The “three-headed hydra” – as the trinity of Libor reform, Brexit and non-cleared margin was recently described by one banker – has haunted dealers’ dreams over the past 12 months. And at the heart of the industry’s response to all these issues is just one law firm: Linklaters.
Its success in seizing the role as the International Swaps and Derivatives Association’s go-to outside counsel – previously enjoyed by rival Allen & Overy – over the past two years has meant they have been in a position to share the industry response to some of its biggest challenges.
“We’ve been working with Isda for many years now, but our volume of work with them has increased over the past two years,” says Deepak Sitlani, a partner at Linklaters. “We were given an opportunity on one or two jobs and it has led us to winning more and more mandates.”
On top of that, the firm helped large banks and asset managers plan and execute plans to shift derivatives business from London to the EU to service their clients after Brexit. They also assisted a dealer consortium in designing a new platform with LCH to standardise calculations for variation margin calls on non-cleared trades.
The firm’s winning streak with Isda began in 2016 in the few days following the UK’s vote to leave the EU. Within a matter of days following the referendum, Linklaters was mobilised to run a webinar discussing the implications of the vote.
From there, Linklaters has continued working with Isda on Brexit-related issues, and in October 2017 the partners released a study revealing the extent firms will still be able to trigger lifecycle events if the UK left the EU with no deal covering market access.
Of the six jurisdictions surveyed – France, Germany, Italy, the Netherlands, Spain and the UK – events such as settlement were shown to still be possible. Compression runs involving a new overlay trade and rollovers, however, may require licences from local authorities. Everything in between differed by jurisdiction.
Sitlani says six dealers wanted more and asked the law firm to produce bespoke versions, with some looking at all 27 EU jurisdictions and others analysing the impact on specific products.
“The Isda cross-jurisdictional lifecycle event survey is an important piece of analysis that needed to be done, and we commissioned [Linklaters] to do a separate second survey,” says one bank client.
“We pooled all the information and worked out how many contracts fell into categories where lifecycle events are anticipated to occur and cannot be done without a local licence. The survey helped us identify whether or not we needed to novate certain trades.”
The process wasn’t easy. Answers from local counsel were not always black and white and often depended on interpretations of local law. To overcome the mix of fact and opinion, Linklaters had to probe local counsel to get full clarity on the issues.
Those surveys have been vital for banks in developing strategies to move derivatives business from London to the EU. Here, large investment banks and asset managers have also leaned on the law firm to strategise and execute these business transfers.
A key part of the transfer process is getting clients that currently use a London-based dealer to sign new swap agreements with its EU entity. Without those agreements, a no-deal Brexit could see dealers to be placed on no-trade lists by clients, or vice versa, if they are unable to continue servicing them.
Given the volumes of documents that need amending, Linklaters turned to automation technology to speed things along.
“For all of the thousands of clients banks have in the European Economic Area, you need to replicate all of those master agreements into new legal entities,” says Matthew Monahan (pictured), a partner at Linklaters.
“We have used document automation technology that allows banks to automatically populate the thousands of new agreements with data in their systems from old agreements, and that saves a huge amount of time.”
Another landmark piece of work saw the law firm assist Isda to develop a fallback to Libor should the disgraced benchmark cease to be published once UK regulators stop propping it up after 2021. Industry-led working groups across different currencies have developed new risk-free rates that can be used as the basis of the fallback. These can be used to replicate Libor if it fails, by using an RFR plus the spread between it and Libor.
But this is no easy task. First, the RFRs are generally overnight, while Libor has a term element, so the RFR will need to be adjusted to match. And second, the Libor rates include bank credit risk that the RFRs lack, meaning there is a basis between the two rates that needs to be calculated and added as a spread on top of the RFR, so there is minimal value transfer if the rates needed to change over.
There is no obvious choice for how to approach these two tasks, so Linklaters helped Isda draft a consultation asking the industry for its views.
Linklaters has also played an active role in developing fallback provisions to be inserted into other types of swap documentation, to enable those contracts to move onto a new rate if required with a minimum of fuss.
Most recently, the law firm helped finalise Isda’s benchmarks supplement on September 19 to provide counterparties with standard provisions that can be voluntarily included in new contracts.
The supplement was drafted in response to requirements laid out in the EU’s Benchmarks Regulation, which requires contracts between EU entities and their clients to set out actions that would be taken if a referenced benchmark materially changes or ceases to exist.
This work is separate from the industry’s wider efforts to find a fallback for contracts referencing Libor. The benchmark supplement for contracts referencing Libor allows counterparties to agree an interim fallback if the rate ceases to exist before the Libor-specific fallbacks are agreed upon and implemented. Linklaters has been advising on how best to co-ordinate work being done by both streams.
“A challenge with that work was not knowing what might happen if a particular rate falls away,” says Sitlani. “We needed to come up with different ways of trying to ensure the contract survives but at the same time satisfy requirements for a robust fallbacks in the regulation. In the end, we had lots of these hurdles needing to be overcome to effectively try to preserve contracts.”
The firm also helped broker agreements in a separate project to update collateral documentation for posting regulatory-mandated initial margin on non-cleared trades.
Isda’s initial margin collateral support annexes have previously been drafted to fit the needs of banks, as they were caught by the first three staggered deadlines as the rules have been implemented. But with a host of buy-side firms set to fall into the next wave of entities to post initial margin, the CSAs need updating to take into account buy-side preferences.
Time has been of the essence. The project started in February 2018, but all the documentation has to be ready for the fourth phase, taking effect in September 2019.
“We said we would look to publish the 2018 regulatory initial margin New York and English law CSAs between the end of September and start of October,” says Douglas Donahue (pictured), a partner at Linklaters. “People thought it was crazy and would never happen by that time. In the end we managed to publish in mid-October.”
One sticking point has been around the conditions dealers and clients would be able to access collateral held at their respective third-party custodians. These terms had already been agreed by dealers in the initial margin CSAs they signed back in 2016, and they wanted clients to use these as well. But clients that were already posting initial margin wanted to instead retain the existing conditions in their own documents.
To break the impasse, a compromise was found that saw counterparties use the dealers’ terms, but with an option to switch to terms set out in the existing custodial documents if both sides to the CSA agree to it.
Now Linklaters is working to craft new collateral transfer agreements, which set out the relationship between swap counterparties and custodians, to enable those to be governed by alternative legal systems than English and New York law – the two dominant choices in the derivatives markets.
Against the clock
Linklaters was also active on the market infrastructure side, representing dealer consortium OTCDerivnet in the creation of LCH’s new SwapAgent platform. This uses LCH’s swap curves to calculate variation margin calls on non-cleared trades, with dealers using LCH-style cash CSAs to minimise disputes. It also uses settled-to-market treatment of variation margin, where the outstanding mark-to-market of positions are considered settled at the end of each day. This allows dealers to reduce their exposures under the leverage ratio.
Initially rolled out in May 2017 for certain interest rate derivatives, the service has been expanding to cover cross-currency swaps in October 2017 and most recently for swaptions in September.
Linklaters’ job was to ensure the structure didn’t conflict with any regulatory requirements placed on dealers, and get banks comfortable with the treatment of trades using settlement-to-market.
“There are a series of technical legal issues we had to go through to make sure the whole structure worked from a regulation perspective,” says Michael Voisin (pictured), a partner at Linklaters.
“We had to assess whether it complied with the non-cleared margin rules, outsourcing rules in the second Markets in Financial Instruments Directive, the Benchmarks Regulation, and explain to banks’ accounting teams how it worked in relation to getting settlement-to-market.”
Linklaters also helped Hong Kong Exchanges and Clearing knock down barriers facing international investors trying to access mainland China bonds through the China Bond Connect scheme.
The lawyers advised HKEx on the development of the legal framework around the platform, which required them to balance demands from Chinese regulators and international investors.
“The year before Bond Connect launched, a lot of the work had centred on sorting the conceptual design of the structure,” says Chong Liew, a partner at Linklaters. “In the end, the structure was quite different as there was a lot of bargaining behind the scenes to get everybody happy, and most work was done in those four months.”
The work didn’t stop there: Liew says they are now helping extend China Bond Connect’s legal framework to allow international investors to hedge their bond investments in the onshore market without having an onshore entity, which can be operationally complex to set up.
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