Podcast: COVID-19: Derivatives Trading Agreements—Considerations for the Buy-Side
In this Ropes & Gray podcast, Isabel Dische, partner in the asset management group, and Molly Moore, counsel in the asset management group, discuss steps buy-side market participants can take to understand and mitigate possible implications of the COVID-19 pandemic on their derivatives contracts. Topics covered include events of default and termination events as well as super-collateral events that may be triggered by the COVID-19 pandemic, credit-related considerations, force majeure provisions, and understanding how governmental and trading exchange actions such as market closures, may affect valuation and payment dates or otherwise trigger disruption events.
Isabel Dische: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on CFTC and derivatives issues for asset managers and other buy-side market participants. I’m Isabel Dische, a partner in our asset management group, based in New York. Joining me today is Molly Moore, a counsel in our asset management practice, based in Washington, D.C. Today, we are going to be talking about certain steps buy-side market participants can take to understand and mitigate potential implications of the COVID-19 pandemic on their derivatives contracts. The COVID-19 outbreak is causing disruption around the world, including containment measures and quarantines, extensions of public holidays, closure of courts and other public services, and travel restrictions. Uncertainty is playing out in the financial markets as well and market declines have resulted in the New York Stock Exchange triggering 15-minute “circuit breaker” trading halts twice this week alone. As part of their crisis management planning, market participants will want to understand what implications, if any, these market dynamics have on their existing derivatives trading arrangements.
In this podcast, we will cover certain events of default and termination events as well as super-collateral events that may be triggered by the COVID-19 pandemic, credit-related considerations, force majeure provisions, and understanding how governmental and trading exchange actions such as market closures, may affect valuation and payment dates or otherwise trigger disruption events for trades.
Molly Moore: Yes. As a first step, market participants will want to understand if there are any events of default or termination events that may be implicated, such as material adverse change or MAC clauses that may be triggered by COVID-19 related events. For example, are there termination events that may be triggered because the outbreak may be viewed as materially and adversely impacting the buy-side participant’s ability to meet its obligations under the relevant agreement? Note that where you have several trading arrangements with a given counterparty – for example both an ISDA and a prime brokerage agreement – you will want to understand the terms of each agreement and whether triggering a default or termination event under one agreement may result in a cross default of another. As an example, dealers’ termination rights under FCM and prime brokerage agreements are often broader than those under ISDAs or repurchase agreements, but the ISDAs and/or repurchase agreements may have cross default provisions that could nevertheless be triggered by such broader termination triggers.
Another area to keep an eye on given the level of market volatility, is credit-based termination events and super-collateral events such as ratings- and NAV-decline trigger events as the broader downturn in the markets could result in those triggers being tripped. In the case of super-collateral events, such triggers can lead to sharp increases in margin demands as well as termination rights for dealer counterparties. In addition, many trading agreements include NAV-decline notification requirements that (along with super collateral events) will likely come into play before NAV-based termination events are triggered. Depending on the precise phrasing of such provisions, such notification and super-collateral events may be implicated before month-end and even within a matter of days of their occurrence. Market participants will want to monitor their compliance with such triggers and determine whether and when to reach out to dealers to ask for waivers.
Isabel Dische: A third area of focus is assessing whether any force majeure provisions are implicated by market events. Many ISDAs, including the standard 2002 Master Agreement include a force majeure termination event. This provision typically gives one or both parties to a derivatives transaction (and their guarantors) temporary relief from having to perform payment, delivery and other obligations under the agreement. Moreover, if the conditions leading to the force majeure event continue, one or both parties may have the option to terminate one or more transactions under the ISDA. Note, however, that the force majeure provisions may only come into play after the parties have first given effect to any fallbacks or adjustments that are otherwise prescribed by the relevant trade confirmations, including provisions in the standard ISDA Definitions.
There is no formal guidance on what constitutes a force majeure event under the ISDA, but events commonly considered to trigger this termination event include civil and political unrest, natural or manmade disasters, labor disputes, and terrorist or other violent events beyond the control of the parties. We note that courts typically interpret force majeure provisions narrowly, and neither operational difficulty nor poor market performance would generally be seen as giving rise to a force majeure event. That being said, the government-imposed closure of businesses as a result of a global pandemic would likely be sufficient for parties to declare a force majeure termination event if they are impacted.
Molly Moore: Governmental actions with respect to COVID-19 may have more direct implications on derivatives transactions. For example, the Chinese government announced on January 27 that the Lunar New Year holiday was extended through February 2. Unscheduled holidays, such as this, impact derivatives transactions where valuations and/or settlements were otherwise due to take place on such dates. Note that depending on the facts, parties may not be able to strictly comply with the contractual terms: as an example, the Lunar New Year holiday extension was announced after the holiday had commenced, but under the Modified Following Business Day Convention or the Preceding Business Day Convention for currency derivatives, a payment originally set for the unscheduled holiday would have had to be made on a day that had already passed. Note that the approach for payment dates may not align with the approach for valuation periods or accrual periods, and market participants will want to understand any such mismatches.
Market participants will also want to understand whether market closures and/or disruptions in trading trigger adjustment and/or termination rights under their trading documents as well as what the relevant fallbacks are if such rights are triggered. Each of the standard ISDA Equity, Commodity and FX Definitions include market disruption-related events that may give dealers broad rights to adjust trades, use alternative inputs for valuations or even delay valuation dates and pricing dates. For example, under the ISDA Equity Definitions, disruption events include early closures of an exchange, “circuit breaker” trading halts by an exchange, or the temporary inability of market participants to effect transactions or obtain market values for transactions.
Isabel Dische: How market disruptions are handled may also vary by type of agreement – for example, cleared versus uncleared derivatives (or even across different clearing platforms) or across transactions governed by different bodies of law. Market participants will want to consider the terms of each carefully. Potential mismatches also may arise between how derivatives contracts handle market disruptions and how the underlying securities that those derivatives contracts are intended to hedge handle the same. Again, this ultimately comes down to understanding the relevant contractual terms. A final point for consideration is understanding how COVID-19 and related market disruptions may impact your counterparties. Again, this is a fact-specific question and beyond the scope of this podcast, but you will want to monitor credit exposures and attempt to understand how your counterparties are exposed to potential disruptions. Needless to say, there’s a lot to consider.
Thank you, Molly, for joining me today for this discussion, and thank you to our listeners. For more information on the topics that we discussed or other topics of interest to the asset management, CFTC and derivatives communities, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we’ve discussed – please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.