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Legal and Regulatory
Framework in the Global Derivatives Market
Derivatives
and Risk Management in Mexico, May 7, 2001
Diane Genova, Managing Director, JPMorgan
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A robust legal
framework is essential for the development of an OTC derivatives market
Parties
need assurance that transaction is enforceable as written
involves
long-term payment obligations
contract
may be relied on as a hedge
Parties
need to be comfortable that they are in compliance with applicable regulatory
guidance
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Legal Framework
must deal with a number of legal and regulatory issues
Contract
Enforceability
Sales
Liability
Standard
Documentation
Netting
and Collateral
Illegality,
Force Majeure, Impossibility
Regulatory
Considerations
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Contract Enforceability
OTC Derivatives
are bilateral contracts
they
are not securities or futures
governed
by general principles of contract law
general
contract law must recognize that derivatives are like any other contract
Recent
amendments to US commodities laws clarify that swaps are legally enforceable
contracts and not off-exchange futures
Counterparty
must have capacity and authority to enter into transactions
Some counterparties
may need specific statutory or regulatory authority to enter into derivatives
Evidence
of authority of counterparty00 representative is important, but possible
to rely on doctrine of apparent authority
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Contract Enforceability
(cont00.)
Hazell
vs. Hammersmith: local authorities in the UK were found to
have exceeded their authority by entering into swaps
Lehman
vs. Minmetals (Chinese corporations): court found Lehman could not
rely on trader00 apparent authority if Lehman knew or suspected that
agreements were illegal under Chinese law
Contract
Formation
transactions
usually executed by telephone
subsequently
confirmed in writing
Statute
of Frauds issues: in some jurisdictions, certain types of contracts
must be in writing
New York
State solution: explicitly recognizes transactions executed by telephone
Australian
case (Powercor Australia): transactions were binding notwithstanding
the absence of signed confirmations
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Sales Liability
Appropriateness
regulators
may require dealers to ensure that its customers have the capability
of understanding the terms and risks of transactions and that sufficient
information given to customers to understand risks
Existence
of Duties
as a general
rule, in order for fiduciary relationship to exist, one party must explicitly
agree to undertake a duty of care
parties
need to be clear as to the nature of their relationship: is it a fiduciary
relationship or an arms length principal-to-principal relationship
Duty of
good faith and fair dealing: each party to a contract must refrain from
making misrepresentations to the the other
Superior
Knowledge: duty to disclose may arise where party has superior knowledge
of information, the information is not readily available to the other
party and the first party knows that the other party is acting on basis
of mistaken knowledge
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Standard Documentation
Standard
Master Agreements are essential for contracts created in a trading environment
Industry
standardization allows parties to focus on the important economic and
credit terms rather than on legal boilerplate
Master
Agreements create consistent contractual rights applicable across the
whole book of derivatives business with a counterparty
Permits
a party to terminate and close-out exposures in a declining credit situation
Allows
all transactions to be netted for credit, financial reporting and collateral
calculation purposes
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Standard Documentation
(cont00)
ISDA Master
is the standard master agreement accepted globally
Utilizes
a flexible architecture: a modular approach
Master
Agreement printed form with representation, events of default/termination
events, early termination mechanics
Schedule
with specific terms tailored to the counterparty
Definitions
booklets incorporating standard definitions and market conventions tailored
to particular products
Credit
Support Documents
Confirmations
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Modular approach
in action
Master Agreement
and Schedule
Interest Rate
Swap
Confirmation
Currency Option
Confirmation
FX Forward
Confirmation
Commodity
Swap
Confirmation
Equity Option
Confirmation
Equity
Definitions
Commodity
Definitions
FX Definitions
2000 ISDA
Definitions
Yield: Net
credit exposure on transaction
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Netting
Types
of Netting
Payment
netting
Close-out
netting
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Payment netting
Single transaction
payment netting
Dealer
Counterparty
$2mm
$3mm
Counterparty pays
net $1mm
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Close out netting
Dealer
Counterparty
ITM $5mm
Netting on termination
Dealer
Counterparty
ITM $3mm
On termination, net
claim is $2mm owed to Dealer
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Netting (cont00)
Benefit
of close out netting
Exposure
reduction--enables parties to do more business with each other
Balance
sheet impact
Regulatory
capital benefits
Enforceability
of close out netting
Recognition
of close-out netting is key to legal derivatives infrastructure
Netting
legislation adopted in 22 countries
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Collateral --Two
approaches
Security
Interest Approach
Requires
pledge and perfection
Ownership
of asset remains with Counterparty
Relies
on enforcement of security interest theory
Use of
collateral by secured party is an issue
Most common
structure in OTC derivatives markets
Title
Transfer Approach
Outright
transfer of assets
Relies
on set-off theory
Most common
structure in repo markets
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Legal issues of
security interest approach
Issues
revolve around 00reation00and 00erfection00of security interests
Procedural
requirements
Filing
or notice requirements
Possession
requirements
Choice
of law/multi-jurisdiction issues
Continuation
requirements
Substitution
of collateral
00fter
acquired property00/font>
00n
flight00securities
Rehypothecation
or 00se and abuse00/font>
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Legal issues of
title transfer
Recharacterization
risk
00allback00
grant of security interest
Used
in repo documentation
Not used
in UK Credit Support Annex
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Enforcement of
remedies
Bankruptcy/insolvency
impediments to enforceability
Stays
Preferences
Superpriorities
or 00riming00/font>
Procedural
requirements
Grace
periods and notice requirements
Prior
notice of liquidation
Liquidation
mechanics - can the secured party buy the collateral?
Requirement
of 00ommercial reasonableness00/font>
Significant
variables
Type of
debtor
Type of
transaction
Type of
insolvency proceeding
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Operational
Risks
May not
call for collateral
Risks
in substitution
may mis-mark
collateral, swaps, etc.
Legal
Risks
Preferences
Stays
Priorities
over secured creditors
Collateral reduces
credit risk but creates legal and operational risk
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Illegality, Force
Majeure, Impossibility
Off-exchange
futures prohibited in some jurisdictions
Law in
US recently amended to clarify that OTC swaps are not illegal off exchange
futures
Gaming/gambling
laws--should provide exception for bona fide commercial transactions
Registration
requirements for certain currency transactions--failure to register
may result in lack of enforceability of transaction
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Illegality, Force
Majeure, Impossibility (cont00)
Force
majeure and impossibility
range
of actions may affect parties ability to perform, e.g. civil unrest
(Indonesia), imposition of exchange controls (Malaysia)
need to
have a roadmap as to what happens to the contracts
ISDA force
majeure/impossibility provisions
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Regulatory Considerations
Safety
and soundness of regulated entities
Banco
de Mexico 31 points
Federal
Reserve derivatives guidelines
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