“The Beak of the Finch” is widely acknowledged to be one of the greatest books ever written on evolution.
First published in 1994, Jonathan Weiner was awarded a Pulitzer Prize for, as one reviewer put it, exploding two of the biggest myths about evolution: (1) that it is slow; and (2) that it cannot be observed. The book recounts the study of finches in the Galapagos Islands, where evolution is taking place hour by hour. Yet it is not necessary to travel as far as the Galapagos archipelago to observe dynamic evolution. Like Darwin’s finches, global OTC derivative markets are also an archetype of transformation.
In September 2009 the G20 committed to extensive changes to OTC market structure and practices, in many cases to be implemented by the end of 2012. To this end we have seen legislative initiatives such as the Corporations Legislation Amendment (Derivative Transactions) Bill 2012 in Australia, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 in the USA, and the European Market Infrastructure Regulation in the EU. The Eurozone debt crisis and US tax reforms have added fuel to the fire. And as OTC derivative markets are evolving, so too is the documentation which underpins it. This article summarises some of the latest developments.
Illegality/Force Majeure Protocol
There has been much discussion recently on the possibility of one or more States exiting the Eurozone. Many entities, including governments, have undertaken contingency planning for this eventuality. ISDA has a “Eurozone Contingency Planning” section on its website, containing legal advice and other material on the subject.
A key concern in the derivatives context relates to the risk of capital controls or other laws being implemented which interfere with performance of derivative transactions. At a basic level it is clear that the 2002 ISDA Master Agreement form contains more extensive provisions relating to illegality and force majeure, when compared with the 1992 ISDA Master Agreement form. However, significant numbers of the 1992 ISDA Master Agreement are still used in the market. A need was therefore perceived for a protocol to facilitate amendments to 1992 ISDA Master Agreements to insert the illegality and force majeure provisions of the 2002 ISDA Master Agreement. On 11 July the ISDA Illegality/Force Majeure Protocol opened for adherence. The protocol has no cut-off date for adherence and over 30 entities have so far adhered.
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 introduced extensive changes to the regulation of OTC derivatives by the US. However it is only now that the concrete form of the changes is becoming clear, in the form of final rules promulgated by the Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission. As the shape of the final rules emerges, ISDA working groups have been drafting precedent contractual provisions to reflect relevant requirements.
At an early stage it was appreciated that the scope of the documentary changes would be so extensive that a new “protocol” approach was required for the OTC derivatives industry. ISDA partnered with Markit to develop an electronic platform known as “ISDA Amend”. ISDA Amend automates the exchange and disclosure of necessary information between market participants and was launched on 13 August. In addition, on 13 August the ISDA August 2012 DF Protocol (the “DF Protocol”) opened for adherence. The DF Protocol is the first in a series of protocols ISDA intends to publish to facilitate amendments to OTC derivative documentation arising from both US and European regulatory reform. The DF Protocol relates to seven rulemakings from the CFTC covering mainly business conduct, recordkeeping and reporting. The DF Protocol has no cut-off date for adherence.
The Foreign Account Tax Compliance Act (FATCA) is US legislation enacted in 2010 which, in broad terms, imposes a 30% US withholding tax on a range of payments, including those under certain derivative transactions. On 15 August the ISDA 2012 FATCA Protocol (the “FATCA Protocol”) opened for adherence. The FATCA Protocol facilitates amendments to OTC derivative documentation to specify that FATCA withholding tax is not an “Indemnifiable Tax” under the ISDA Master Agreement. As a result a payer will not be required to gross-up for FATCA withholding tax. The rationale for this amendment is that payees may take certain steps so as not to be subject to FATCA withholding tax. By placing the burden of the FATCA tax on the payee, payees are incentivised to take these steps. The FATCA Protocol has no cut-off date for adherence.
Central clearing of standardised OTC derivatives is one of the cornerstones of the G20 commitments to regulatory reform. At present there are two dominant alternative clearing models in the OTC derivatives world. One is the principal-to-principal swap clearing member (SCM) model of clearing houses such as LCH.Clearnet. The other is the futures commission merchant (FCM) agency model used by clearinghouses in the United States (such as CME). Each model has a different contractual structure. We are seeing Australian clients working to obtain access to both models so as to maximise coverage of eligible clearing houses.
Central clearing impacts on ISDA Master Agreements in a number of ways. A significant development is the emergence of standard credit support documentation aimed at closely aligning collateralisation arrangements between cleared and non-cleared OTC derivatives. It is anticipated that standard credit support annexes governed by New York law and English law will be published by ISDA in the near future. In addition, ISDA and the Futures Industry Association are preparing to publish a form of addendum for cleared OTC derivatives transactions. This addendum is intended to provide a template for addition to FCM model client agreements reflecting current regulatory requirements, as well as detailing the close-out process for cleared OTC derivatives.
More information on the protocols and non-Galapagos based developments discussed in this article can be found on the ISDA website.