Recent market disruptions have resulted in reports of margin calls in amounts unseen since 2020. Those reports have turned the spotlight on derivatives, repos and other transactions. The significant role these products play in uncertain times is widely acknowledged.
What we have learned from recent times is that market disruptions happen quickly and increasingly in unpredictable ways.
Our global derivatives, finance, financial services, litigation and restructuring teams have practical hands-on experience in a wide range of market disruption events including the Asian, Russian and Euro-zone currency crises, the dot.com bust, Northern Rock, Bear Stearns, Lehman, Madoff, 1MDB, Covid, Greensill, Archegos and Ukraine. Based on these experiences, we are sharing our thoughts on key contractual items and regulatory points for the buy-side to consider in times of market and geopolitical distress and volatility.
1. Practical steps
- Obtain, check and review trading documents, ensuring they are complete.
- Consider if a key terms matrix or summary would be helpful.
- Events often unfold quickly with little time to consider items in detail. Consider creating a default playbook (e.g., a scenario-based flowchart) to look to when something unexpected happens or conducting “default drills” (see “Default provisions” below).
- Be familiar with the terms of your documents and the interplay of terms across multiple derivatives, repos, prime brokerage arrangements and other financing and investment arrangements.
- Closely monitor exposures and cross default risks.
- Extend analysis beyond default and termination event provisions to include items such as disruption events (e.g., those contained in the standard ISDA provisions for equity derivatives).
- Keep a dialogue open with counterparties and service providers.
2. Margin calls
- Margin provisions are often broadly drafted, in particular for non-regulatory margin.
- Consider whether there is visibility in terms of the amount of margin being demanded and the basis for that margin call. Consider how to react to an unforeseen margin call and whether there are dispute rights.
- Confirm the required timing for satisfaction of margin calls. Margin is typically required to be posted on a same day basis if the margin call is made by a certain time in the morning (and an event of default may be triggered subject to only a 1-2 business day grace period at most or an operational/administrative error carve-out).
- Plan for the value of posted margin (e.g., U.S. Treasuries) to decrease and for the trade to move out-of-the-money at the same time.
- Ensure sufficient liquidity to post margin when called (e.g., through drawing on redemption facilities or capital call lines). Ensure sufficient time to draw on such sources of liquidity.
- Failure to post margin on time may result in an event of default. That failure will entitle the non-defaulting party to terminate all transactions under the relevant agreement and potentially trigger cross default with respect to other agreements.
- Monitor whether there are any market events that allow a counterparty to terminate any margin lock-up or similar arrangements.
3. Eligible collateral
- Consider whether collateral haircuts remain appropriate, given the current price of U.S. Treasuries and other eligible collateral.
- Consider whether there should be interest on cash margin that has been posted and how this changes given the current interest rate environment.
4. Leverage/cost of financing
- Access to a dealer’s balance sheet for financing under a prime brokerage arrangement may be negatively impacted during periods of market turmoil. A dealer may have rights to end lending arrangements in a prime brokerage arrangement on short (or no) notice.
- Confirm the number of days of prior notice a prime broker or a counterparty is required to give before changing financing spreads.
5. Default provisions
- Review all events of default and termination events, including any “additional” events of default or termination events. Also consider whether any “automatic” early termination/repurchase date or similar concept applies.
- Be aware of the factual circumstances that could trigger a default, including a failure to pay or post margin, bankruptcy trigger or written/verbal admission of inability to pay.
- Review the consequences of potential events of default. A non-defaulting party may be entitled to suspend payment and delivery obligations to the other party, even when an event of default has yet to occur.
- Review cross default provisions where default (or potential default) under one agreement may result in (or permit) termination of another arrangement either with the same or a different counterparty. This contagion effect can have significant implications.
- For trading documents with the same counterparty, consider applying a working assumption that a default under one document will enable a default under all other documents with that counterparty.
6. Market disruption-related events
- Some agreements contain a force majeure termination event that could be activated by certain market disruptions. Trading documents designed for certain emerging markets-related products often contain such additional termination events.
- Some agreements also incorporate other terms relating to market disruption events, trading disruptions, imposition of sanctions or similar events that would allow the termination of transactions.
7. Financial metric-related termination triggers
- Review default or termination triggers such as:
- NAV floor or periodic (e.g., monthly) NAV decline triggers. Check relevant definitions: some NAV triggers are based on NAV that take into account redemptions.
- Minimum liquidity triggers. Check relevant definitions: minimum liquidity may be defined to exclude liquidity that is encumbered. Consider when these triggers are tested.
8. Termination and close-out process
- Engage relevant board and governance processes early.
- Be familiar with the process for terminating relevant trading documents – note the differences across master agreements and across dealers.
- Fees, expenses, default interest and interest on late margin will need to be paid.
- Review set-off rights of the non-defaulting party.
- Special resolution regimes implemented in multiple jurisdictions typically involve a temporary stay on the close-out of derivatives and other transactions. They also confer governmental authorities wide-ranging powers to resolve institutions that impact buy-side rights under in-scope transactions if the processes under those regimes are triggered.
- Check whether there are optional early termination rights which can be exercised even in the absence of a default or termination event.
9. Hedging risks
- Consider FX hedging, interest rate, inflation-linked or other index-linked hedging.
- Derivatives contracts may contain terms allowing a party to terminate where certain disruption events occur in respect of the transaction or its hedge position.
10. Regulatory considerations
- Consider applicable regulatory regimes and if there are disclosure or other requirements triggered by related events such as a NAV decline.
- Rule 18f-4 under the Investment Company Act of 1940 for registered funds and business development companies:
- Full compliance registered funds and BDCs are subject to a number of obligations, including VaR testing, weekly stress testing that reflects current market conditions, weekly backtesting of VaR calculations against actual daily gains and losses during the relevant period and periodic reviews. With current market volatility, stay vigilant to compliance with these requirements.
- Limited derivatives user funds and BDCs should monitor the 10% derivatives exposure threshold. If derivatives exposure remains constant as fund NAV declines, a fund risks exceeding the threshold.
- CPO exemptions under CFTC Regulations 4.5 and 4.13(a)(3):
- As a commodity pool’s NAV declines, if the aggregate initial margin and premiums and the aggregate net notional value of commodity interest trades remain constant, the pool risks exceeding the de minimis thresholds when it next trades a commodity interest.
- Monitor the thresholds to avoid being required to be registered to operate the pool.
11. Futures market considerations
- In the United States, be aware of cross-market circuit breakers that follow cash equity market halts and resetting interval price limits that may halt trading for periods of time.
- Clearing brokers and FCMs will often have broad rights to impose trading limits and position limits on short (or no) notice. This may result in the close-out of certain positions to maintain such limits.