Fund managers may be struggling to decide what new technology and operational procedures to implement to be able to trade interest-rate swaps and other derivative securities, as they move onto centrally cleared markets.
But managers should not overlook one key task: creating and keeping track of all the new legal documentation involved.
"Fund managers must now decide what type of category of firm they fit under, which contracts they will centrally clear and what new contracts they will enter into with executing parties and clearing brokers," said Andrea Kramer, a partner in the Chicago office of McDermott Will & Emery.
Broker-dealers are widely considered to be the largest players in the $600 trillion marketplace for derivatives that range from interest-rate and credit-default swaps to foreign exchange, equity and commodity derivatives. But hedge fund and other institutional fund managers are also showing interest. The Dodd-Frank Wall Street Reform Act calls for many derivatives contracts to be traded on exchanges or "swap exchange facilities" and cleared through a central counterparty at a clearinghouse.
There are some exceptions. Corporations considered "end users," which only rely on derivatives contracts to hedge risks in their industries, can opt out of clearing. Managers of plans governed by the Employee Retirement Income Security Act also won't be required to centrally clear their trades. Clearinghouses may even decide which contracts are eligible for clearing. That could leave an estimated 30% of transactions in over-the-counter contracts being processed they are today-between counterparties which each put up some collateral to make the other whole in the event of a default or bankruptcy.
Fund managers have until now been relying on two types of legal agreements, to enter into deals. One is the "give-up contract" is for futures contracts for which the Futures Industry Association has developed guidelines. The other agreement, developed by the International Swaps and Derivatives Association, governs swaps contracts. The so-called ISDA master agreement also has a credit support addendum which governs the terms of any collateral agreement between counterparties.
Neither the FIA nor the ISDA model address transactions in derivatives which must be traded on an exchange or the new type of electronic platform called a swap execution facility and then cleared through a clearinghouse. But the FIA and ISDA have now devised a new model contract called Cleared Derivatives Execution Agreement that fund managers can use with their executing counterparties prior to the time trades are cleared through a clearinghouse.
A full copy of the template and optional annexes is located on http://www.futuresindustry.org/fia-and-isda-publish-documetation-for-cleared-swaps.asp.
The FIA is also separately working on a separate model contract for fund managers to use with each of their clearing brokers that likely will be an addendum to futures and options contracts called a Futures Agreement or Futures Clearing Agreement.
"The industry's demand for a standardized agreement addressing certain issues related to the execution of swaps that must be cleared emerged with the prospect of a larger and more diverse swap market with far more participants," said Lauren Tiegland-Hunt, a partner in the New York law firm of Tiegland-Hunt, who participated in drafting the new FIA-ISDA model contract. About 60 firms worked on the project, which took six months to complete.
The cleared derivatives execution agreement creates boilerplate language to permit them to determine the responsibilities of each counterparty. "It's a starting point for negotiations between two counterparties and we expect it will provide a template for firms to come up with more specific language," said Will Acworth, a spokesman for the FIA.
The trade group represents banks, broker-dealer and other firms which offer clearing for listed futures and options contracts. The ISDA represents dealers, end-users and other market participants who actively trade OTC contracts.
Acworth acknowledged that the legal template created by the FIA and ISDA could be superseded by final rules issued by regulators, swap execution facilities and clearinghouses. However, because some fund managers have already started to process their trades through units operated by CME Group, Intercontinental Exchange and LCH.Clearnet, fund managers and swap dealers may want to consider the template.
Other options exist. "Some fund managers and dealers would prefer to negotiate additional clauses to their futures agreements while some would like to add to their ISDA agreements," Kramer said.
Yet, other dealers are pushing fund managers to sign a global agreement governing trade executions and clearance for both futures and OTC contracts. "Fund managers which don't have the technological resources to handle multiple executing brokers and clearing firms may ultimately decide that's the best approach," Kramer said.
Those opting to follow the new FIA-ISDA model agreement can determine the procedures and timing for affirming and confirming a transaction. They can also designate who will responsible for sending the matched trade to a clearinghouse. Counterparties can store the document in an FIA-operated electronic document storage platform called the electronic give-up agreement system (EGUS), which will make it legally binding.
The most critical element of the FIA-ISDA model agreement is understanding just what to do if the trade does not clear. Such a scenario could occur if (a) either counterparty does not send affirmation and confirmation details in time, (b) if one counterparty decides it no longer wants to centrally clear or (c) if the clearinghouse rejects the trade as ineligible for clearing.
Counterparties have one of three options in such cases. They can clear the trade through an affiliate of the counterparty dealer, revert the trade to a bilateral trade or cancel the trade. Should the transaction be canceled, one of the counterparties may decide to make the other whole. This is a process attorneys have coined "breakage waterfall."
The parties may also consider the failure to clear the trade through a central clearinghouse was no one's fault and create a no-fault scenario in which they compensate each other.
Just who will decide whether to move a transaction from a central clearing system to bilateral processing or cancel it is likely to be a sticking point between fund managers and swap dealers. "The FIA and ISDA model agreement gives counterparties the flexibility to decide whether it should be the fund manager or the dealer, but if one of the parties is a dealer it is likely the dealer will want to have the final say," said Tiegland-Hunt. "Some fund managers may want to push back." MME