In this episode of Fully Invested, Ropes & Gray asset management attorneys Molly Moore, Egan Cammack and Lindsey Jones provide an overview of key areas of focus for GCs and asset managers when negotiating and entering into derivatives transactions, including credit and counterparty risk, documentation, potential CFTC registration, and other regulatory considerations.
Molly Moore: Hello, and welcome to Fully Invested, a podcast series from Ropes & Gray’s global asset management team. Drawing on the perspectives of attorneys from all areas of our broad, integrated practice, we provide insight into essential considerations associated with current and emerging asset management products. I'm Molly Moore, and today I’m joined by my colleagues Egan Cammack and Lindsey Jones—each of us is a member of Ropes & Gray’s derivatives & commodities group within the firm’s asset management practice. On this episode, we'll be discussing at a high level, areas of focus for asset managers when negotiating and entering into derivatives transactions, including credit and counterparty risk, documentation, potential CFTC registration and other regulatory considerations.
Egan, could you give an overview of documentation required for derivatives trading?
Egan Cammack: Sure—thanks, Molly. Over-the-counter (OTC) derivatives, including swaps and options, typically are documented using industry standard documentation developed by the International Swaps and Derivatives Association (or “ISDA” for short). A typical OTC derivative transaction is governed by a suite of agreements, product-specific definitional booklets, protocols and other documents, and a transaction confirmation. Some of these documents are highly negotiated, and others are not negotiable at all.
Two key points for asset managers to keep in mind when entering into an OTC derivative trading relationship are that, first, the counterparties to a transaction typically do not have a contractual right to terminate the transaction until its stated maturity date, which could be weeks, months or even years after the date a transaction is entered into. Additionally, the parties to a transaction have credit and counterparty risk to each other. Accordingly, OTC derivative documentation typically includes a number of provisions that are designed to address those risks, including representations, covenants and events of default. Another key feature of the documentation is that it provides the parties with a roadmap for closing out and netting exposures across a portfolio of transactions in the event the transactions are terminated, including following a default by one of the parties.
Molly Moore: Thanks, Egan. Another way parties can address credit and counterparty risk is through collateralization of OTC derivative transactions. There are generally two types of margin in OTC derivative transactions—variation (or “mark-to-market”) margin and initial margin. Variation margin generally is intended to cover daily mark-to-market movements in the value of a transaction, whereas initial margin is intended to provide an additional buffer to cover extreme events. One point to keep in mind is that, pursuant to regulations that came into effect in 2017, most funds have been required to exchange daily mark-to-market margin, and some funds that use derivatives extensively will be (or already are) required to exchange initial margin. The application and implementation of these regulations is quite complicated, and asset managers that use derivatives should seek advice on how the regulations apply based on their transactions and client base.
Lindsey, can you tell us a little bit about the process for entering into an OTC derivatives trading relationship?
Lindsey Jones: Sure. At the beginning of the process, before any documentation is negotiated or trades are executed, the parties go through an extensive credit and counterparty risk review process. This process typically takes weeks or even months to complete, so it is important to plan ahead. In a typical arrangement between an asset manager and a swap dealer, the dealer will request a wide range of information about the fund or client entering into the relationship, including the fund’s net asset value (or “NAV”), performance history, portfolio of investments, investment objective and strategies, use of leverage, portfolio managers, financial statements, governing documents and tax status. Buy-side counterparties may want to put confidentiality agreements in place to protect the disclosure of such information. The result of this credit review process will influence the terms that the fund will be able to negotiate. Buy-side counterparties may also conduct their own due diligence and credit review of the swap dealer.
Molly Moore: Thanks, Lindsey. Could you elaborate on how the credit review process influences the terms of OTC derivatives transactions?
Lindsey Jones: Yes. The information given to the swap dealer during the credit review process will have an impact on contractual terms governing derivatives. For example, the parties typically seek to include “Additional Termination Events” (ATEs) in ISDA Master Agreements. ATEs generally are credit-related events, the occurrence of which gives the non-defaulting party the option to terminate all transactions outstanding under the ISDA. For example, if a hedge fund is seeking to enter into an ISDA, and the fund has a key person event in its PPM, the swap dealer may ask to include the key person event as an ATE under the ISDA. Another example is a NAV trigger, which allows the swap dealer to terminate the ISDA if the fund’s net asset value declines by a certain percentage over a given period of time. Many funds seek to include credit rating ATEs in their ISDAs to give the fund the right to terminate transactions if a dealer counterparty’s credit rating drops below a specified level. ATEs are a key area of focus in the negotiation of derivatives documentation.
Egan Cammack: Shifting gears to regulatory requirements, as we mentioned before, there are a number of regulatory requirements that apply to OTC derivative transactions. As part of the credit and counterparty review process we discussed earlier, asset managers will be required to provide extensive representations regarding each client’s status under various regulations. One example is whether a client is a “U.S. person” under different regulations. This will help the parties determine which regulatory regimes are applicable and tailor their documentation appropriately.
Depending on the location and regulatory status of the parties and the types of transactions they enter into, different regulatory requirements will apply. Molly, do you want to take us through a sampling of these?
Molly Moore: Sure. In addition to the margin regulations that we’ve discussed already, most derivative transactions are subject to mandatory reporting. Under these regimes, one or both parties to a transaction are required to report information about the transaction to a data repository shortly after execution of the transaction. As part of this, parties are required to obtain a legal entity identifier, which is sometimes referred to as a global markets entity identifier (or “GMEI”). The LEI is a unique alphanumeric code that is used to identify the parties to a transaction, including in regulatory swap data reporting. Any fund that enters into derivative transactions needs to obtain an LEI.
Swap counterparties also may be subject to certain risk mitigation and business conduct requirements. These rules generally require parties to have procedures in place to resolve certain types of disputes related to derivative transactions, and to periodically reconcile and compress their portfolio of transactions. Swap dealers also may be subject to business conduct rules, which include a range of requirements to collect certain information and representations from counterparties and to make disclosures to their counterparties. ISDA has developed various documentation protocols to assist market participants in complying with these regulations. These documentation protocols, or bilateral variations of them, are widely used in the derivatives markets and are a standard part of entering into OTC swap trading relationships.
Egan Cammack: Lindsey, there’s one other regulatory point we want to highlight, and that’s the CFTC’s commodity pool operator and commodity trading advisor registration and regulatory regime.
Lindsey Jones: Yes. CFTC rules apply to asset managers who engage in CFTC regulated derivatives transactions, known as commodity interests, for funds and separate account clients. Commodity interests include futures, options on futures and most swaps. An asset manager who sponsors funds that transact in commodity interests must register with the CFTC as a commodity pool operator unless an exemption from registration is available. Sponsors of funds that use a de minimis amount of commodity interests typically are able to rely on registration exemptions under CFTC Rule 4.13(a)(3) (with respect to privately offered funds) or CFTC Rule 4.5 (with respect to registered investment companies). Depending on the facts and circumstances, other CFTC registration exemptions may be available. Even if a fund sponsor relies on a registration exemption, it may need to make a filing in order to claim the exemption. Other conditions may apply, including requirements to make certain disclosures to investors in offering or other fund documentation. In addition, an asset manager that provides advice to clients regarding commodity interest transactions must register with the CFTC as a commodity trading advisor unless an exemption applies. Asset managers that are required to register with the CFTC must comply with extensive regulatory and compliance obligations and are subject to periodic examination by the CFTC.
Molly Moore: Thank you, Lindsey and Egan, for joining me for this discussion. And thank you to our listeners—we appreciate you tuning into Ropes & Gray’s Fully Invested podcast series. Please visit our website at www.ropesgray.com/assetmanagement, or feel free to reach out to any of us via email or phone for more information. You can also subscribe to this series wherever you typically listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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