INSIGHT

Impact of COVID-19 on derivatives

By Tom Highnam, Rod Aldus, Tania Joppich
Banking Capital Markets COVID-19 Financial Services

In brief

COVID-19 will have a range of impacts on over-the-counter (OTC) derivative transactions. We set out below some key documentation issues arising as a consequence of COVID-19 and our practical tips.

Separately, we have considered the Impact of COVID-19 on corporate financing transactions and Impact of COVID-19 on debt capital markets and offer both our analysis and practical means for responding in these related insights.

Practical effects of a lock-down

We are yet to truly see how a lock-down or working from home will affect derivatives, but there are number of practical considerations. For example, the general methods of serving default notices under an ISDA Master Agreement, the standard document under which derivatives are traded, are mail deliveries, couriers and facsimiles. In a lock-down, a counterparty may not be able to locate a courier or, even if they can, there may be no one at the delivery location to receive the notice. We saw in the 2008 GFC that getting default notices right under an ISDA Master Agreement is very important in ensuring that a counterparty is able to terminate.

Tip

Read through your ISDAs and make sure that you have the ability to send notices by other means, including to process agents. If necessary, check that you have the correct up-to-date details of your counterparty and drag that fax machine out of storage.

A Force Majeure Event

The 2002 ISDA Master Agreement provides that a Force Majeure Event occurs where it is 'impossible or impractical' for a party to perform so long as the force majeure or act of state is beyond that party's control and despite that party's reasonable efforts it cannot overcome such impossibility or impracticability. While this is a difficult threshold to pass, the COVID-19 pandemic is enlivening Force Majeure Events. For example, if staff are unable to physically attend the relevant office and perform their functions. To enliven a Force Majeure Event the counterparty must go through all of the other fall-backs first, but the end result is that the ISDA may be terminated.

Although the standard 1992 ISDA Master Agreement does not contain a Force Majeure Event, often parties have negotiated in an "Impossibility" clause which had a similar effect. Therefore, you cannot think that this won't apply to you just because you are trading under the 1992 version.

Tip

The legal onus of making a successful claim that COVID-19 results in a Force Majeure Event is high and, as mentioned, it is the last resort. Consequently, it is challenging for parties to rely on such provisions to exit their contractual obligations, but it is worthwhile being prepared for this eventuality.

Local Business Days

The majority of the obligations under the ISDA Master Agreement need to be performed on a Local Business Day for the relevant jurisdiction specified in the relevant transaction confirmation or separately agreed between the parties. As we saw in China, the local governments may extend public holidays, so it is important to understand the jurisdictions where your Local Business Days occur.

Tip

If your OTC derivative transaction is linked to other aspects of your business a mismatch between your definition of Local Business Day in your ISDA Master Agreement and your other documentation may cause cashflow issues. For example, if your interest rate swap is linked to your loan facility, you should ensure that your interest payments to your lenders coincide with your swap settlements.

Exchange disruption

With the current market turbulence, equity derivatives are likely to be affected on price for the underlying asset or index and disruptions to the exchanges (eg, suspensions or delays). Equity derivatives have a variety of 'Disruption Events' which may be triggered, and it is important to understand what the rights and obligations of a counterparty are, including when a derivative is capable of being terminated.

Tip

If you have equity derivatives, the Disruption Events will be contained in the Equity Definitions and your confirmations. We recommend that you read these carefully.

Collateral obligations

Often a counterparty will use listed assets as collateral for its margining obligations. However, the market turbulence in relation to those assets may diminish their value which would in turn reduce the value of the posted collateral. A collateralised counterparty would then be able to make a collateral call, requiring additional collateral to be posted. A failure to meet collateral calls can allow counterparties to close out and terminate outstanding transactions.

Tip

You should be mindful of your collateral exposures to counterparties and the market fluctuations in respect of your posted collateral.

Ipso facto and safe harbours

In Australia, derivatives were excluded from the recent changes to the ipso facto provisions which prevented, in certain circumstances, terminating contracts or enforcing cross-default provisions due to certain insolvency events. In light of the recent announcements made by the Australian government, we believe it is unlikely that the status quo in relation to derivatives will change. However, it is worthwhile keeping an eye on these changes to ensure that there is no effect on derivatives.

Regulatory requirements

Following the 2008 GFC, regulatory reforms were implemented across the globe to increase the stability of the OTC derivative market. One of these, mandatory initial margining, is still being phased in with certain entities due to come into scope in September 2020. The documentation requirements for compliance with the initial margin regulations are quite time consuming, with a need to engage with custodians, collateral managers and counterparties.

Given the amount of activity in the OTC derivative market, entities may find it difficult to get traction with their custodians and counterparties on initial margining documentation if they leave it too late.

Tip

There may be regulatory relief provided in respect of this compliance, but if not then in scope entities will need to ensure that there is sufficient time to put the documentation in place ahead of the 1 September 2020 deadline.