardised matrix terms, which will be given the meanings set out in detail in the Main Book and the Appendix. The objective of using this matrix format is to eliminate the lengthy MCAs, with a view to promoting standardisation and electronic trading and settlement.
The matrices themselves will be a series of spreadsheets, containing approximately 25 to 30 trade terms per product type, detailing the industry-agreed trading terms for a particular product in a particular region. Beyond basic product terms, each matrix will also detail treatment of certain extraordinary events, which will be configured differently for each region, reflecting varying trading conventions. This new approach requires a separate matrix for dozens of individual products in each region to be drawn up based on standardised terms and conventions to make the equity derivatives market as standardised as possible.
The matrices themselves are still to be developed. The first two matrices are expected to be published by 31 August 2011, with further matrices to follow. Once completed, the new matrices are expected to greatly simplify the process of negotiating and agreeing trades in equity derivatives.
Short-form Transaction Supplement
The Transaction Supplement is the fourth limb of the new documentation structure. The Supplement will be a short-form document outlining the basic economic terms of the contract, such as trade date, buyer, seller, premium, expiry date and initial margin, and is intended to be fully electronically confirmable on the MarkitServ platform.
Risk Allocation Provisions
Under the 2011 Definitions, the concepts of "Automatically Applied Extraordinary Events" and "Additional Disruption Events"(ADEs) are substantially amended and expanded, allowing for a more detailed risk allocation to be specified between the parties.
Some examples of the new ADEs include a new ADE relating to "Hedging Party Hedge Disruption", a new "Governmental Intervention" ADE, three new FX disruption related-ADEs, and the expansion of the Loss of Stock Borrow and Increased Cost of Stock Borrow ADEs into seven new Securities Borrowing related-ADEs.
In relation to the Change in Law provisions, there are now three (as opposed to one in the 2002 Definitions) Change in Law related ADEs; namely, "Change in Law", "Transaction Illegality" and "Increased Performance Cost due to Change in Law". These provisions in turn allow parties to specify additional elections including Legal Uncertainty, Inadvisability and Avoidance, which build upon the Change in Law ADEs.
Under the 2002 Definitions, if the Change in Law provision applies to a trade, a party is allowed to terminate the trade if a change in law occurs. However, in response to industry requests for greater clarity as to whether a counterparty can take action in anticipation of a law change (or whether the change has to take place first), the amended Change in Law ADEs allow parties to:
specify (under the "Legal Uncertainty" election) that a party may take actions "in face of a reasonable likelihood of a change in law";
and, separately (under the "Avoidance" election), specify that the terminating party must "take all commercially reasonable action… that satisfy all of the Avoidance Conditions in order to avoid the relevant [ADE]" before any action may be taken in relation such ADE.
The 2011 Definitions also gives parties a broader range of consequences to apply following Extraordinary Events and ADEs. Parties will be able to choose from a waterfall of "Consequences" for a relevant Event, unless the Event falls within a list of "Prescribed Consequences Events" (in which case, "Prescribed Consequences" will apply). Notably, the Change in Law ADEs fall within the list of "Prescribed Consequences Events".
Another key change to the risk allocation provisions is the considerable expansion of Market Disruption Events and their rebranding as "Pricing Disruption Events". There are now 60 "Pricing Disruption Events" and 28 "Pricing Disruption Events Consequences", which parties can further adjust by specifying modifications in their Confirmations.
Role of Calculation Agent and Dispute Resolution
The role of Calculation Agents and the Dispute Resolution procedures are possibly the biggest areas of controversy that are addressed by the 2011 Definitions.
The 2002 Definitions gave the Calculation Agent a high level of discretion in determining whether a disruption event had occurred and the settlement prices payable by the parties following certain events. Very often, the Calculation Agent is the dealer, causing many buy-side firms to complain that the banks are being favoured by these arrangements and the resultant valuations.
In order to mitigate these concerns, some buy-side firms seek to appoint third parties as Calculation Agents, or alternatively, require independent, third-party prices to be used as a reference. Other parties negotiate for joint Calculation Agent status as a compromised solution, or allow the dealer to have sole determination rights provided that they can subsequently challenge the Calculation Agent’s determinations. In view of all the disputes surrounding these issues, standard Calculation Agent and Dispute Resolution terms have been included in the 2011 Definitions, which is a first for ISDA in a product-specific context.
The new dispute resolution regime allows the parties to choose between two separate resolution procedures:
the "Standard Resolution Process" under which the parties can each appoint up to two Independent Dealers as Dispute Resolution Calculation Agents (DRCAs); and
the "Anonymous Dispute Resolution Procedure" under which the parties appoint a Dispute Agent who then appoints up to four DRCAs while maintaining the anonymity of the parties in dispute.
Notably, these dispute resolution procedures potentially apply not only to determinations made by Calculation Agents but also to those made by a party determining a Calculation Amount (which may or may not be the Calculation Agent). The 2011 Definitions also contains detailed provisions on how Resolution Amounts are to be determined, and how settlement costs, fees and expenses may be calculated and allocated between the parties.
The Calculation Amount provision has been heavily revised. What used to be a one-page provision in the 2002 Definitions has now been expanded to cover over 10 pages in the 2011 Definitions.
In contrast to the approach taken in the 2002 Definitions where the determining party simply calculates the replacement value of the relevant transaction, the 2011 Definitions sets out a variety of options and data inputs that may be taken into account when determining the value of the Calculation Amount. The new provision allows the parties to address situations where no replacement transaction is possible. Moreover, it gives the parties more flexibility in deciding how losses and gains resulting from hedge close-outs are to be allocated in respect of each transaction.
New drafting devices and changes to functionality
The 2011 Definitions introduces a new framework for drafting provisions and defined terms through the use of methodologies, features, toggles, suffixes and prefixes.
New frameworks and functionalities are also introduced for Days, Dates and Date Adjustments, Currency Conversions and FX fixings, and Options and Dividends. In addition, a new modular approach is applied to Times and Time Periods, Pricing elections and Settlement Disruption Events, allowing parties to select and combine terms and provisions as they see fit without having to hardwire their elections.
While the publication of the 2011 Definitions represents a significant milestone for the documentation of equity derivatives transactions, its practical implications are not expected to be seen immediately, and definitely not until the ISDA Transactions Matrices have been published. Even after the publication of the Matrices, it will still take a certain amount of time for market participants to gradually adopt and implement the 2011 Definitions. In the meantime, parties may continue to use the 2002 Definitions, with the freedom of incorporating any of the updated provisions if they wish.
Thanks to Flora Ho for her help in writing this article