LexisNexis Practical Guidance®

Derivatives are one of the most important financial instruments in the global economy and form an extremely significant, complex and large financial market. Their contribution to the Global Financial Crisis cannot be negated.

A derivative is a type of financial instrument whose value is derived (based upon) the value of an underlying asset, index, rate or reference point. Derivatives involve the transfer of risk from one party to another and are used as a form of risk management. Derivatives are financial products under the Corporations Act 2001 (Cth) and regulated under Ch 7 (Financial services and markets). The derivatives markets consist of both exchange-traded and over-the-counter (OTC) derivatives.

This guidance note sets out where derivatives sit in the global economy, who uses derivatives, what are the underlying reference points for a derivative and describes the commercial drivers for entering into derivative transactions:

• •speculation;
• •hedging;
• •arbitrage; and
• •exposure to asset classes.

The global derivatives market is largely driven by standard documentation developed by the International Swaps and Derivatives Association (ISDA). Within Australia the Australian Financial Markets Association (AFMA) is the relevant trade association.

See The nature of derivatives.

There are two broad types of derivatives, Over the Counter (OTC) derivatives and Exchange Traded Derivatives (ETD’s). An OTC derivative is a privately negotiated contract between two parties. An ETD is bought or sold on an exchange like the ASX. Documentation differs between these types of derivative. All ETD derivatives are cleared as are most OTC derivatives however some OTC derivatives may not be cleared which may involve a greater risk than a cleared derivative. Derivatives will be settled either by cash or by physical delivery.

See Over-the-counter and exchange traded derivatives.

The flexibility of derivatives means that they are used for a myriad of different purposes.

The main types of derivatives are:

• •swaps — including interest rate swaps, currency swaps, commodity swaps, and credit default swaps;
• •forwards;
• •futures; and
• •options.

This guidance note explains the key features of each of the above types of derivative.

For more information on these classifications, see Types of derivatives.

Some derivatives are specific to certain sectors of the economy. These include:

• •commodity derivatives;
• •energy derivatives;
• •credit derivatives;
• •derivatives in structured finance;
• •equity derivatives;
• •foreign exchange (FX) derivatives; and
• •property derivatives.

This guidance note describes each of the above types of sector-specific derivative.

For more information on these sector classifications, see Sector-specific derivatives.

A total return (or total rate of return) swap, (TRS), is a method of transferring the credit and market, risk of an asset or basket of assets from one party to another party. It is an over-the-counter, off balance-sheet transaction.

The structure of a TRS resembles a credit default swap (CDS) in many ways, which is why it is typically characterised as a credit derivative, even though it does not share all the characteristics of a typical CDS.

This guidance note describes how a TRS works, as well as who enters into a TRS and for what reasons. See Total return swaps.

Commodity derivative contracts take their value from the underlying price of a traded commodity and require payments to be made or products delivered based on the movement of that price.

This guidance note details common types of commodity derivatives, describes typical users of commodity derivatives, and summarises the European regulation of commodity derivatives.

See Commodity derivatives.

Energy derivatives reference the underlying price of an energy source, such as oil, gas or electricity.

This guidance note follows a similar structure to that for commodity derivatives.

See Energy derivatives.

A foreign exchange (FX) derivative is a type of derivative whose payoff depends on the foreign exchange rates of two or more currencies.

This guidance note describes common FX derivatives and their uses. It also summarises the documentation of foreign exchange contracts.

See Foreign exchange (FX) derivatives.

A credit derivative is an over-the-counter bilateral transaction whereby the lender transfers the risk that a loan will not be repaid to another party.

This guidance note details what a credit derivative is and explains the types of funded and unfunded credit derivatives and how they work. It provides the rationale for using a credit derivative and how they are documented. It also considers what a constitutes a default ie a credit event, under a credit derivative and how they are settled.

Finally how credit derivatives are cleared in Europe.

See What are credit derivatives?

When a party is documenting a credit derivative transaction, typically the confirmation will incorporate the 2014 ISDA Credit Derivatives Definitions (the 2014 Definitions).

This guidance note covers what the 2014 Definitions are and why they are used. It explores the key changes made to the 2003 ISDA Credit Derivatives Definitions and why these were deemed necessary.

See An introduction to the 2014 ISDA Credit Derivatives Definitions and Key terms found in the ISDA Credit Derivatives Definitions.

This guidance note sets out what each section of the 2014 ISDA Credit Derivatives Definitions covers.

See Key terms found in the ISDA Credit Derivatives Definitions.

A credit derivative aims to give the purchaser protection against the occurrence of a number of different credit events occurring on the underlying reference entity to that transaction. What a credit event is and the types of credit events that can occur are set out in the 2014 ISDA Credit Derivatives Definitions. They are:

• •Bankruptcy;
• •Obligation Acceleration;
• •Obligation Default
• •Failure to Pay;
• •Repudiation/Moratorium;
• •Restructuring; and
• •Governmental Intervention.

This guidance note describes each of the seven credit events and shows which credit event applies to each transaction type. Additionally, the guidance note considers the two types of obligations that need to be understood when a credit event occurs. They are:

• •Reference obligations; and
• •Deliverable obligations.

ISDA’s 2019 Narrowly Tailored Credit Event Supplement which contains amendments to the 2014 ISDA Credit Derivatives Definitions is discussed.

See Credit derivatives — credit events.

While there are a number of credit events, the Restructuring credit event is the most complex of the credit events. The 2014 ISDA Credit Derivative Definitions have sought to clarify this credit event which has been the source of dispute and uncertainty in the market. This guidance note explains when a restructuring credit event occurs and when it will not occur. It further considers physical settlement options following a restructuring credit event.

See Restructuring credit event.

The occurrence of a credit event is not sufficient to trigger performance under a credit derivative — certain formalities must also be complied with. Since 2009, the majority of credit events are determined by the ISDA Credit Derivatives Determinations Committee (the DC). A credit event is triggered by raising a question with the DC or by sending a credit event notice to the other party. This guidance note describes the DC and describes the documentation that should be sent on the occurrence of a credit event.

See Triggering and settling credit derivatives.

Once a credit derivative transaction has been triggered, the parties to that transaction will want to settle it so that each receives any amounts that are owing to it. This guidance note describes each of the settlement method parties may elect which will apply for the relevant transaction:

• •auction settlement;
• •cash settlement; or
• •physical settlement.

This guidance note describes each of the three settlement methods.

See Credit derivatives — settlement procedures.

Because a total return swap resembles a credit default swap it is characterized as a credit derivative though there are some differences between them. This guidance notes explains where they are similar and where they are different. Further a step by step guide as to how total return swaps work is set out in this guidance note.

See Total return swaps.

It is not only banks and financial institutions that enter into derivative transactions and when other types of entities seek to enter into derivative transactions this raises the issue of the relevant parties’ capacity and authority to do so. The legal issues relating to capacity and authority are complex and require careful consideration.

This guidance note explains the following:

• •the key issues to note when considering an entity’s capacity to enter into a derivatives transaction;
• •the key points to consider when looking at a signatory’s authority to sign derivatives documentation; and
• •issues surrounding the most common types of counterparty where capacity and authority may be an issue.

The guidance notes also considers some case law where capacity was an issue in relation to entry into derivative contracts.

See Derivatives — capacity and authority.

The International Swaps and Derivatives Association (ISDA) has produced documentation that is used globally by derivative market participants. In order to be able to document derivative transactions an understanding of ISDA documentation is required. The ISDA documentation architecture for over-the-counter derivatives involves layers of documentation. While constituting a single agreement the key layers are as follows:

• •Master Agreement;
• •Schedule;
• •Credit support documents (only applicable if the parties require collateral or security to be provided); and
• •Confirmations.

This guidance note explains the key ISDA documents, their framework and how they interrelate.

See ISDA documentation framework.

This guidance note summarises the key provisions which are applicable to both the 1992 ISDA Master Agreement and the 2002 ISDA Master Agreement and their related schedules. It also sets out the three key concepts the ISDA Master Agreement is based upon. They are:

• •a single agreement;
• •flawed asset (right to payment); and
• •close-out netting.

See ISDA master agreements and schedules — key provisions.

This guidance note provides guidance on what needs to be considered when completing the ISDA Schedule, from correct identification of the parties to the transaction to the need to include additional termination events.

This guidance note describes in detail sections 1 and 2 of the ISDA Master Agreement to assist in understanding each section. This will assist when entering into an ISDA agreement.

Section 1 of the ISDA Master Agreement sets out the hierarchy of the master agreement, schedule, and confirmation and elaborates on the single agreement concept. In section 2 (obligations), the parties make the commitment to pay or deliver all that is required of them in each confirmation.

See Scope of the ISDA master agreement — sections 1 (interpretation) and 2(obligations).

This guidance note describes in detail the contents of the Section 3 representations of the ISDA Master Agreement and the importance of the representations made under an ISDA. Representations are pre-contractual statements of fact made by a party to a contract which induce another party to enter into that contract.

In s 3 of the ISDA Master Agreement (representations), the parties make a number of representations to one another.

See Scope of the ISDA master agreement — section 3 (representations).

In s 4 (agreements) of the Master Agreement, the parties make agreements as to certain points. These “agreements” are essentially covenants to perform or not perform certain actions.

This guidance note describes the nature of these covenants.

See Scope of the ISDA master agreement — section 4 (agreements).

A confirmation sets out the commercial terms of a particular transaction as agreed between the contracting entities. It is an integral part of any OTC derivative transaction.

This guidance note explains:

• •how confirmations fit into the ISDA documentation framework;
• •the purpose of confirmations and what they contain;
• •the confirmation documentation; and
• •the legal effect of confirmations.

See ISDA confirmations.

The ISDA definitions provide a common set of defined terms for use in derivative transactions. The terms constitute the mechanics of derivative transactions and the payment obligations under them.

This guidance note explains:

• •how the ISDA definitions booklets fit into the ISDA documentation framework;
• •the purpose of ISDA definitions;
• •the key ISDA definitions; and
• •key points to consider when incorporating ISDA definitions into trade documentation.

See ISDA definitions.

This guidance note summarises the differences between the key clauses in the 1992 Master Agreement and the 2002 Master Agreement.

See ISDA documentation — comparison of the 1992 and 2002 master agreements.

The International Swaps and Derivatives Association, Inc (ISDA) publishes two versions of its Master Agreement, which sets out the terms and conditions for over-the-counter (OTC) derivatives transactions. They are:

• •the ISDA Master Agreement (multicurrency — cross border) (the 1992 Master Agreement); and
• •the ISDA 2002 Master Agreement (the 2002 Master Agreement).

This guidance note summarises the key changes brought about in the 2002 Master Agreement and highlights negotiation points for the 2002 Master Agreement as compared to the 1992 Master Agreement.

See Comparing negotiations of the 1992 ISDA master agreement (Multicurrency — cross border) and the 2002 ISDA master agreement.

Protocols are a means of amending ISDA's standard form documents in a quick and practical way. The amendments suggested by ISDA in the protocols can be incorporated into parties' existing documents by those parties agreeing, or “adhering”, to that protocol.

This guidance note describes how and why one would adhere to a protocol and lists the protocols currently open for adherence.

See What is an ISDA protocol.

Derivatives can be used for both speculation and hedging purposes. Derivatives are frequently used to support (or “hedge”) a loan by swapping a floating interest rate under the facility agreement into a fixed rate.

This guidance note is a broad review of what hedging is, why it may be used and of the hedging documentation in loan transactions, including the ISDA documentation framework and the lender’s lawyer’s role.

See Dealing with hedging arrangements in loan transactions.

Netting is a contractual arrangement between two parties. It means that the parties have agreed that, when they transact with each other, they will not have individual cross-claims against each other. Instead, at any time there will be just one amount owed by the party whose notional cross-claim is worth less than its counterparty's cross-claim.

Netting is different from set-off and is extremely important in the context of derivatives.

This guidance note explains the use of netting in derivative transactions, including payment netting and close out netting.

See Financial derivatives — netting.

This guidance note explains the key documentation and drafting issues to consider when hedging risks in a lending context. It addresses issues such as:

• •hedging strategy letters or protocols;
• •hedging agreements; and
• •tailoring the swap to the risk profile.

This guidance note also considers how the loan documentation and derivative documents should be drafted to ensure they are consistent.

See Use of derivatives in a lending context — documentation issues.

This guidance note considers the non-ISDA documents in a loan financing transaction that deals with hedging. It analyses drafting issues such as:

• •what to think about in relation to hedging requirements;
• •hedge payments;
• •prepayments;
• •financial requirements;
• •matching; and
• •security.

See Guide to hedging within a financing context — for the financing lawyer.

This guidance note considers the use of ISDA documents in a loan financing transaction that deals with hedging and how by considering the ISDA documentation in the light of the facility agreement and other finance documents, a consistent position can be reached which reflects the commercial agreement, rather than presenting the hedging arrangement at the end of the transaction as a condition precedent to drawdown of the loan and as a “standard” document to be executed.

See Guide to hedging within a financing context — the ISDA documents.

Most standardised OTC derivatives across Europe and the US are now centrally cleared. However, uncleared derivatives still represent a significant portion of the market. These uncleared derivatives are increasingly subject to margin requirements.

The terms “collateral” and “margin” are often used interchangeably. However, technically, collateral refers to the asset posted that represents the margin amount. Margin is the amount that is posted to address the risk of a transaction or counterparty failing.

Posting margin is a risk mitigation tool. It has an effect on a party's liquidity and increases the liquidity burden on all parties who have to post margin since those parties have less assets freely available to them if those assets are posted with their counterparty.

This guidance note sets out the margin requirements for uncleared derivatives, explaining why these requirements are necessary and how the requirements are being implemented. It describes the exchange of initial margin (IM) and variation margin (VM) and summarises recent international developments.

See Margin requirements for uncleared derivatives.

Following the credit crunch in 2007, the G20 asked the Basel Committee on Banking Supervision (BCBS) (part of the Bank of International Settlements (BIS)) and the International Organization of Securities Commissions (IOSCO) to produce a framework for margin requirements for non-centrally cleared derivatives.

This guidance note summarises the eight elements that are detailed in the BCBS/IOSCO report.

See BCBS/IOSCO margin requirements for uncleared derivatives.

European Market Infrastructure Regulation (EU) 648/2012 on the European Market Infrastructure Regulation (EMIR) was adopted in the European Union.

This guidance note discusses the regulatory technical standards on risk mitigation techniques for uncleared derivatives under EMIR.

See EMIR margin requirements for uncleared derivatives.

ISDA has published a number of documents in relation to the margin requirements for non-cleared derivatives.

This guidance note provides an overview of ISDA SIMM, ISDA 2016 Variation Margin Protocol, the ISDA regulatory margin self-disclosure letter, and ISDA credit support documentation for VM and IM.

See ISDA margin requirements for uncleared derivatives.

When a transaction is centrally cleared, that transaction is “given up” or “novated” to a central counterparty (CCP). This means that the two parties entering into the derivative transaction do not have credit exposure to each other as they would have in a bilateral transaction. Instead, the CCP takes margin in exchange for assuming the credit risk of each of the two parties. See Clearing derivatives.

See What is clearing?

Derivatives fit into 2 broad categories, OTC derivatives and exchange traded derivatives. This guidance note sets out how and what derivatives are cleared.

See What derivatives are cleared?

Clearing houses are used to clear derivatives. How this works is set out in this guidance note.

See How does clearing work?

Collateral is required when transactions occur through a clearing house. Margin calls are made for both Initial and Variation margin. What these are and when they are required is set out in this guidance note.

See Margin requirements for cleared derivatives.

The benefits and risks of centrally clearing derivatives is outlined in this guidance note.

See What are the benefits and risks of centrally clearing derivatives?

An explanation of what settlement is set out in this guidance note. See Settlement of OTC derivatives.

See What is settlement?

The Global Financial Crisis of 2007 has brought significant reform in relation to the clearing and settlement of OTC derivative contracts. Some of the reforms brought about in the European market are considered in this guidance note.

See Reform of clearing and settlement requirements for OTC derivative contracts.

Not all OTC derivatives are cleared and settled through clearing houses and a significant number are still transacted on a bi-lateral basis and settled under the terms of the ISDA Master Agreement.

See Settlement of uncleared OTC derivative contracts.

Credit support is a means of providing collateral or a security interest for payment obligations under derivative transactions. It is a way for a party to reduce its credit risk on its counterparty. Credit support arrangements may be referred to as “financial collateral arrangements”, "margin arrangements”, “collateralization” and “credit enhancement”.

One (or both) parties will deliver or otherwise make available assets (known as collateral or margin) to the other party (known as the collateral taker) to secure or support its present or future obligations. In the event the credit support provider defaults, the collateral taker can rely on the collateral provided by the defaulting party to secure any debt outstanding. Collateral may be provided by one party only (ie where one party is higher rated than the other, it may take collateral) or may be provided by both parties.

Collateral in this context refers to the assets that are provided under a credit support arrangement. These can be:

• •cash; or
• •securities.

The International Swaps and Derivatives Association, Inc (ISDA) has produced standard form credit support documentation which either takes the form of:

• •a credit support annex — known as a CSA; or
• •a credit support deed — known as a CSD.

It is usual, although not mandatory, to select a credit support document with a governing law that matches the governing law of the relevant master agreement.

This guidance note considers what form credit support will take and what are the benefits or problems with using credit support. It further explains key terms found in the ISDA credit support documents and looks at how collateral is transferred under these documents. Further, it references useful additional ISDA documentation which will assist in understanding this process.

See What is credit support and how is it used in the ISDA credit support documentation?

There are three forms of credit support documentation published by ISDA which are governed by English law. This guidance note describes the 1995 English law ISDA Credit Support Annex. This document:

• •does not create a security interest — it constitutes an outright transfer of title to collateral;
• •forms part of the Schedule to the Master Agreement; and
• •constitutes a Transaction (as defined in the ISDA Master Agreement).

The guidance note also looks at the 2016 ISDA Credit Support Annex for Variation Margin (VM) Title Transfer — English law (the English Law VM Annex) and further ISDA margin requirements for uncleared derivatives.

See ISDA Credit Support Annex: transfer — English law.

There are three forms of credit support documentation published by ISDA which are governed by English law. This guidance note describes the 1995 ISDA English law Credit Support Deed. This document:

• •creates a security interest in the collateral;
• •does not form part of the Schedule to the Master Agreement — it is a stand-alone agreement; and
• •constitutes a Credit Support Document (as defined in the ISDA Master Agreement).

Also considered in this guidance note is the Phase One IM Credit Support Deed for Initial Margin produced by ISDA in 2016 which updates the English Law Deed.

See ISDA Credit Support Deed: security interest — English law.

This guidance note discusses how to terminate a derivative transaction that is governed by an ISDA Master Agreement, including:

• •the differences between Termination Events and Events of Default;
• •what to include in Termination Notices;
• •what to include in calculation statements;
• •the interest payments that accrue on the Early Termination Amount (and different setting out between the 1992 and 2002 ISDA Master Agreements); and
• •what close-out netting is.

See Terminating derivatives entered into under an ISDA master agreement.

A Termination Event is different from an Event of Default because it may be due not to the act or failure to act of a party but rather to an event which is outside its control.

This guidance note takes you through the Events of Default and Termination Events in the ISDA Master Agreement.

See Scope of the ISDA Master Agreement — section 5 (Events of Default and Termination Events).

Section 6 of the ISDA Master Agreement sets out the consequences of an occurrence of an Event of Default or Termination Event.

Importantly, it sets out how the close out netting mechanism operates following an Event of Default or Termination Event.

See Scope of the ISDA Master Agreement — section 6 (Early Termination).

Under an ISDA Master Agreement, if an Event of Default occurs, often the Defaulting Party is given a period of time in which to “cure” the default. This means that until that cure period has ended, the derivative transaction cannot be terminated early on the grounds of an Event of Default.

This guidance note sets out the cure periods for the different Events of Default in both bullet point format and in a table.

See Potential Events of Default under an ISDA Master Agreement and cure periods — summary and comparison table.

If an ISDA contract is going to be terminated, it is important to ensure that the terms of the ISDA Master Agreement permitting Early Termination are followed to the letter. Any error can lead to the termination not having been effected properly and being invalid.

This guidance note details how to send a notice under s 6 of the ISDA Master Agreement to terminate a derivative transaction and what to include in:

• •a Potential Event of Default notice;
• •an Event of Default notice;
• •a Termination Event notice; and
• •a calculation statement.

See Notices to send when terminating derivative transactions early.