Fund managers are up in arms over the amendments that the International Swaps and Derivatives Association is planning to make to its master ...

Fund managers are up in arms over the amendments that the International Swaps and Derivatives Association is planning to make to its master agreements. It is generally agreed that ISDA’s master agreements, the prearranged contracts that counterparties in hedge funds pull off the shelf when doing deals, have needed updating for some time. The amendments were originally conceived in the aftermath of the collapse of Long-Term Capital Management in 1998. Critics of ISDA’s plans, who include the US Managed Funds' Association, believe that the amendments are in the interests of swaps dealers rather than end users such as HNWs and their private banks. Charges of muddled thinking have also been levelled at the association’s strategic document task force. The central complaint here is that the new annexes will obfuscate the rules by which HNWs and others can participate in transactions and will make the process ‘uncertain’.

ISDA’s numbering and renumbering of the annexes exemplifies the confusion caused by the reform process. An ISDA official told Complinet that there are now 15 annexes, three of which cover the redenomination or transition of euroland to the euro. Three have ignited especial controversy.

Annex 2, on failure to pay, which pertains to s5a(I) of the master agreement. This applies to closeout procedures and how counterparties should proceed in the event of bankruptcy. Any kind of termination agreement is relevant here, including a merger.
Annex 7, the definition of a specified transaction, which pertains to s14. This covers payment and delivery obligations and has been recently modified, according to an ISDA spokesman.
Annex 8, payments on early termination, which pertains to s12a. This covers the ways in which counterparties have to undertake replacement valuations for terminated transactions. Under the current plans, which have not yet been fully formalised, there are now three ways to do this: using market quotations; using loss; and a hybrid of the two.

An ISDA spokesman told Complinet that these documents will be finalised by the end of September. Institutions will be able to pull the text off the ISDA web site and send in ‘adherence letters’. Once they have done this ISDA will act as their agent, keeping track of the institutions that have signed up for each part of the agreement. It charges a $2,000 fee for this service. At the end of April 2002, the web site will ‘freeze’ and no new names will be admitted. After that, counterparties will have to indulge in the more expensive process of bilateral bargaining over which part of the agreement to use. All annexes are amendments to the 1992 master agreement. Three of them, none of which is considered controversial, relate to the redenomination of currencies in euroland that is scheduled for the end of this year.

Pat McCarty, general counsel of the Managed Funds' Association, suspects that ISDA is ignoring the submissions of people in the market who are not its members, even while it is claiming to consult them. The bodies in question are the MFA, the Association for Financial Professionals, the End Users of Derivatives Council and the Committee on Investment of Employee Benefit Assets. He also believes that ISDA’s strategic document task force is not fulfilling its duty to plan systematically. Emily Jelich, ISDA’s general counsel who was not available for comment, has told the US press that members of the task force met recently but had to defer submitted changes to the amendments because they could not agree. McCarty was in no doubt why.

"It stemmed from a conference call which the task force had in July. They had it on a Tuesday and continued till a Friday because they hadn’t even gone through the first of five items on the agenda. Even though the staff had been working on it for 15 months they couldn’t get it done. It seems to me that they had bad staffwork. There was no consensus. They’re excluding the objectors from discussing how to fix the problems, especially our organisation, the end-users organisation and the Association of Corporate Treasurers in the UK. They’ve failed to bring us to the table. The task force has only two end users on it; all the rest are dealers."

"The bankruptcy event in annex 2 has always been contentious. The problem is the 30-day amount of time you’ve get to not be in default on your ISDA agreement before a counterparty can close you out. Once the period passes it can then say you’re in default and you have to tidy up your accounts between each other. ISDA is proposing to go down to five days after the date when a creditor files a bankruptcy application. A lot of end users are saying it should be 15 days at least. You lose liquidity when closing out procedures and this will be very damaging for investors. It’s not just a hedge fund manager issue; it affects fund managers, HNWs and other end users."

McCarty was also worried about the payment and delivery obligations under annex 7. The controversy here centres on the way ISDA has drafted its amendment. ISDA, he said, wanted to expand the ambit of this agreement to cover repurchase agreements, reverse repurchase agreements, the lending of securities and other things, adding that "the last language said that it would be basically every other financial contract." This means that although the current master agreement only covers derivative transactions with this rule, it will have near-universal application in future.

This is a problem because repo and other transactions are commonplace and they commonly fail. After LTCM counterparties were keen to tighten up close out documentation to promote ‘trigger close-outs’ at credit events. McCarty claimed that because of this the number of triggered close outs was therefore set to rocket. "The fear is that these close-outs will not only happen to fund managers or other counterparties who are in financial straits but also to those who have merely decided to use it for another transaction and are unable to find a replacement at 7pm at night", he added.

"Any day of the year you have large numbers of defaults on minor repo transactions. ISDA told us that they didn’t want to include minor fails, but we pointed out that the agreement doesn’t say it. They said that we’d just have to trust them. There’s no materiality provision. They haven’t drafted one in. They say that they’ve changed it to say that you need to close out the entire repo book before it’s considered a default under the master agreement. It’s the same for securities lending as well as repo, but they haven’t called us about it.

"Significant end users are complaining and they’re turning a deaf ear. I think they’ve probably always been like that. I think it’s the credit swap dealers and the lawyers pushing this. They’ve got a lot of end users as members but they’re risking alienating them. These guys are trying to jam their changes down people’s throats and eventually they are going to drive themselves off the cliff."

The third area of controversy, annex 8 on payments for early termination, seems to have resolved itself. ISDA’s tripartite solution, commonly known as the waterfall approach and promoted by end users, was initially rejected by the task force but is now ISDA doctrine. Counterparties who have to calculate the amounts to be paid will have to use market quotes if they have them and then move to loss calculations if no quotes are available. ISDA originally strove to rule out the use of market quotes.

ISDA officials were careful to stress to Complinet that these annexes to the master agreement are voluntary and counterparties will be free to draw up any variations they please in formulating their own agreements. This, they said, was the reason why controversy was unnecessary. The argument did not impress McCarty.

"Check this out. All the dealers will sign up to them and force them on everybody else who is trading, including the fund managers and probably HNW individuals. One day someone will make a mistake during a market correction. A dealer will say that he isn’t going to be the last one out the door on this or that distressed company. He’ll instinctively try to close them down. Liquidity will be harmed, and at a dangerous time. If people stop paying on time, the market will seize up."