Recent market shocks (from the 2022 mini budget which triggered a pension fund crisis to more recent developments with respect to Credit Suisse, Silicon Valley Bank and Signature Bank) will prompt market participants to review their hedging arrangements. There are several matters to take into account when market participants start to experience distress, and in particular, their hedging counterparties will likely start to consider the position under outstanding OTC derivatives transactions, and the terms of their ISDA Master Agreement (“ISDA”) (as well as any related collateral/ financial arrangements).

Whilst bank/market maker failure is uncommon, it is certainly not impossible. Post-Lehman, with the implementation of EMIR and Dodd-Frank (and, with respect to OTC derivatives transactions, introduction of clearing requirements and regulatory margin requirements for non-cleared trades), counterparty exposures are generally more contained for those trading relationships where there are clearing or margining requirements, and such failures are generally not perceived to be as catastrophic as they may have been seen in the past.

Having said that, it is not surprising to see some ripple effects caused by bank distress – for example, credit default swaps (“CDS”) pricing has rocketed in recent weeks, particularly those referencing Credit Suisse. In other words, it is now very expensive to hedge or insure against the risk of Credit Suisse default. Given that protection via CDS may no longer be economically viable, parties will likely be looking at other risk-management tools, and a good starting place for many would be to ensure that there are robust and effective contractual protections in master netting agreements and margin agreements.

For further information on some of the key initial considerations for derivatives participants when dealing with general counterparty distress, Leona McManus, Robert Lendino and Sabina Khan have co-authored an article: What is in your Derivatives?

By way of brief summary, the following key points could potentially come into play and are worth reviewing:

Events of default/ Termination Events/ Automatic Early Termination

  • Parties will want to review the terms of their ISDAs and related collateral/ financial arrangements to ensure that their terms are in line with the parties’ expectations. This is particularly true for participants operating under the 1992 ISDA Master Agreement, who have not fully, or only partly, updated their agreements to bring them in line with the 2002 ISDA Master Agreement.
  • Parties should be conscious that close-out mechanisms (and which parties sit in the driving seat) differ between default events (regarded as fault-based events by the market) and termination events (regarded as non-fault based events by the market).
  • Parties who have elected for Automatic Early Terminations will need to be vigilant and act quickly in the event that there are signals that their counterparty may be heading towards a bankruptcy event.

Other/bespoke provisions – A holistic review of the full terms of the ISDA may also be undertaken, e.g. what counterparty group members are tied in as specified entities, are there specific additional termination events captured, has specified debt definitions been appropriately expanded (if not, are there other trading agreements, e.g. GMRAs that can be relied on), are materiality thresholds adequate/trackable, is there a clear set-off mechanism, are there dispute rights with respect to the calculation agent etc. These are the type of provisions that could come into play when dealing with counterparty distress. It is important to have a holistic view of the entire credit relationship with counterparties.

Market/legal developments – Post-Lehman, there has been case law on certain points such as s.2(a)(iii) of the ISDA both in England and New York, which will also need to be factored in.