The Derivatives Market
The derivatives market is the
financial market for derivatives, financial instruments like futures
contracts or options, which are derived from other forms of assets. The
market can be divided into two; one is for exchange-traded derivative
and that for over-the-counter derivatives. A commodity market is a
market that trades in the primary economic sector rather than
manufactured products. Soft commodities are agricultural products such
as coffee, sugar, and cocoa. Hard commodities are mined products such as
gold and oil. Futures contracts are the oldest way of investing in
commodities. Futures are secured by physical assets. The commodity
market can include physical trading in derivatives using spot prices,
forwards, futures, and options on futures. Collectively all these are
called Derivatives.
Derivatives can seem like totally foreign
concepts to those outside the world of finance. However, derivatives are
part of our everyday life even if we are unaware. Below is a real-world
example of derivatives in action.
Derivatives Example
There
is a Beyonce concert next week that Ms X wishes to attend.
Unfortunately, when she got to the ticket counter, she saw all the
tickets have been sold out. With only seven days left until the concert,
she is trying to quickly find a ticket including on the black market
where prices are now twice the actual cost. Luckily her friend works
closely with the venue owner, and her friend has given a letter from
that owner to organisers recommending one ticket to Ms X at the actual
price. She is now delighted she can attend the concert. However, in the
black market, tickets are still available at a higher price than the
actual price.
Here, the letter is the underlying asset and the value of the letter is the difference between the actual price of the ticket and the black market price.
Risk Mitigation
Risk
managers who oversee the drafting of an ISDA Master Agreement may
consider requesting “standard terms” when it comes to drawing up the
agreement to expedite the process. However, in the world of ISDA
negotiation, there is no such thing as “standard terms”. The process may
be simplified by focusing on the counterparty type so the risk manager
can gauge the bargaining power of both sides and determine which terms
are “must-haves” and which are “nice to have”.
If, for example,
the counterparty’s creditworthiness is dependant on the continued
support of a powerful parent company, would be prudent to consider how
best to reflect this in the documentation and incorporate possible exit
provisions in case of adverse change in control or ownership occur. If a
third party guarantee is provided, the guarantor can be recognised as a
Credit Support Provider in the ISDA Master Agreement Schedule. They
will then be automatically added to the Events of Default and
Termination Events.
Once the risk manager’s requirements have been
set out in the first draft Schedule they will be reviewed by the
counterparty’s negotiator, who will then respond with other changes to
the proposed terms. At this stage, the risk manager is likely to be
approached again for guidance on the proposed modifications and because
of this, it is useful for risk managers to be familiar with commonly
negotiated amendments. It may well be the case that many such changes
are provided for in an institution’s documentation or credit policy but
it of course makes sense for risk managers to understand what a given
counterproposal is intended to achieve and any disadvantages that
agreeing to it would entail.
The Structure of an ISDA Agreement and the Importance of Negotiation
The
ISDA Agreement is made up of two parts: the master terms (legal
provisions) and the schedule (elections and optional provisions, credit
and jurisdictional provisions). It is only the schedule that needs to be
negotiated. The ISDA can therefore be tailored to suit the counterparty
and the particular credit risks or jurisdictional requirements of the
counterparty by negotiating terms into the schedule.
Below is a list of credit provisions that may be negotiated:
Specified Entities
You
may have requested all affiliates but your counterparty may only want
to include certain named entities, or perhaps none at all.
Additional Termination Events
For example, if the parent ownership percentage drops below 51% this can be cause for termination.
Grace periods for certain Events of Default
Grace periods can be extended or shortened beyond the ISDA standard.
Cross Default vs. Cross Acceleration
Whether
defaults under other agreements between the parties can lead to a
default under your ISDA and the timing of when this Event of Default can
be triggered. This can be a major sticking point in some negotiations
if the parties want differing terms.
Threshold Amount
This
the trigger at or above which a Non-defaulting Party can terminate all
Transactions under the ISDA Master Agreement’s Cross Default clause. The
level of this is often negotiated and whether it should be measured as a
fixed monetary sum or a percentage of shareholders’ equity.
Without
an expert, however, negotiating ISDA Master Agreements can often be
lengthy, expensive and tedious. Negotiations can take months as parties
go back and forth over legal, business and credit terms. Although much
has been done to standardize the documentation process as far as
possible, there are still numerous issues that parties must negotiate
before executing the ISDA master agreement. Because of continuing legal
uncertainty and credit risk in the OTC market, ISDA master agreements
will probably always prove difficult to negotiate. Avoiding unnecessary
delays in completing these agreements, however, will pay dividends.
Negotiating ISDA master agreements faster can open up the possibility
for even more profitable trading to be done between the parties.
An
ISDA negotiator provides an essential service in the creation of an OTC
derivative trading relationship. A good negotiator can ensure a trade
agreement that suits a party’s goals and risk tolerance, and create a
firm foundation for profitable trading.
ISDA Negotiation as a Career
ISDA
negotiators are not required to be qualified lawyers, although legal
training is certainly an advantage. Generally, an ISDA negotiator’s
background includes specialised training and extensive knowledge of the
financial products involved in the trade. The negotiator needs to be
skilled at getting the stipulations of his party into the contract, and
at swiftly reaching an agreement with the other party so that key trades
can take place. There are incredible career opportunities for skilled
ISDA negotiators, from working in-house for asset management companies
or global banks like Goldman Sachs to negotiating for corporates like
Google and Coca Cola (who use ISDAs for currency hedging purposes). ISDA
negotiation is a highly specialised role and lucrative, it is well
worth considering for those with a financial or legal background.
