The Situation: The increased use of financial sanctions (in particular "sectoral" or targeted sanctions) by the United States and European Union has the potential to cause short-term illiquidity, contagion, and market dislocation in derivative markets, which, in turn, can lead to significant financial losses for non-sanctioned entities.
The Result: In order to minimize the risks to non-sanctioned market participants, the International Swaps and Derivatives Association® ("ISDA") has published a detailed analysis of the impact of sanctions on related derivative transactions, with a request for lawmakers and regulators to take account of eight general principles when enacting any new sanctions program.
Looking Ahead: The background and analysis in ISDA's paper will be an important resource for market participants in the event of any new or expanded sanctions programs. However, it remains to be seen how global sanctions authorities will respond to ISDA's calls for clarity at the point of implementing sanctions.
Over the past decade, the United States and European Union—as well as other jurisdictions such as Canada, Australia, and Japan—have significantly expanded their financial sanctions programs—not only in terms of persons targeted but also scope and complexity. This expanded application has, notably, been marked by:
- Increasingly complicated restrictions, such as the so-called "sectoral" sanctions targeting Russia (for further information, see here) and financial restrictions on Venezuela (for further information, see here, here, here, and here);
- The imposition of sanctions on countries and persons deeply integrated into international markets, including companies listed on major international stock exchanges—whereas, in the past, the application of sanctions had been relatively limited to countries and persons isolated from global commerce; and
- Divergence between the sanctions programs imposed by key jurisdictions, as well as increased conflict in compliance obligations across those jurisdictions.
These trends—with the general risks associated with financial sanctions—have had far-reaching consequences for international markets and non-sanctioned persons, including the over-the-counter ("OTC") derivatives market.
In this context, ISDA has published a detailed reflection on the consequences of financial sanctions on the global OTC derivatives market entitled Economic Sanctions Programs and Derivatives: Issues for Derivatives Transactions and Principles for Minimizing Impact on Non-sanctioned Entities and Avoiding Market Disruption (the "ISDA White Paper"). The ISDA White Paper analyzes particular transaction features which raise difficulties when interpreting the application of key international sanctions programs in the context of derivatives, summarizes the extent to which those programs have mitigated risks for derivatives transactions, and presents proposals through which sanctions regulators might further minimize risks and uncertainties.
ISDA Highlights Key Sanctions Compliance Risks
Given the unique features of the OTC derivatives market, ISDA has identified certain key risks (both under existing sanctions regimes and upon the implementation of new or expanded sanctions) that market participants face, including:
- Restrictions on terminating, transferring, or unwinding derivatives with or relating to sanctioned persons;
- Restrictions on enforcing collateral arrangements; and
- Uncertainties over the scope of prohibited activities that may prevent ordinary trading activities.
Although sanctions regulators have issued guidance intended to address these risks and, at times, provided authorizations to mitigate the impact of newly imposed sanctions, such measures have been, as ISDA notes, limited, ad hoc, and often inconsistent across sanctions programs.
ISDA Proposes General Principles to Minimize Impact of Sanctions
Having identified these issues, ISDA proposes eight general principles to reduce uncertainty and mitigate the impact of sanctions, without compromising overarching foreign policy objectives or conferring any benefit on sanctioned persons. In particular, ISDA proposes that:
- Sanctions programs should provide clarity and certainty regarding which, if any, OTC derivatives transactions are intended to be affected and the actions that non-sanctioned persons are required to take in respect of those transactions;
- Where sanctions programs affect the performance of OTC derivatives transactions, non-sanctioned persons should be given at least 30 days to manage transactions in accordance with their terms, provided that, if required under the relevant sanctions, any payments to sanctioned persons are blocked;
- Non-sanctioned persons should be permitted to net or set off any collateral or margin received or posted under credit support documentation against amounts owed by or to sanctioned persons, provided that, if required under the relevant sanctions, any excess collateral owed to sanctioned persons is blocked;
- Counterparty credit exposure under derivatives transactions or collateralization arrangements arising in the ordinary course of a derivatives trading relationship should not constitute an "extension of credit" for the purposes of any prohibitions on dealings in new debt of a sanctioned entity;
- Derivatives transactions entered in the ordinary course of a derivatives trading relationship should not be considered "facilitation" or "services in support" of prohibited new debt, equity, or other instruments, unless the rights and obligations under those transactions are expressly linked to the issuance, performance, or existence of prohibited instruments;
- Non-sanctioned persons should be permitted to enter into, and perform their obligations under, OTC derivatives transactions that reference underlying entities (or their obligations or instruments) which have become sanctioned, including transferring prohibited debt, equity, or other instruments to the extent necessary to enable the orderly settlement in accordance with established industry processes;
- As far as practical and within the legal framework of each relevant jurisdiction, sanctions regulators should ensure that where sanctions programs are imposed on a "coordinated basis" across jurisdictions (i.e., the sectoral sanctions targeting Russia) the approach to derivatives is harmonized to avoid uncertainty; and
- Where obligations under specific sanctions programs create conflict with other sanctions programs or with other legal, regulatory, or contractual obligations, sanctions regulators should, as far as practicable, ensure that such conflicts do not arise or provide clear guidance as to how non-sanctioned persons are to resolve such conflicts.
The analysis set out in the ISDA White Paper is an important resource for market participants and sanctions regulators when assessing the potential impact of sanctions on derivative transactions and associated adverse effects on global financial markets and non-sanctioned persons. Nevertheless, the risks and uncertainties ISDA addresses and seeks to ameliorate with its general principles may be features, rather than unintended consequences, of relevant sanctions programs. Indeed, it is the draconian nature of financial sanctions and the inherent uncertainty which follows the imposition of a sanctions program that ensures sanctions are seen as an effective and increasingly used foreign policy tool.
It therefore remains to be seen whether sanctions regulators will respond to ISDA's request for more clarity at the point of imposing sanctions or will prefer to leave open the prospect of overcompliance due to uncertainty.
In any event, ISDA will continue to engage with sanctions authorities to promote certainty and market stability in accordance with its overall mission statement, and Jones Day will continue to monitor and assess the implications of international sanctions for OTC derivatives transactions.
Three Key Takeaways
- The ISDA White Paper is an important resource for market participants and sanctions authorities and sets out a range of issues to consider when new or expanded sanctions are put in place.
- The proposed ISDA general principles, if adopted by sanctions authorities, will make it significantly easier for market participants to assess how derivative transactions are affected by any existing, new, or expanded sanctions.
- At the same time, the inherent complexity and bespoke drafting of many sanctions programs means that careful consideration of individual transactions will remain necessary.