Conference on Cross-Jurisdictional Netting and Global Solutions Update on Netting in Asia May 12, 2011 London School of Economics and Political Science Peter M Werner Senior Director ISDA pwerner@isda.org 2011 International Swaps and Derivatives Association, Inc. ISDA is a registered trademark of the International Swaps and Derivatives Association, Inc. Financial law reform: purpose and key questions Creating a more stable and predictable legal environment for derivatives trading, close-out netting and related financial collateral arrangements Knowing where you stand : the practical value of increasing legal certainty An abstract goal, but with concrete results: increased market confidence, more liquidity, greater financial stability Key questions: Will my agreement be respected and enforced by a court or arbitration tribunal? Will foreign law governed contracts and foreign based counterparties be treated equally? Will it be enforced as written, both before and after my counterparty s insolvency? How can I protect against the risk of my counterparty s insolvency? Early termination and close-out netting under a master agreement Set-off rights Financial collateral arrangements and other forms of security Guarantees, letters of credit, insurance, credit derivatives 2 1
Selected int l legal instruments UNCITRAL Legislative Guide on Secured Transactions UNCITRAL Legislative Guide on Insolvency UN Convention on the Assignment of Receivables in International Trade UN Convention on Contracts for the International Sale of Goods Geneva Securities Convention Hague Securities Convention Hague Choice of Court Convention EU Directive on Financial Collateral Arrangements plus Amending Directive EU Directives on Winding-up of Banks and Insurance Undertakings EU Insolvency Regulation EU Regulation (Rome I) on the Law Applicable to Contractual Obligations EU Regulation (Brussels I) on the Recognition and Enforcement of Judgments in Civil and Commercial Matters Other law reform initiatives affecting international finance (e.g. proposals for EU and UNIDROIT instruments on netting) New York Convention (arbitration in derivatives disputes) 3 Importance and nature of close-out netting The single most important credit risk mitigation technique in the derivatives market Collateral is enforced against net balance and is calculated and taken on assumption netting works A three step process (requires a master agreement): 1. early termination 2. valuation of positions 3. determination of net balance Third step may be effected by contractual set-off, but not necessarily In other words, netting and set-off are related but distinct concepts Close-out netting under ISDA Master Agreement works on basis of conditionality, not set-off Other forms of netting: payment netting and netting by novation 4 2
Risk reduction through close-out netting Bank for International Settlements, November 2010 As of June 30, 2010, total notional amount of all outstanding OTC derivatives was $582.7 trillion Total gross market value of outstanding OTC derivatives was $24.7 trillion (4.2% of notional amount) After applying close-out netting, total credit exposure was $3.6 trillion (0.6% of notional amount), a reduction of 85.5% from gross market value 100 90 80 70 60 50 40 All banks, 1998-2010 Reduction of mark-to-market exposure Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 US banks, 1996-2010 U.S. Office of the Comptroller of the Currency, 3 rd Quarter 2010 As of September 30, 2010, close-out netting reduced counterparty credit exposure at U.S. banks by 92.1% 69% of the netted credit exposure was covered by collateral 100 90 80 70 60 Reduction of mark-to-market exposure 50 40 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 6 3
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Netting legislation - status Country Netting Legislation Lithuania Under Consideration Andorra Adopted Luxembourg Adopted Anguilla Adopted Malta Adopted Argentina Under Consideration Adopted Mauritius Australia Adopted Mexico Adopted Austria Adopted Adopted New Zealand Belgium Adopted Norway Adopted Brazil Adopted Pakistan Under Consideration British Virgin Islands Adopted Peru Adopted Canada Adopted Poland Adopted Chile Under Consideration Portugal Adopted Colombia Adopted Romania Adopted Czech Republic Adopted Russia Adopted Denmark Adopted Seychelles Under Consideration Finland Adopted Slovakia Adopted France Adopted Slovenia Adopted Germany Adopted South Africa Adopted Greece Adopted South Korea Adopted Hungary Adopted Spain Adopted Ireland Adopted Sweden Adopted Israel Adopted Switzerland Adopted *United Kingdom: ISDA provides legal opinions for the laws of England & Wales as well as Scotland. As of February 21, 2009, the UK Banking Act introduced a new insolvency law for all UK jurisdictions providing for a special resolution regime for banks and building societies. This includes specific netting legislation for transactions with such counterparties. With regard to most other counterparties the previous regime remains in place. In England, the enforceability of netting is widely accepted without the need for specific statutory recognition. Please refer to the ISDA netting opinions on English and Scots law respectively. For other jurisdictions without specific netting statutes, eg, Turkey, Netherlands, Hong Kong, please refer to the relevant ISDA netting opinions. Italy Adopted United Kingdom * Adopted (see note) Japan Adopted United States Adopted 9 ISDA netting legislation initiatives Across jurisdictions globally the scope and contents of netting legislation vary significantly, especially regarding: Scope of counterparties eligible Scope of transactions covered Hence current and recent initiatives in: Russia, Kazakhstan, Ukraine, Poland, Czech Republic, Slovakia, Slovenia, Hungary, Lithuania, Bulgaria, Romania, Croatia, Serbia, UK, Pakistan, UAE, Bahrain, Qatar, Colombia, Peru, Mauritius, Nigeria, South Africa, Seychelles, South Korea, China, India, Indonesia, Malaysia, USA, Canada, Australia, New Zealand Relation between collateral transactions and netting legislation 10 5
Certain issues (1) South Korea: Netting legislation in place ( 2005 Debtor Rehabilitation and Bankruptcy Law ), but inconsistencies remain (e.g. re. any type of physical or financial commodity transaction plus corporates, central bank, public law entity, pension funds). India: No netting legislation, but gradual liberalisation via RBI circulars, policy statements etc. Certain products not allowed (e.g., equity, credit). Transactions limited to hedging. Additional problems remain due to inconsistencies with existing primary legislation, esp. re. legislation beyond the remit of RBI, e.g. central bank, certain state and nationalised banks, other government companies and insurance companies. 11 Certain issues (2) China: Close-out netting is not recognised under Chinese law. The 2006 Enterprise Bankruptcy Act recognises insolvency set-off, but subject to several major restrictions. Also, cherrypicking still possible. This far, no further clarifications made by legislator, financial regulators or Supreme Court (e.g. by way of special opinion on interpretation of the 2006 act). Hong Kong: No netting legislation, but netting is recognised under general principles of law. Netting analysis generally regarded positive with regard to financial and corporate counterparties. Problems remain re. insurance companies, funds, central bank, public law entities. Taiwan: No specific legislation. Netting enforceable under general principles of law. Wide scope of transactions and counterparties covered. 12 6
Certain issues (3) Malaysia: No netting legislation. Mandatory set-off on insolvency. However, in certain circumstances close-out netting may not be enforceable, esp. during moratoria pursuant to 1998 Danaharta Act and 2005 Deposit Insurance Corporation Act. Otherwise, scope of counterparties (excl. insurance companies) and transactions fairly wide. Indonesia: No netting legislation. Enforceability based on general principles of law, but relatively large degree of uncertainty regarding the material content of legal rules. Otherwise, scope of counterparties and transactions fairly wide. Philippines: No netting legislation. General principles of law apply. However, application of general insolvency law rules is limited to certain counterparties only. 13 Certain issues (4) Japan: Enforceability based on both legislation and general principles. Problems remain re. some types of corporations, funds, public law entities as well as all types of commodity transactions and new products. Australia: Both legislation and general (1998 Payment Systems and Netting Act) principles. Fairly wide scope of counterparties and transactions covered, but proposals for moratorium pending. Middle East:..nothing (almost). Some rudimentary provisions here and there in Bahrain, UAE, Qatar, but not sufficient by any measure. Very good draft bill pending in Pakistan (on netting and collateral). Central Asia:.not much better (esp. Kazakhstan). 14 7
Conclusion: We need a global instrument on close-out netting now! 15 Conference on Cross-Jurisdictional Netting and Global Solutions Update on Netting in Asia May 12, 2011 London School of Economics and Political Science Dr Peter M Werner Senior Director ISDA pwerner@isda.org 2011 International Swaps and Derivatives Association, Inc. ISDA is a registered trademark of the International Swaps and Derivatives Association, Inc. 8