Hedging Disruption - Equity Derivatives Provision
Regulator informal action
Does a regulator’s direction to ditch a hedge mean a Hedging Party is “unable to commercially reasonably maintain” its hedge? As long as there is no regulatory-approved alternative means of hedging (you know, but futures, for example), then yes – the apprehension of sanction by the regulator (be it a monetary penalty, adverse publicity or the regulator barring you from operating in its market or even a dim view being taken) - just the general aspiration to maintain good relations with a body having power to regulate your operations — provided it is sincere — is a reasonable commercial consideration which would prevent you from maintaining that hedge.
Why the “why should I pay your hedging costs? I have no control over them” argument is bogus
Because synthetic PB is just cash brokerage done with derivatives and you would wear them in a cash trade, is why.
- The broker owes best execution. That means it has to interrogate all venues and get the best possible price.
- Under best execution rules the client may instruct the broker to exclude certain venues and brokers.
- To comply with best execution, the broker must configure its order router to accommodate the client’s preferences.
- But excluding a venue impacts the quality of the available execution (whenever the excluded venue had the best price, you’d miss it).
- By not excluding the venue, therefore, you benefit from the venue being present (as long as it doesn’t fail) every order you place.
- Trades settle DVP so there is market risk in replacing the trade, not credit risk.
- The market risk could be significant: failure of a venue will heavily impact liquidity and market volatility for a period.
- Asking the broker to underwrite a market loss when a venue or intermediate broker fails while getting the benefit its best pricing as long as it does not is asking for a free option on your own execution risk.
Pernickety amendments
Expect to see some amendments to this clause, chiefly to appease fastidious counsel. For example:
- You may see some tinkering with “transaction(s) or asset(s) it deems necessary to hedge the equity price risk of entering into and performing its obligations with respect to the relevant Transaction” — perhaps to refer to “Hedge Positions” instead of “transaction(s) or asset(s)”[1], and to broaden equity price risk to “market risk (including but not limited to equity price risk, foreign exchange risk and interest rate risk)”
- Some counsel may wish to add to limb (B) “convert into the Settlement Currency” and upgrade “remit the proceeds of and/or collateral posted with respect to any such Hedge Positions”, just in case it might be thought that collateral didn’t count as proceeds of a hedge.
- The Hedging Party may only be allowed to terminate any transaction pro rata with the actual Hedging Disruption