Most dealers require their counterparties to execute an ISDA Master Agreement (“ISDA”) as a prerequisite to trading. With all the time and money being spent on putting over-the-counter (“OTC”) trading arrangements in place, do we really need to enter into additional complex and often lengthy (or never-ending) negotiations of the ISDA terms? At the end of the day, ISDA is a well-known, standardised master agreement, why not simply agree to the “standard” broker terms and sign on the dotted line without any modifications?
I have to admit, I have been asked this question many times by asset managers, and the answer is always the same – “standard” ISDA terms are a complete myth. The world of OTC derivatives was designed to offer market participants the opportunity to customise their terms of engagement. This is what distinguishes OTC products from their less flexible and highly regulated “siblings” – exchange traded derivatives.
So the question is why wouldn’t you want to improve on your legal terms and limit the risks for you and your investors?
Here are my top five reasons why you should negotiate ISDAs with your dealer counterparties:
1. Additional Termination Events (“ATEs”): ATEs are events that your broker can include in the ISDA Schedule. They have been designed to act as additional protections or early warning signs and pre-empt potential hazards. From net asset value triggers (which by definition may include redemptions), change of control, change in investment manager, change of investment guidelines events, change of weather conditions or inclusion of key man provisions, to having to seek your broker’s permission if you decide to change your custodian or update your management structure – sky is the limit when it comes to the drafting of the ATEs. This could be a real minefield if left unamended!
- Credit provisions: Your broker counterparties are most likely to present you with a template that includes the highest protections for themselves and their organisations (why wouldn’t them?), and let’s not forget that the ISDA in its unamended form was designed to protect the dealers. Cross Default is one of the most common examples given in this context. Whether defaults under your other agreements can lead to a default under your ISDA (and the timing of when this can be triggered) is often a major sticking point in negotiations. In addition, the trigger at or above which the non-defaulting party can terminate the ISDA also needs to be agreed upon. If no elections are made in respect of Cross Default (or other credit-related provisions), certain fallbacks or broker standard terms automatically kick in and these are usually not favourable for the buy-side.
- Bespoke jurisdictional requirements: Certain entities, depending on their domicile and legal structure, are either entitled to more enhanced protections or require some additional provisions to be included in the ISDA Schedule, mostly for compliance and regulatory purposes. UCITS being a prime example – they have a so-called “early termination right” and the ability to request valuations of their broker counterparties. It is important to include these additional jurisdictional provisions in your ISDA Schedule (to the extent applicable) to ensure that you are not exposed to any unnecessary regulatory, reputational or litigation risks.
- Regulatory considerations: You want to ensure that your ISDA accurately reflects the regulatory status of the fund / entity that will be entering into OTC transactions. From EMIR or ERISA related representations, to reporting, tax and Dodd Frank considerations – these terms have to be tailored on a case-by-case basis.
- Investor DDQs: It is customary for investors and asset allocators to conduct standard periodic due diligence checks on their investment managers. “What is your ISDA negotiation policy?” or “What are the key ISDA terms under which you contract with the brokers?” are just a few examples of the most commonly asked questions in the context of OTC trading; the range of your NAV triggers is another example. Needless to say, with a duty to protect your investors’ assets, not only you want to be able to demonstrate your understanding of the importance of your trading terms, but also showcase your commitment to achieving the best possible terms for them. Responding that you do not negotiate your ISDA terms may not be well received.
To sum up, you can either decide to customise your terms or accept the risks of potential misrepresentation and inclusion of inappropriate, obsolete terms or highly sensitive triggers Also, let’s not forget that the tables have turned – while standard ISDAs may have been insisted on by the dealers in the past, it is now the buy-side that is expected to be scrutinising them to ensure they and their clients are properly protected when banks become vulnerable.
The banking and finance industry relies on the “Three Lines of Defence” model, which has become the most common benchmark for assigning control and risk management responsibilities to business functions. The quality of your ISDA terms can either act as a booster or an enhancement to your existing internal controls or deflate and weaken them. Thought-through and tailored to your business and trading strategy ISDA terms are a great risk mitigation tool – and your Board of Directors will thank you for it!
Solution? Invest in a good ISDA template. Having pre-agreed terms in place with your key counterparties will accelerate the on-boarding process and time to market, it will also limit the scope of negotiations to the more bespoke to the fund terms.
If you’d like any assistance with your ISDA templates or have any questions about this article, please feel free to email me at firstname.lastname@example.org.
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