The ins and outs of derivatives

Nigel Brahams delves into the world of derivatives and looks at the legislation governing these financial instruments

Nick Leeson broke Barings covering his tracks in Tokyo stock futures.

Enron traded energy futures, and that is all most lawyers know about derivatives.

Although the term 'derivative' has been used only for the past ten years, Flemish merchants traded cloth futures in the 16th century.

The volume of outstanding transactions in interest rate and currency derivatives alone rose from $866 billion in 1987 to $63 trillion at the end of 2000.

So, what is a derivative? A derivative is an instrument the performance of which is based on the value of an underlying asset (in other words, shares), which the derivative's holder may or may not own.

Over the counter

Buying derivatives is like choosing a suit.

Investment exchanges sell them off the peg.

The London International Financial Futures and Options Exchange (LIFFE) offers options on individual FTSE 100 shares, FTSE 100 options, and FTSE 100 Index futures.

Such exchange-traded derivatives are governed by exchange rules, and create little legal work.

The suit-rail selection may not meet requirements.

Banks sell a range of bespoke products over the counter.

The use of over-the-counter derivatives has resulted in much new law and practices.

There are three basic derivatives: swaps, options and futures.

l Swaps.

Under an interest rate swap, party A exchanges interest payments (fixed or floating in the same or different currencies) with party B for an agreed period.

Equity and currency swaps are also common.

l Options.

The holder has the right - but no obligation - to buy or sell underlying assets (shares, commodities, currency) at a pre-set price on a prescribed date or during an option period.

Equity and currency options are the most common.

l Futures.

These are usually exchange-traded.

The investor agrees to deliver or receive a quantity of a commodity (for example, oil or coal) on a future date.

FTSE 100 Index futures are settled in the cash difference between purchase and exercise price - it would be impractical to deliver an actuarially calculated pool of shares equivalent to the FTSE index.

Other derivatives include 'swaptions' (options to enter into swaps) and credit derivatives.

The buyer of a credit default swaps obtains quasi-insurance against a range of potential credit events, including insolvency, failure to repay, or credit downgrade, affecting a party indebted to him.

Why trade derivatives?

Users of derivatives are speculators seeking volatility, or hedgers, managing their risk.

The following examples demonstrate two uses of equity options:

l Speculation.

A speculator wants to invest 100.

Instead of buying 100 shares for 1 each, he spends his 100 on an option (costing 10p per share) to buy 1,000 shares for 1 each at any time during the next three months.

If the share price rises to 1.40 he exercises his option and buys 1,000 shares at 1 each, which he sells for 1.40, making a 300 profit (400 less his original stake).

If he had bought the shares, he would have made 40.

If the share price falls below the option's exercise price, the option is valueless and he loses his 100.

l Hedging risk.

A fund manager holds 100 1 shares, which he bought for 50p each last year.

The fund manager wants to retain the shares, but secure a profit lest the price falls.

He spends 10 buying an option for 10p per share, entitling him to sell 100 shares for today's price of 1 any time in the next six months.

If the price rises he will not exercise the option, but if it falls to 50p, he will have locked into a profit of 40p per share (50 less 10 option fee).

ISDA

The International Swaps and Derivatives Association (ISDA) is the London and New York-based global trade association, representing the OTC derivatives industry.

Chartered in 1985, today ISDA has more than 550 members from 42 countries, including the world's major dealers (banks, securities houses, asset managers) in over-the-counter derivatives.

Originally, derivative transactions were documented by individual contracts between parties.

However, as volumes increased, an industry standard document became necessary.

In 1987, ISDA issued its first master agreement for swaps.

In 1992, ISDA updated and expanded the 1987 agreement.

The 1992 ISDA master agreement is the global industry standard agreement for OTC derivatives transactions.

ISDA is working on a 2002 update.

Under the agreement, master parties agree to make payments and deliveries under a series of transactions.

It includes warranties and provisions for payment in the event of default or termination.

It is a printed form, with a four-part schedule.

Parties make elections in the schedule, regarding, among other things, cross default, merger, collateral, netting on default and governing law.

Most financial institutions produce their own extended schedule to the ISDA master, and include part 5, miscellaneous provisions.

In Hazell v Hammersmith & Fulham London Borough Council & Others [1992] 2 AC1, the House of Lords held that all swaps entered into by all local authorities are ultra vires.

As a result, banks often include provisions in part 5, intended to ensure that their counterparty is capable of trading derivatives.

While the ISDA master governs the overall relationship between parties, individual transactions are documented by confirmations, incorporating the ISDA master and giving details of price, transaction period and settlement.

English or New York law may govern ISDA masters and confirmations.

Outside the US, English law governs most transactions, even where neither party is incorporated here.

The ISDA has drafted definitions for use in confirmations, including the Equity Derivatives Definitions 1996 and the Credit Derivatives Definitions 1999.

Also, the ISDA has created credit support documents, under which one or both parties provide collateral.

English courts have occasionally scrutinised the ISDA master, focusing on payments on default.

The ISDA master offers two calculation methods: loss and market quotation.

Loss is the actual loss suffered by a party.

Market quotation requires the non-defaulter to obtain quotes for loss from other market makers (usually three from which to take the middle figure) as its calculation of damage.

In ANZ v Socit Gnrale [2000] 1 All ER (Comm) 682, the Court of Appeal stated that market quotation and loss measures were intended to reach broadly similar results.

In the controversial High Court case of Peregrine Fixed Income v Robinson Department Stores (2000) 277 QBD (COMM), Mr Justice Moore-Bick ignored the parties' election of market quotation.

He relied on a provision in the agreement, stating that loss remains the fall-back where market quotation would not produce a 'commercially reasonable result'.

Market quotations were inconsistent: $750,000, $9.5 million and $25.5 million.

The loss figure was nearer $80 million.

Market quotation is a popular election, and many commentators maintain this decision is flawed and should be limited to its own facts.

Still, given the dearth of other case law, the case has affected the drafting of ISDA schedules.

Enron and beyond

Enron traded derivatives in volume.

Following its collapse, US senator Dianne Feinstein proposed repealing liberalising reforms made in the US Commodity Futures Modernization Act 2000.

ISDA urged the Senate to reject these proposals.

It maintains that there is substantial discipline in the international swaps market and that Enron's collapse resulted from its attempts to evade such discipline and that further regulation would backfire.

On 3 May, the UK's Financial Services Authority published a working paper - Cross-Sector Risk Transfers - focusing on risks in the credit derivatives market.

Nigel Brahams qualified as a solicitor at Clifford Chance in 1992 and has worked as legal counsel for several investment banks during the past seven years.