Learning Curve

An increasing number of asset managers are turning to fx as a cheaper, more liquid way to hedge cross-asset portfolios. They are prepared to accept some mismatch between the risk profile of their portfolio and their fx hedge, but are ultimately looking for hedging instruments which provide a payoff in times of risk aversion. The term risk aversion can be measured, and therefore traded, in one of the following three ways: carry unwind, increase in correlation and an increase in fx volatility.

From the second half of the 1990s onwards, credit derivatives and insurance products have been commonly used by market participants to manage and transfer credit risk associated with financial instruments such as structured finance and traditional debt instruments including loans and bonds. Credit derivatives have been popular but their unregulated nature has been blamed for playing a role in the bankruptcy filing of Lehman Brothers, the federal rescue of American International Group as well as the downturn of the stock markets during the global financial crisis. While there may be uncertainty in the future of credit derivatives due to regulation and standardization, financial institutions have been creating alternative financial instruments to manage and transfer their credit risk, and financial guarantees are one of the hot topics in the current market.

In last week's Learning Curve, we highlighted certain provisions in the Wall Street Transparency and Accountability Act of 2010 that will impose new requirements and restrictions on a hedge fund that is categorized as a swap dealer or a major swap participant when the various provisions of Subtitles A and B of the Act become effective. In this issue, we discuss the Act's additional requirements for swap dealers and major swap participants and the effects on hedge funds of other significant provisions.

The Wall Street Transparency and Accountability Act of 2010 is Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Subtitles A and B of the Act deal with the regulation of over-the-counter derivatives. Hedge funds that meet certain specified criteria will experience a radical and costly change in the way they trade derivatives.

The release of the European Markets Infrastructure Regulation consultation paper in Europe two weeks ago and the expected signing of the Financial Reform Bill in the U.S., mean central clearing for many OTC derivatives and cash financial instruments will soon become part of the trading landscape.

Established participants in the equities and commodities markets view over-the-counter foreign exchange as an alpha-generating opportunity.

-- Richard Schetman, partner at Cadwalader, Wickersham & Taft LLP

The development of OTC derivatives collateralization can be traced back over 15 years and its progress appears to dovetail with the various financial disasters that have hit the global and regional communities during that time.

On March 1, 2010 after many months of work, the International Swaps and Derivatives Association and the International Islamic Financial Market jointly issued the first Shari'ah-compliant master agreement for over-the-counter derivatives. Named the "ISDA / IIFM Ta'Hawwut Master Agreement," it provides a framework for the expansion of derivatives activity in the Middle East, South Asia and many regions throughout the world where hedging is not standard practice. Part I focused on derivative transactions within Shari'ah-compliant finance principles, and in Part II, we look at some of the differences between the Ta'Hawwut Agreement and the 2002 Master Agreement.

On March 1, 2010 after many months of work, he International Swaps and Derivatives Association and the International Islamic Financial Market jointly issued the first Shari'ah-compliant master agreement for over-the-counter derivatives. Named the "ISDA / IIFM Ta'Hawwut Master Agreement" it provides a framework for the expansion of derivatives activity in the Middle East, South Asia and many regions throughout the world where hedging is not standard practice.. Based on the 2002 ISDA Master Agreement, the Ta'Hawwut Agreement has been developed under the guidance and approval of the IIFM Shari'ah Advisory Panel. The Ta'Hawwut Agreement is therefore expected to be used as a reference for market participants where they or their customers need to hedge risks in line with Shari'ah principles.

On May 5, 2009, Judge James Peck, the bankruptcy judge in the Lehman Brothers bankruptcy cases, held that the safe harbor provisions of the Bankruptcy Code do not override the mutuality requirements for setoff under section 553(a) of the bankruptcy Code. As a consequence, the bankruptcy court prohibited Swedbank, a non-debtor counter party to a swap agreement, from setting off pre-petition claims against Lehman against funds collected for Lehman's account post-petition. See In re Lehman Bros. Holdings Inc., Bankr. Case No. 08-13555 (JMP) (Bankr. S.D.N.Y. May 5, 2010) (the "Opinion"). While Swedbank does not involve a triangular setoff, the analysis of the Swedbank court should equally apply to triangular setoff situations (or to any setoff lacking mutuality).

A string of recent decisions from the English courts in disputes over capital markets transactions has highlighted the importance of getting the jurisdiction clause right to all of those involved in the OTC industry. This article examines some of the key messages arising, the most fundamental of which is that it would be unwise for anyone dealing with derivatives contracts to treat the jurisdiction clause as a standard "boiler plate" provision, to be addressed at the last minute of any transaction and unworthy of serious negotiation.