The chain of events unleashed by the Lehman Brothers bankruptcy painfully illustrated the many risks faced by various market participants, including hedge funds and others who act as swap counterparties and prime brokerage customers. Managers of hedge funds and other market participants should consider various risk mitigation practices with respect to their derivatives transactions and prime brokerage relationships.

In part two of this two-part series, we focus on the risk mitigation practices relevant to derivatives transactions. Read part one here.

  • Diversity of counterparties. Diversification of trades across different counterparties and jurisdictions may reap a number of benefits:
    1. The effect of a failure of any given counterparty should be less severe
    2. Changes in margin requirements by any given counterparty will have less impact
    3. Managers could take advantage of the most favorable cross-margin and netting policies

Increasing this diversity of counterparties, however, increases operational risk and may result in higher all-in pricing as there will be less economy of scale with any one counterparty. Managers should therefore weigh the desirability of this diversity against the increases in complexity, additional costs and practical challenges of aggregating risk and position data across multiple counterparties.

  • Set-off rights and netting. Managers should consider expanding their document set-off and netting provisions to include set-off and netting with their counterparty’s affiliates where possible.
  • Termination and default provisions. Managers should have a clear understanding of their rights around a termination of contractual arrangements with counterparties and the process required to implement those rights.
  • Margin requirements and sweeping of excess collateral. The credit support documents for derivative transactions should provide for collateral posting by both parties, and managers should have clear processes and procedures in place to monitor margin requirements. In addition to managers maintaining sufficient funds to cover expected day-to-day margin requirements (the minimum balance), they should promptly “sweep up” any excess collateral they have posted. Moreover, they should quickly make demands for the posting of collateral by their counterparties when their positions are collectively in the money.

When determining the minimum balance, managers should take into account that margin requirements are subject to change on short notice, and that the consequences of a failure to meet a margin call are severe. In order to further reduce the likelihood of having to scramble to meet a margin call, managers should establish a minimum transfer amount in their contractual arrangements in a manner that will not require transfers of nonmaterial changes in exposure while at the same time noting that such minimum transfer amount is the level of incremental credit risk they are taking with their counterparties when their positions are collectively in the money.

Additionally, derivative documentation should provide for daily margining and specify an appropriate notification requirement with respect to margin posting, and managers should consider modifying the standard next-day posting requirement under the International Swaps and Derivatives Association (ISDA) Credit Support Annex to a same-day requirement.

  • Custodial accounts. Managers should consider entering into tri-party agreements under which third-party custodians would hold all margin collateral.
  • Governing law. Where possible, managers should consider specifying English law as the governing law of all swap contracts with non-U.S. counterparties, as U.K. courts have generally adopted much stricter interpretations of swap contracts than their U.S. counterparts.
  • Amendments to ISDA master agreement. Managers should consider:
    1. Adding a provision permitting a nondefaulting party that owes a termination payment to a defaulting party to discharge that payment obligation by delivery of an obligation of an affiliate of the defaulting party using the delivery mechanics for physical settlement of a credit derivative
    2. Changing the definition of “applicable rate” in 1992 ISDA master agreements so that a late payment of a termination amount by the nondefaulting party bears interest at the nondefault rate rather than the default rate
    3. Modifying the condition precedent in Section 2(a)(iii) to clarify that the section is intended to be a suspension of the obligation rather than a forgiveness of the obligation and provide for an accounting for, and settlement of, all payments suspended pursuant to the provision at a specific time notwithstanding the existence of the event as to which the condition precedent was not met
  • Assignments. Although assignments of transactions under an ISDA master agreement generally require the consent of the remaining party, managers should consider specifying in their agreements that such assignments would be permitted by a nondefaulting party without such consent where the assignment is of termination amounts owed to: the defaulting party so long as the assignee is at least as creditworthy as the nondefaulting party.

Of course, different managers will make different determinations regarding the substance of their derivatives transactions depending on their appetite for the various risks involved and the nature of their particular business. Moreover, counterparties to these derivative agreements may resist making changes that would implement these suggested risk mitigation practices and could, in return, increase overall pricing and transaction costs. Nonetheless, a manager that understands the options and implications of various negotiated provisions in its master agreements for derivative transactions will be in a better position to manage these risks.