Turbulent Waters for Derivatives Markets

Central clearing may sound like a wonder drug to regulators and politicians around the world anxious to control trading in over-the-counter (OTC) derivatives, but it has side effects.

US authorities realise this and have “backed off” from a position of requiring all derivatives to be cleared. Some in the US believe there will be a world where cleared swaps co-exist with bespoke swaps that won’t be cleared. Where that boundary is drawn is going to be a critical issue.

Among questions facing proponents of central clearing are what type of derivatives would need to be cleared, whether interest rate swaps as well as credit derivatives would come under the rule, whether trade execution would also be centralised and the impact of increased transparency.

The heart of the OTC derivatives world has been bilateral prices, individually negotiated. The regulators would like more centralisation and transparency. Some believe this has enormous business consequences.

Inevitably, the contracts used for derivatives will be affected by way they’re cleared. Of the different sets of contracts, the biggest changes will be in contracts between dealer and customer which have always been done bilaterally.

Source of Additional Risk

A similar debate in Europe has thrown up different questions. There, the fear that centralized counterparty (CCP) clearing houses may be a source of additional risk could mean imposition of rules of conduct on CCPs.

If, as expected, central counterparty clearing becomes mandatory for standardized derivatives, two questions arise: “What is a standardized derivative and who will determine that?”

At the same time, portability – the ability to transfer positions between cleared members efficiently – and segregation of the collateral are issues that need to be addressed at the EU level.

Meanwhile, in Asia, many countries are jumping on the central clearing bandwagon. Their reasons vary from practicalities such as reducing systemic risk and improving standardization of documentation to political opportunism, i.e. deciding it’s a good way of making money.

However, only Singapore is considering whether there should be interoperability between different CCPs. It has probably been regarded as one jurisdiction thinking ahead for the business opportunity, but it is also looking at clearing contracts in Asian currencies, rates etc. By concentrating on commodities business and other areas where it is already active, Singapore has demonstrated its further aspirations to be the clearing house for Asia.

International banks conducting global business transactions from Asia are also worried about the impact of possible duplication of regulatory requirements between jurisdictions.

In smaller markets such as Korea, fundamental questions surround proposals to introduce clearing for currencies, interest rates, credit derivative and other trades. Whether investors understand the markets is as much an issue as whether they want to, or can afford to join them.

Conflict between Jurisdictions and Disputes

Recent court cases involving derivatives divide into three main types. These include conflict between jurisdictions, mis-selling (and unusual defences, raised by clients of financial institutions) and drafting issues.

English and US courts came to different conclusions in a case involving the enforced payout from a synthetic collateralised debt obligation (CDO), managed by Perpetual Trustee Co Ltd. The credit default swap provider, Lehman Brothers Special Financing (LBSF), lost its priority over investors to receive the proceeds of the enforcement because of the collapse of Lehman Brothers. This ‘flipping’ was allowed by the English court but subsequently ruled unenforceable by a New York court. Appeals are expected on both sides of the Atlantic.

This illustrates the problems that can arise on cross-border deals. It has occurred before with BCCI etc, but it’s more of a challenge these days with the numbers of jurisdictions involved in cross-border deals.

Where clients raise defences based on alleged mis-selling, as a general rule English courts are disclaimer friendly. Where contractual documentation contains disclaimers, an interesting point is whether the legal principle of contractual estoppel – that the true facts do not change something already agreed – will prove useful for banks. Various cases have demonstrated that is does.

One particularly creative (but unsuccessful) attempt to avoid liability was the argument by Wockhardt EU that the early termination of foreign exchange transaction contracts by BNP Paribas, following an event of default, amounted to a penalty in law. That defence would have resulted in some chaos in the market had it succeeded.

First Experience of Derivatives

In Asia, alongside the relatively sophisticated jurisdictions which have seen derivatives before, there are others that are seeing them for the first time in the current crisis. Also courts in these countries cannot be expected to mirror a Western approach; Hong Kong, for example, has set a higher watermark than the UK in cases based on the so called “anti-deprivation” principle.

Elsewhere in the region, courts have misunderstood documentation and confused confirmations of transactions with the agreement itself. In one case, a court in China, where the legal system draws on German sources, gave 50% of damages to a bank even though the court concluded that there was no contract constituted between the parties.

In Korea, ‘knock in, knock out’ (KIKO) trades have resulted in hundreds of cases in which investors argued that the risks of the derivatives had not been properly explained. Courts have struggled, trying to be helpful, not understanding the contracts and finding the whole derivative setup quite complicated.

Stressed markets have brought renewed focus and scrutiny to bear on contractual documentation worldwide. Even where you have reasonable drafting, if the numbers are large enough, you tend to end up in litigation.

Unhelpfully, the trend in England at the Supreme Court level, as seen in the paradigm Sigma Finance Corp case, is to rely heavily on the commercial objective of agreements and correct what the court sees as obvious errors; in other words, to rewrite agreements to some extent to achieve the court’s view of the right commercial outcome.

The trend toward that sort of commercially purposive document construction may be admirable in spirit, but often commerciality is in the eye of the beholder and it depends on which side you sit as to what’s the right commercial answer.

Clearer drafting will reduce these risks, but many lawyers would argue that the clause in Sigma was clear.

Changes in Structured Products

Across Asia, changes are expected in the way structured products are treated, and not all of them welcome. In Hong Kong, for example, proposals to amend the offering, production and disclosure requirements for retail products would have quite serious knock-on consequences.

Reacting to the earlier Lehman minibond crisis, Hong Kong regulators want to limit creation of special purpose vehicles (SPVs) and the use of collateralized debt obligations (CDOs) as collateral while requiring that product providers are locally-based. Everyone in Hong Kong, according to experts, is “in lot of pain” about the future of both the retail and non-retail markets and what kind of products will be available when the markets do come back.

In Singapore, the region’s other major market, the authorities have “toned down” some of their proposals following responses to a paper issued last March. They’ve been quite helpful so far in listening to the public. It will be interesting to see whether Singapore and Hong Kong continue their competition in offering products for retail investors.

Elsewhere in Asia, countries including Korea, Indonesia and Taiwan are introducing legislation to regulate derivatives, to make it harder to access that market, or to require approval from local trade bodies for products to be offered.

In Germany, the Ministry of Food, Agriculture and Consumer Protection (which has general responsibility for consumer protection) is looking at adapting traffic light labelling from the food and beverage sector for financial instruments for use alongside product information sheets. This has similar aims to the European Commission’s Packaged Retail Investment Products (PRIPs) initiative, which aims at harmonising the rules for the distribution of funds, structured notes and deposits and insurance based and other investment products that could be substituted for one another. It has been described as an attempt to create a level playing field and avoid regulatory arbitrage by wrapping investments into different forms to gain regulatory benefits. Some believe there will be a lot of discussion about the scope of this initiative.

In the US, the Financial Industry Regulatory Authority (FINRA) has released documents on disclosure, specific results, scenarios and risks. One reoccurring theme is suitability – making sure the product being sold is suitable for that particular client.

Elections and Time

One thing most agree about the current state of affairs is that we can’t live with this degree of uncertainty; it’s crippling for the financial world. The highly polarized political climate in the US does not offer much hope of getting policy made.

According to Clifford Chance partner Habib Motani, the markets, trade associations and legal world have a vested interest in ensuring the authorities understand the implications of reform. But two factors stand in the way: the political imperative behind the actions of regulators and politicians, and the time scale.

“The biggest problem is that intervening elections make it impossible to address this calmly. We can all see sense in some of what’s proposed. The issue for us is to take it forward and help the politicians score their political points in a sensible fashion that would benefit everyone.”

“You need time for that, not the hurried timescales we now face.”