8.      INTERNATIONAL FINANCE MARKETS   

 

The rest of the course examines the nature and structure of the principal international finance markets and the main documentation used. This includes the international loan finance (Euroloan) market, international bond (Eurobond) market as well as the international project finance, securitisation and financial derivatives markets. The course will also consider the structure and operation of the principal international stock markets and exchanges as well as the operation of some of the main Alternative Investment Markets including hedge funds, private equity and sovereign wealth funds.

 

A large number of different types of financial transactions exist although a number of common elements arise in each case. These can be considered in terms of finance structure (nature of funding), documentation, parties (and rights and duties), party liability (and limitation and exclusion of liability) and remedy. The three most commonly used sources of funding are loans (personal debt obligations between a creditor, or group of creditors, and borrower), debt securities (transferrable debt obligations issued in the form of a paper or electronic form) and financial derivatives (payment obligations tied to other reference assets or prices).

 

A correspondingly large number of different types of contracts and documents may be used. Most of these contain certain common terms governing financial provisions (amount or advance, draw down, term or duration, interest and repayment), obligations or conditions (principally with conditions precedent, representations and covenants) and remedies (events of default, termination and recovery). Almost all finance contracts are based on these core provisions. Standard documentation is often prepared by industry trade associations such as the Loan Market Association (LMA), International Capital Markets Association (ICMA) and International Swaps and Derivatives Association (ISDA) which is adjusted as necessary to reflect a particular deal.

 

The most complex transactions with the most documents (or ‘deliverables’) to be prepared are usually project finance (due to the tied construction element), acquisition finance (with the takeover or merger of companies) and structured finance (incorporating large numbers of underlying securitised and re-securitised transactions).

 

Finance contracts may either be conducted on a formal stock market or exchange or off-exchange which is commonly referred to as over-the-counter (OTC). International lending and domestic loan, mortgage or other credit transactions are generally OTC due to the personal nature of the debt obligations created. Capital market financing, principally through longer term bonds, medium floating rate notes (MTNs) and shorter duration commercial paper (less than one year) instruments can either be OTC or on-exchange. Many bonds and notes are listed on stock markets to increase the range of potential investors, including in particular institutional investors, such as pension funds, unit trusts and other professional asset managers, due to restrictions on the types of assets they may otherwise hold. Even where securities and derivatives transactions are carried out OTC, there has been an increasing trend to use central trade repositories and central counter parties (CCPs) for transactional reporting and clearing purposes. CCPs became of particular importance following the global financial crisis during 2007-2009 with calls for OTC derivatives contracts to be centrally cleared.

 

(1)    Euro Loans

 

The international loan market emerged in London after the Second World War with the influx of US dollars. This became known as the ‘Eurodollar’ market as the currency of the debt was separated from the local currency of issuance which was sterling in London. There had been international financial markets during the 19th century in major cities such as London, Paris and Berlin although the debt was always denominated in local currencies. The Eurodollar markets expanded quickly following the restoration of international currency convertibility in 1958 and the need for governments and large international companies to borrow on the international markets.

 

The following more specific sets of issues may be considered with regard to Euroloans although all of this is considered in further detail during the course:

 

(i)   Loan Structures

 

A loan is created through a borrower entering into a personal debt obligation with a specific bank or group of banks in larger transactions (referred to as a syndicate). This may either be for a fixed duration (a term loan) or revolving basis (a corporate credit line or individual overdraft). The main financial terms are concerned with the amount of the advance (the principal), draw down (initial single amount or separate tranches), term or duration (fixed or adustable), interest (fixed or floating) and repayment (again single amount or in tranches or through amortisation over a period). Loan contracts generally used a single document based on a term loan agreement (although this may be relatively lengthy) with supporting security instruments or guarantees with any transfer instruments usually being incorporated as an appendix to the loan agreement. .

 

(ii)  Loan Facilities

 

A simple term loan arrangement can be used as the basis for a number of different types of lending facilities. These include large international single bank or syndicated lending (Euro loans), Multi-Currency Facilities (with draw down in different foreign currencies), revolving credit facilities (RCFs), credit lines (up to agreed limits), property finance (secured on commercial or residential property), project finance (secured on project assets and repaid from project income), asset finance (with title retention or security over other large assets such as aircraft or ships), acquisition finance (to facilitate a corporate acquisition, merger or restructuring) and subordinated finance (with the borrowing being postponed to other priority creditors).

 

(iii) Issue Procedure

 

The issuance procedure for a term loan is relatively simple. Where a group of banks is involved, an arranging bank is appointed to solicit interest and negotiate the loan documentation. The borrower issues a Mandate Letter in appointing the arranging bank with the core financial provisions being set out in a Term Sheet. A longer Information Memorandum is prepared which explains the borrower’s business and management and financial conditions and the purpose of the advance. The draft loan agreement is prepared and circulated for comment. Conditions precedent documents are collected and the loan agreement signed after which the borrower will be able to draw down the funds. Separate commitment, management and agency fees are charged.

 

 

 

(iv) Loan Syndication

 

Where large sums are to be advanced, banks will form a syndicate to divide and allocate the risk. The principal risk that arises is with regard to credit risk which is the risk of counter party default with the borrower not paying interest during term nor repayment of principal on maturity. The loan agreement includes provisions governing the relations between the banks who will generally act on a principal basis with only limited functions being delegated to the agent bank who managers the distribution and collection of payments after the loan amounts have been advanced. The general principles governing the relations between the syndicate members may be summarised in terms of severality (independence), proportionality (shared lending amounts), equality (shared receipts), democracy (limited majority rights) and limited delegated agency function (with the agent bank’s functions generally consisting of payment, receipt, banking, notification and limited default duties).

 

(v)  Documentation

 

A term loan is based on the loan agreement. While a single document is involved, this can be substantial as it has to set out the conditions under which the amounts are to be advanced and protect the interests of all of the lending banks until full repayment. Term loans include, as noted, all of the key financial terms (amount, draw down, duration, interest and repayment), conditions (obligations) and events of default (remedies).

 

The conditions generally consist of the Conditions Precedent, Representations and Warranties and Covenants. Conditions precedent are generally corporate and constitutional in nature and involve providing copies of all relevant company documentation, board resolutions, country confirmations, security and legal opinions. Representations and Warranties (‘Reps and Ws’) specify the conditions under which the advance is to be made and generally consist of a series of legal and financial or commercial confirmations with regard to the status of the borrower (and any connected companies) and its legal capacity to act and the validity of the transactions entered into. The Covenants (‘Covs’) are continuing obligations to be complied with following draw down until repayment which are generally concerned with providing information to the banks and protecting the financial condition of the borrower or other group companies.

 

A series of events of default will be specified, including non-repayment, breach of financial or non-financial covenants, misrepresentation, cross-default on other debts, insolvency, commencement of creditor processes, loss of control, illegality, repudiation or other material adverse change (referred to as the ‘MAC’ clause). Contractual default remedies principally consist of suspension, cancellation of subsequent draw downs, demand for repayment, acceleration and termination. Lenders may be able to use other remedies including netting and set-off, appropriation of amounts across accounts, combination of amounts in different accounts and enforcement of security and guarantees. Where the borrower is in breach but able to continue to make some payments, some form of rescheduling or restructuring of the debt may be agreed without prejudice to any other rights of the lending banks.

 

(2)    Euro Bonds

 

A parallel Eurobond market quickly emerged in which the debt was issued in a transferable security based form rather than simply exist as a bilateral debt obligation between the banks and borrower. The has substantial advantages in terms of tradability, increased liquidity and lower borrowing spreads for higher credit standing counterparties. The international loan market had generally fallen by around a quarter by the beginning of the 1980s with the bond market expanding by an equivalent amount. Both the loan and bond markets are supported by an underlying Eurodollar deposit, or inter-bank, market within which funds were transferred between the banks on a wholesale basis.

 

 The number of currencies involved in the Eurobond market has expanded substantially from an early stage to include sterling, Japanese yen, previously deutschemarks and French and Swiss francs and later Euros. The history of the Eurobond market has also been one of the production of shorter duration instruments that can be rolled over on a continuous basis. Early more traditional bonds may have been from between 20-50 years, which were followed by shorter Medium Term Notes (MTNs) of between 5 and 15 years and then shorter Euronotes (of less than one year). While these have to be re-issued, or rolled over, more regularly, this allows the borrower to benefit from flexibility in terms of the total amount of debt outstanding at any one point. Shorter commercial paper can also be used for borrowings of up to one year with the difference between commercial paper and Euro notes being that the banks are not committed to purchase the paper from the issuer which has to rely on market uptake.

 

The following more specific issues may be considered with regard to Eurobonds although all of this is considered in further detail during the course:

 

 

(i)   Bond Structures

 

Debt or bond finance consists of the issuance of transferrable debt securities by governments or companies which provide for both the payment of a dividend amount (biannually or annually) and repayment of the value of the bond on maturity or redemption. The principal financial terms are again then amount, dividend and repayment or redemption. As the debt is issued in a tradable form, the issuer government or country decides such issues as amount, currency and duration initially with different classes of bonds being issued as necessary over time. Each class of bonds may lack the same contractual flexibility as under a loan agreement although this can be replicated by issuing different types of bonds, in different amounts and on different terms at different times. The general advantage of bonds is that their transferability can create additional market liquidity although the amount the issuer will have to pay through dividend will be determined by market conditions. Higher standing governments or higher quality companies can obtain funds more cheaply on the bond markets with less quality issuers having to either pay higher dividends or rely on the banking markets.

 

(ii)  Bond Facilities

 

Debt or bond instruments may be issued in a number of forms. This includes long, fixed duration and interest rate bonds, or Eurobonds of between 15/20 and 40/50 years. Eurobonds are transferrable debt securities denominated in a currency other than that of the issuer’s home country. While bonds generally provide for a fixed dividend, Floating Rate Notes (FRNs) can be used to pay variable interest rates which are usually calculated with regard to the London Interbank Offered Rate (LIBOR) managed by the British Bankers Association (BBA). Variations include floor, drop lock, double drop lock, cap, collar and inverse FRNs. Perpetual notes may be issued without a fixed redemption date. Bonds and notes can be issued with warrants attached to allow the holder to acquire additional bonds or notes on predetermined terms. Equity linked and convertible bonds may also be issued.

 

Euro medium term notes (MTNs) are unsecured debt instruments for between nine months and 15 years. Euro commercial paper (ECP) or sterling commercial paper (SCP) consists of unlisted short dated debt for one year or less. Multi-Option Funding Facilities (MOFFs) combine a number of facilities including possibly long bonds or more likely MTNs with ECP, or SCP, and short term advances, swing line facilities (overdrafts) and possibly bankers’ acceptances (accepted bills of exchange) or certificates of deposit (securities evidencing an underlying deposit of funds with a bank).

 

(iii) Parties and Documentation

 

Debt instruments are issued by the issuer who may be a government or corporate borrower with the bonds, notes or paper being purchased by end investors. A Lead or Managing Bank is appointed to manage the issue with the securities being sold by a Selling Group or through an Underwriting syndicate which guarantees purchase and on-sale. A Trustee will be appointed in large issues to represent the interests of bondholders. A Paying Agent is appointed to manage the payment of dividends and redemptions during the duration of the issuance. A separate Fiscal Agent is appointed where there is no trustee with the fiscal agent holding payments due to investors on trust on their behalf.

 

(iv) Issuance Procedure and Listing

 

The Lead Manager will receive the Mandate Letter from the issuer and prepare draft documentation including a Prospectus to solicit investor interest. The Prospectus is the equivalent of the Information Memorandum under a lending transaction and can also act as the Listing Particulars where the bonds are to be offered to the general public or traded on a specific stock market of exchange.

 

In terms of procedure, a public announcement of the proposed issuance was traditionally made on the launch date with an invitation telex, fax or email being sent out to selling group members and underwriters. A Subscription Agreement is generally signed around 14 days after the launch date with a final closing seven days later. Bonds may be dealt with on a ‘grey market’ between the launch and listing subject to local market stabilisation rules which would otherwise prohibit such dealings. Eurobonds have generally been issued in the form of a single Global Note on the closing which is held by one of two major custodians, Euroclear in Brussels (formerly Cedel) and Clearstream in Luxembourg. The Global Note is replaced by definitive notes following their production which are again held with the custodian and transfers effected through account entries. Most modern issues are now managed on an electronic, or dematerialised form, with no single global or definitive notes being used.

 

Where bonds are to be sold to the general public, they have to comply with local listing requirements. These are now set out in Europe under the EU Transparency Directive and Prospectus Directive with the Financial Services Authority (FSA) acting as the Listing Authority in the UK. The bonds and prospectus must comply with relevant requirements. They will also have to comply with separate rules for admission to trading on a particular stock market or exchange. They will then be admitted both to listing and to trading on the specific market. Listing is desirable to allow the bonds to be sold to a wider group of potential investors including principally institutional entities, unit trusts and other professional investment managers.

 

(v)  Liability

 

Financial institutions and, in particular, the Arranging Bank under a syndicated loan or Lead or Managing Bank under a Eurobond issuance, have to take care not to mislead other members of the lending syndicate or potential investors. This may become relevant where the borrower or issuing company becomes unable to pay and defaults with other syndicate banks or external investors looking to other financial institutions for recovery. Various heads of potential liability may arise including under Common Law misrepresentation, statutory misrepresentation or deceit, agency liability, breach of fiduciary duty and potentially separate regulatory liability. Finance documentation attempts to reduce the risk of loss partly by incorporating a range of ‘limited duty’ clauses (which define contractual and other duties of care narrowly) or ‘limited liability’ clauses (which either exclude liability or reduce loss through set-off, estoppel, indemnity or possibly contribution or contributory negligence). Exclusion clauses are nevertheless subject to statutory control under the Unfair Contract Terms Act 1977 which imposes a general reasonableness test with consumer contracts being dealt with under the Unfair Terms and Consumer Contracts Regulations 1999 (SI 1999/2083). This is an important part of documentation drafting and negotiation especially in light of a number of recent high profile cases involving large value actions after borrowers or issuing companies defaulted.

 

 

 

 

(3)    Project Finance

 

Major construction projects are generally managed through some form of project finance with the funding being repaid principally from the income stream generated by the project on a non-recourse, or more commonly, limited recourse basis. This can be achieved through the establishment of a special purpose company or vehicle (SPV) to manage the project with the funding being made available to the SPV either through an international term loan or bond, note or paper programme. As repayment is dependent on the viability of the project, the credit providers will take security over all the assets involved, including income streams, bank accounts and insurance policies, with other additional credit support also commonly being provided such as through guarantees, performance bonds or insurance. The principal advantages are the debt separation and sponsor insulation that arise from the limited recourse nature of the financing. A number of additional risks nevertheless arise that have to be managed through considerably more complex documentation which has to be negotiated with all of the larger number of parties involved.

 

The following more specific issues may be considered with regard to project finance:

 

(i)   Structure

 

Project finance involves the provision of funding for a discrete, single purpose investment on a non, or limited recourse, basis with repayment principally being serviced through the income generated under the project. The five key elements of the transaction then involve the SPV and project concession, limited recourse financing, extended project cycle, full risk assessment and allocation and confirmation of contractual integrity and validity. The SPV obtains the initial project concession and manages the project, receiving all income and making appropriate repayments to the creditors. The transaction is limited recourse with repayment being made through the income streams generated and without separate recovery against the sponsors or project contractors. As repayment is made from the income streams produced, there is an extended project cycle which continues either until repayment has been made in full of all funds advanced or the project is no longer viable. A large number of separate risks can arise, including with regard to construction, operational, financial, legal and regulatory and political and other matters. The objective of the documentation used is to ensure that all of these risks are fully assessed and allocated between the parties involves. Contractual integrity is concerned with confirming that the rights and duties of all of the parties under all of the documentation are consistent and work effectively together.

 

(ii)  Advantage and Disadvantage

 

A number of project finance advantages can be identified in using this form of limited recourse financing. These principally include funding and debt separation, sponsor insulation, off-balance sheet financing, project separation and independent credit assessment, improved credit standing and ratings, higher project security, other taxation, legal and regulatory advantages, covenant compliance, available investment and expertise, maximum leverage, political risk mitigation and successful project completion. A number of limitations and disadvantages may also arise which have to be managed, including with regard to project complexity, documentation complexity, possible negotiation delay and higher cost, project length and continuing service costs, commitment, insurance and credit support costs and higher overall costs and lending commitment. All of these limitations and potential costs can nevertheless be reflected through the contract pricing, which is dependent on the initial credit assessment, and though the final documentation entered into. All relevant risks can be fully identified and managed through well drafted legal documentation.

 

(iii) Parties

 

A large number of contracts have to be entered into with the construction of major infrastructure projects or with the manufacturing and production of specific large value assets, such as aeroplanes or ships. This necessarily involves a number of further parties are involved in addition to the core borrower, in the form of the project vehicle or SPV, and lenders. Other parties include the sponsors, shareholders and private equity contributors, the host government providing the relevant concession, the project banks, project contractor, project manager and operator, project suppliers and purchasers (off-takers), project advisors and other experts, project insurers, possible involvement by multilateral or development banks, export credit agencies and other project parties. The interests, rights and duties of all of these parties have  to be properly reflected in the documentation entered into.

 

 

 

 

(iv) Documentation

 

A large number of documents are required in light of the complexity of the underlying construction or production processes and large number of parties involved. Five principal sets of documentation (deliverables) have to be prepared with regard to initial sponsor documentation (project or pre-development agreements, joint venture agreement, shareholders’ agreement, sponsor/shareholder support agreement and credit support documents), original project company documentation (memorandum and articles of association, declaration of trust and separate administration agreement where appropriate), project documentation (concession, feasibility study and information memorandum, construction contract, equipment supply contracts, operating and maintenance contracts, supply and purchasing agreements and advisory and expert agreements), financial documentation (project loan agreement, security issue or lease finance agreement, interest rate and currency derivatives, direct agreements and collateral warranties and inter-creditor agreement) and security, insurance and credit support (including security agreement, credit support guarantees, insurances, third party rights and modifications and inter-creditor agreements).

 

(v)  Negotiation

 

A series of specific additional legal or negotiation issues arise in project finance transactions. These include managing all of the relevant project risks, recourse, viability and financial ratios, risk management and project accounts, risk allocation and distribution, guarantees, credit support and insurance and risk cover. All of this will be examined in further detail in the relevant part of the course.

 

(4)    Securitisation

 

The international securitisation markets provide a link between the banking or credit markets and capital markets. Pools of credit instruments, such as trade receivables, commercial or residential mortgages and corporate, car or student loans, can be sold to a special purpose vehicle (SPV) which pays for the pool by issuing new bonds, notes or paper. This takes the credit asset pool off the balance sheet of the originating bank and transfers it to the SPV which allows the bank to receive additional funds for further lending purposes. The bank will nevertheless often continue to manage the assets with this function having been re-delegated by the SPV back to the bank in return for a service fee. Additional credit support may also be provided through over-collateralisation (transferring excess assets as security), credit lines or insurance. Synthetic securitisation structures may also be set up using financial derivatives (and principally credit default swaps or CDSs) to create the same economic effects as an assignment without a legal transfer of the assets from the bank to the SPV.

 

The following more specific issues may be considered with regard to securitisation:

 

(i)   Structure

 

Securitisation is based on asset transfer, SPV funding, servicing and profit extraction, collateral provision and credit enhancement. It operates through the transfer of the asset pool from the ‘originator’ bank to the SPV principally through equitable assignment (under s136 of the Law of Property Act 1926). The assets are effectively sold to the SPV with the SPV paying for them by issuing new bonds, notes or short term commercial paper. The originator acts as servicing agent to manage the underlying debts in return for a fee with other forms of profit extraction being used. The SPV grants security over the whole of the asset pool either through fixed or floating charges with collateral being taken over all of the other contracts, insurance policies and moneys held in bank accounts or investments. Additional credit enhancement may also be provided, such as through over-collateralisation, guarantees, originator support, subordinated debt, additional credit enhancement may be provided to ensure that the securities issued by the SPV are AAA.

 

(ii)  Advantage

 

The advantages of securitisation can be summarised in terms of new capital asset, high grade debt, income stream, improved payment profile and portfolio diversification, asset matching, off-balance sheet treatment, tax relief, capital allowance, credit protection, bankruptcy remoteness and last resort funding.

 

(iii) Parties

 

The parties to a securitisation may include the SPV, originator, servicer or servicing agent (to manage the collection of interest payments and repayments), investors, security trustee, financial guarantors, liquidity provider, funding manager, investment management, swap counter party and guarantor, arranger (investment bank responsible for setting up the structure) and credit rating agencies.

 

 

 

(iv) Documentation

 

Various sets of documents have to be prepared in connection with the establishment of the SPV, transfer agreements, funding agreements, enhancement and a security trust deed. SPV enhancements include a Memorandum and Articles of Association, Declaration of Trust in respect of the SPV share, administration agreement, board resolutions and company registration forms. Funding agreements may include, depending upon the financing structure adopted, a loan or syndicated agreement, prospectus or offering circular, subscription agreement, agency agreement, trustee agreement and derivatives master agreement using common ISDA formats. Enhancement may also require subordinated loan agreement, financial guarantees, letters of credit, surety bonds, interest rate caps or swaps, tranching arrangements, account pool policy and possible reserve fund policy.

 

(v)  Negotiation

 

A number of other negotiation issues arise in practice. These may relate to the nature of the assignment and transfer of the assets to ensure that there is a ‘true sale’ and no court ‘re-characterisation’ (or re-classification) of the transaction. The securitisation cannot work economically if there has been no effective legal transfer of assets. Courts have re-characterised transactions where they have amounted to a deceit or sham or the rights and obligations created do not reflect the stated nature and purpose of the contract (re George Inglefield Ltd [1993] Ch1 CA; and Welsh Development Agency v Export Finance Co Ltd [1992] BCC 270). The SPV must also be bankruptcy remote from the originator. Cash flows on the underlying receivables or other assets may have to be matched with the SPV funding commitment. The originator will look for adequate profit extraction, such as through servicing fees, subordinated debt, dividends and a receivables trust or sale. Other issues include ensuring sufficient enhancement and collateral (above) to secure an adequate ratings (above) as well as realising the most effective accountancy, taxation and capital adequacy treatment. Any securities offering by the SPV have to comply with relevant UK, EU and US laws and regulations.

 

 

 

(5)    Financial Derivatives

 

While forward contracts have always been available throughout history, which provide for contract settlement at a subsequent agreed date, modern financial derivatives instruments principally arose during the early 1970s due to the currency and interest rate instability created after the collapse of the Bretton Woods system of managed currency arrangements. This led to the creation of early currency and interest rate swaps (exchange contracts) with later exchange traded futures and traded and OTC options.

 

A wide range of products have since been developed tied to a whole range of financial assets, indices and commodities, including most recently energy and the weather. These can either be used for risk cover (or hedging) purposes or for investment (or speculation). Derivatives may be dealt with on a formal exchange or OTC. Early forms of standard documentation were produced by the International Swaps and Derivatives Association (formerly the International Swaps Dealers Association) which has since produced various forms of master agreements (with long and short form confirmations), common definitions, bridge documents and protocols (for multilateral amendment).

 

Specific regulatory concerns arise with regard to the lack of transparency in the OTC market, high levels of concentration and the potential ability for derivatives speculation to affect the prices of underlying assets or commodities. Much of this has been dealt with following the global financial crisis by requiring increased disclosure and transparency especially through trade repositories, increased capital and liquidity cover and with clearing and settlement being conducted through formal central counterparties (CCPs).

 

The following more specific issues may be considered with regard to financial derivatives:

 

(i)   Market Structure

 

The most commonly used financial derivatives are futures, options and swaps. A future provides for the purchase (or sale) of an item at a future agreed time and price. An option provides for the right, or election, to purchase (or sell) the item at a future agreed time and price. While they involve a forward element, they are distinct from other private forward contracts which are non-transferable, non-traded, have no exchange cash or collateral margin calls, do not used customised documentation and have no central counter parties (CCPs) or trade repositories. A swap provides for the exchange of financial obligations most commonly including currencies or interest rates (fixed for floating or floating for fixed).

 

The most recent development within the derivatives market has been the emergence of credit derivatives which provide different forms of credit risk or counter party default cover. These principally consist of credit default swaps (CDSs) although other forms of total return swaps (TRSs) or credit spread swaps (CSSs) may be used. Credit derivatives are often incorporated into larger ad hoc or standard financial arrangements which create structured products, such as credit linked notes (CLNs). A collateralised debt obligation (CDO) is not a financial derivative as such but a re-securitisation of the income streams from a number of underlying securitised products (above).

 

(ii)  Advantages and Disadvantages

 

Financial derivatives provide end-users with additional risk coverage or certainty, lower borrowing costs, higher returns, improved debt management and additional choice and election which can improve production, growth or other innovation. Financial intermediaries benefit through improved risk cover and management, additional liquidity, higher earnings, improved portfolio management and enhanced client service and increased customer loyalty with derivatives also allowing further financial innovation such as through the construction of structured products (above).

 

Certain market disadvantages also arise with the speed of risk transfer, higher concentration levels, product complexity, possible underlying asset price distortion and a lack of market transparency, especially in the OTC market. Other issues may arise with regard to reduced regulation of ‘outliers’ (higher risk institutions), leverage, liquidity collapses, cross-border exposures, alteration on settlement risk as well as legal risk and increased inter and intra-sector loss transfer, contagion and collapse. A number of initiatives have since been taken to attempt to increase disclosure and transparency and to strengthen transaction clearing and settlement. 

 

(iii) ISDA and Standard Documentation

 

Exchange traded derivatives use pre-prepared standard contracts on each of the markets involved, such as on the London International Financial and Futures Exchange (LIFFE). OTC contracts use standard documentation prepared by ISDA, such as its most commonly used 2002 Master Agreement. Earlier standard documents included those prepared by the British Bankers Association  with its BBA Interest Rate Swap document (BBAIRS). All of these contain standard terms and conditions, including definitions, conditions precedent, representations and warranties, covenants, events of default and termination procedures. ISDA parties enter into the standard master agreements to govern their relations with confirmations being entered into in connection with each contract. Long confirmations can be used with full terms although short form confirmations are also available which incorporate standard product Definitions. Any adjustments or elective clauses under the master documentation are dealt with in Schedules. The use of such standard documentation across the market creates the form of proxy or surrogate regulation in the absence of formal statutory regulation.

 

(iv) Financial Crisis

 

Financial derivatives were a factor in the global financial crisis during 2008-2009 although they were not the direct or immediate principal causes. Credit default swaps (CDSs) were used in synthetic CDOs (re-securitisations without assignment of the underlying securities) although later synthetic CDO collapses were attributable to the design of the specific products constructed rather than the use of CDSs within these larger structures as such. AIG had to be supported by the US authorities due to the high levels of concentration that it amassed in the CDS market rather than due to defects within the CDS contracts themselves. There were other operational and settlement delays, a general lack of transparency especially with regard to loss allocation, all of which aggravated a larger collapse in confidence.

 

Financial derivatives were one factor in a larger chain of complex events although only one factor. The principal causes of the crisis can be more accurately summarised in terms of poor credit assessment in the US subprime market, aggressive re-securitisation and product complexity, mispricing of debt by credit rating agencies, retention of ‘super senior’ CDO tranches (uncovered non-securitised amounts) by firms and a lack of effective market supervision and support as the crisis unfolded.

 

 

 

(v)  Financial Regulation

 

While derivatives contracts specifically are not subject to direct regulation but governed by exchange or trade standard documentation, almost all intermediaries will be authorised persons and subject to the laws and regulation of their home territory. A number of measures have also been strengthened following the recent financial crises. Firms have been subject to improved risk management, higher capital and liquidity levels, enhanced margin cover requirements, improved governance and increased supervisory disclosure. Customers and end-users can be protected through higher disclosure and warning requirements, cancellation (‘cooling-off’) periods, segregation of cash and asset obligations, deposit protection and outright prohibitions in appropriate cases. Derivatives markets more generally have been strengthened through the development of increased reporting and transparency especially through trade repositories, central clearing through CCPs, firm RRPs and official SRR and substantially improved domestic and cross-border crisis management procedures.

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