MFA raises concerns over ISDA Novation Protocol for credit derivatives

The Managed Funds Association has written to ISDA suggesting changes to its new trading protocol for the booming USD 12.43 trillion credit derivatives market.


According to the mid-year 2005 market survey by ISDA (International Swaps and Derivatives Association), the notional amount for credit derivatives grew by almost 48 per cent in the first six months of the year to USD 12.43 trillion from USD 8.42 trillion.  This represents a year-on-year growth rate of 128 per cent from USD 5.44 trillion at mid-year 2004. Credit derivatives, for the purposes of the Survey, comprise credit default swaps, baskets and portfolio transactions indexed to single names, indexes, baskets, and portfolios.


With the boom in derivatives trading, the Federal Reserve Bank of New York and regulators worldwide are placing pressure on investment banks to reduce paperwork backlogs associated with trading in credit derivatives, which effectively allow investors to hedge or speculate on corporate credit risk without owning any of the underlying bonds or loans.


In response to this pressure, ISDA laid down its Novation Protocol in September, and leading investment bank dealers have already informed regulators this month that customers, including hedge funds, would be refused certain trades if they had not agreed to follow the rules stipulated by ISDA.


The Novation Protocol


The protocol addresses directly the potential for backlogs and uncertainty associated with the transfer of a party's position in a privately negotiated derivatives transaction.  Under the existing terms of the ISDA Master Agreement, the prior written consent of the remaining party is required when its counterparty in a trade wishes to 'novate' or 'assign' (i.e.: transfer) its position in a trade to a third party.


ISDA says the new Novation protocol enables the parties to modify this requirement to a more definitive, simpler and more streamlined exchange of electronic communications among the parties involved, providing a solution which facilitates the transfer of an existing trade to a third party.


One of many ISDA initiatives geared toward increasing operational efficiency and legal certainty in the industry, the protocol will apply to credit and interest rate derivatives in its first iteration, with a view to extending to other derivatives product areas in future iterations.


MFA's concerns
  
John G. Gaines, President of the US-based Managed Funds Association, has written to ISDA expressing the MFA's concerns, stating: "Although MFA agrees in large part with the Novation Protocol as published, we are concerned that certain aspects of the published version of the Novation Protocol are not practicable and, as a result, have the potential to create an undesirable level of legal and operational uncertainty for market participants."


MFA's proposals


Gaines stated: "In particular MFA maintains that, by providing that a Remaining Party is not bound by its oral consent but rather must provide its consent in writing by 6 p.m. in the location of the Transferee, the published version of the Novation Protocol would impose a process that is unworkable from a practical standpoint given the global nature of the markets that depend on the ability to engage in novation transactions."


"For example, a Transferor in New York that agrees to a novation with a Transferee in London at 1 p.m. New York/6 p.m. London time would be incapable of obtaining the Remaining Party's consent by the Novation Protocol's deadline. We note in this regard that 14 major dealers recommended in a letter to the
New York Federal Reserve Board yesterday a change to this particular aspect of the Novation Protocol in order "to accommodate cross-border concerns."


"Perhaps more importantly, the approach dictated by the Novation Protocol would be inconsistent with market participants' expectations and intentions, which creates substantial risk that it would be disregarded in practice in order to avoid the frustration of market participants' objectives - that is, the processing of mutually agreed novations in an orderly fashion.


"As a result, the process required by the published Novation Protocol has the potential to disrupt the proper functioning of the derivatives markets that depend on novation transactions for liquidity and transparency.


"Therefore, MFA recommends that the Novation Protocol be revised to better achieve the principal objectives that this initiative had at its outset - that is, to (1) recognize that novation transactions should become binding upon the agreement of the parties thereto (whether the agreement is oral or in writing) in the same manner as other transactions executed under the ISDA Master Agreement and (2) provide for prompt written confirmation of novation transactions.


We believe that the revisions we propose below will eliminate the risk of legal and operational uncertainty presented by the current version of the Novation Protocol while at the same time satisfying regulators' objectives of ensuring that novation transactions are confirmed properly and promptly.


"Accordingly, MFA recommends that the Novation Protocol be amended to address the points described below and attaches a markup of Annex 1 (see full letter and annex on www.mfainfo.org ) to the Novation Protocol in order to illustrate the few changes needed to implement these recommendations.


• The Transferor should be required to obtain the consent of the Remaining Party within one (1) business day of agreeing to the terms of a potential novation with a Transferee. This approach would ensure timely execution of novation transactions while at the same time recognizing that parties need adequate time to agree to the terms of their transaction, particularly where multiple time zones are involved.


• The Remaining Party should be bound to a novation from the moment it consents, whether orally or otherwise. This standard would be consistent with the standard applicable to all other transactions executed under the ISDA Master as well as market participants' expectations.


• Once the Transferor obtains the consent of the Remaining Party to a novation, the Transferor should issue written notice to the Transferee and Remaining Party affirming the novation that has been agreed within one business day of agreeing to the terms of a novation with a potential Transferee. MFA believes that this approach will facilitate the timely processing of novations by providing documentary evidence of the novation agreed to and enable the back offices of the Transferee and the Remaining Party to enter into communication on a timely basis in order to record the new trade between them.


"In addition to revising the Novation Protocol as proposed above, we think that ISDA should consider exploring the feasibility of providing parties that may often be in the position of a Remaining Party with the ability to establish a list of pre-approved Transferees that may be relied upon by Transferors in lieu of obtaining specific consent to a novation transaction, subject to the right of the Remaining Party to amend the list at any time upon notice.


"MFA believes that this approach would facilitate the timely execution and confirmation of novation transactions by providing market participants with advance notice of parties with which a Remaining Party is willing to contract.


In light of the number of discussions between our respective organizations and the above-referenced letter from a number of your members to the Federal Reserve Bank of New York yesterday, MFA respectfully requests a meeting with you and your interested members to work through the issues on which we disagree.


Gaines concluded: "We believe resolution of remaining issues will yield a workable solution to the novation processing issues identified by the regulators and recognized by the industry. By embracing these recommendations in some form to address regulatory concerns in the short term, our respective trade associations can then collaborate on expediting the development and usage of electronic platforms, which we believe the entire industry agrees is the long-term solution."


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