Legal and Regulatory Framework

in the Global Derivatives Market

Derivatives and Risk Management in

Mexico, May 7, 2001

Diane Genova, Managing Director, JPMorgan

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A robust legal framework is essential for the development of an OTC derivatives market

Parties need assurance that transaction is enforceable as written– involves long-term payment obligations– contract may be relied on as a hedge

Parties need to be comfortable that they are in compliance with applicable regulatory guidance

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Legal Framework must deal with a number of legal and regulatory issues

Contract Enforceability

Sales Liability

Standard Documentation

Netting and Collateral

Illegality, Force Majeure, Impossibility

Regulatory Considerations

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Contract Enforceability OTC Derivatives are bilateral contracts

– they are not securities or futures– governed by general principles of contract law– general contract law must recognize that derivatives are like

any other contract– Recent amendments to US commodities laws clarify that

swaps are legally enforceable contracts and not off-exchange futures

Counterparty must have capacity and authority to enter into transactions– Some counterparties may need specific statutory or

regulatory authority to enter into derivatives– Evidence of authority of counterparty’s representative is

important, but possible to rely on doctrine of apparent authority

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Contract Enforceability (cont’d.)– Hazell vs. Hammersmith: local authorities in the UK were found to have

exceeded their authority by entering into swaps– Lehman vs. Minmetals (Chinese corporations): court found Lehman could not

rely on trader’s apparent authority if Lehman knew or suspected that agreements were illegal under Chinese law

Contract Formation– transactions usually executed by telephone– subsequently confirmed in writing– Statute of Frauds issues: in some jurisdictions, certain types of contracts must

be in writing– New York State solution: explicitly recognizes transactions executed by

telephone– Australian case (Powercor Australia): transactions were binding

notwithstanding the absence of signed confirmations

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Sales Liability Appropriateness

– regulators may require dealers to ensure that its customers have the capability of understanding the terms and risks of transactions and that sufficient information given to customers to understand risks

Existence of Duties– as a general rule, in order for fiduciary relationship to exist, one

party must explicitly agree to undertake a duty of care– parties need to be clear as to the nature of their relationship: is it a

fiduciary relationship or an arms length principal-to-principal relationship

– Duty of good faith and fair dealing: each party to a contract must refrain from making misrepresentations to the the other

– Superior Knowledge: duty to disclose may arise where party has superior knowledge of information, the information is not readily available to the other party and the first party knows that the other party is acting on basis of mistaken knowledge

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Standard Documentation

Standard Master Agreements are essential for contracts created in a trading environment– Industry standardization allows parties to focus on

the important economic and credit terms rather than on legal boilerplate

– Master Agreements create consistent contractual rights applicable across the whole book of derivatives business with a counterparty

– Permits a party to terminate and close-out exposures in a declining credit situation

– Allows all transactions to be netted for credit, financial reporting and collateral calculation purposes

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Standard Documentation (cont’d)

ISDA Master is the standard master agreement accepted globally

Utilizes a flexible architecture: a modular approach– Master Agreement printed form with representation,

events of default/termination events, early termination mechanics

– Schedule with specific terms tailored to the counterparty

– Definitions booklets incorporating standard definitions and market conventions tailored to particular products

– Credit Support Documents– Confirmations

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Modular approach in action

Master Agreementand Schedule

Interest RateSwap Confirmation

Currency OptionConfirmation

FX ForwardConfirmation

Commodity SwapConfirmation

Equity OptionConfirmation

EquityDefinitions

CommodityDefinitions

FX Definitions

2000 ISDADefinitions

Yield: Net credit exposure on transaction

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Netting

Types of Netting

– Payment netting

– Close-out netting

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Payment netting

Single transaction payment netting

Dealer Counterparty

$2mm

$3mm

Counterparty pays net $1mm

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Close out netting

Dealer CounterpartyITM $5mm

Netting on termination

Dealer CounterpartyITM $3mm

On termination, net claim is $2mm owed to Dealer

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Netting (cont’d)

Benefit of close out netting

– Exposure reduction--enables parties to do more business with each other

– Balance sheet impact

– Regulatory capital benefits

Enforceability of close out netting

– Recognition of close-out netting is key to legal derivatives infrastructure

– Netting legislation adopted in 22 countries

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Collateral --Two approaches

Security Interest Approach– Requires pledge and perfection– Ownership of asset remains with Counterparty– Relies on enforcement of security interest theory– Use of collateral by secured party is an issue– Most common structure in OTC derivatives markets

Title Transfer Approach – Outright transfer of assets– Relies on set-off theory– Most common structure in repo markets

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Legal issues of security interest approach

Issues revolve around “creation” and “perfection” of security interests

Procedural requirements– Filing or notice requirements– Possession requirements– Choice of law/multi-jurisdiction issues– Continuation requirements

Substitution of collateral

“After acquired property”

“In flight” securities

Rehypothecation or “use and abuse”

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Legal issues of title transfer

Recharacterization risk

“Fallback” grant of security interest– Used in repo documentation– Not used in UK Credit Support Annex

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Enforcement of remedies Bankruptcy/insolvency impediments to enforceability

– Stays– Preferences– Superpriorities or “priming”

Procedural requirements– Grace periods and notice requirements– Prior notice of liquidation– Liquidation mechanics - can the secured party buy

the collateral?– Requirement of “commercial reasonableness”

Significant variables– Type of debtor– Type of transaction– Type of insolvency proceeding

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Operational Risks– May not call for collateral– Risks in substitution– may mis-mark collateral, swaps, etc.

Legal Risks– Preferences– Stays– Priorities over secured creditors

Collateral reduces credit risk but creates legal and operational risk

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Illegality, Force Majeure, Impossibility

Off-exchange futures prohibited in some jurisdictions– Law in US recently amended to clarify that OTC

swaps are not illegal off exchange futures

Gaming/gambling laws--should provide exception for bona fide commercial transactions

Registration requirements for certain currency transactions--failure to register may result in lack of enforceability of transaction

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Illegality, Force Majeure, Impossibility (cont’d)

Force majeure and impossibility– range of actions may affect parties ability to

perform, e.g. civil unrest (Indonesia), imposition of exchange controls (Malaysia)

– need to have a roadmap as to what happens to the contracts

– ISDA force majeure/impossibility provisions

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Regulatory Considerations

Safety and soundness of regulated entities– Banco de Mexico 31 points– Federal Reserve derivatives guidelines