Hedging Disruption - Equity Derivatives Provision
2002 ISDA Equity Derivatives Definitions
Section 12.9(a)(v) in a Nutshell™
Full text of Section 12.9(a)(v)
Content and comparisons
It isn’t brilliantly worded, but the spirit is clear: it is not just that your particular hedge that you actually had on went kaput, but that you could find any reasonably suitable replacement for it. You can’t be picky. Okay, the equities market might be locked up, but what about futures? I grant you, if the underlying market is disrupted, it’s likely the listed futures market will be too, but you never know. How about ADRs or GDRs?
Triple Cocktail — a trilogy in five parts
- Change in Law: due to a change in law after Trade Date it becomes (a) flat-out illegal [or (b) materially more expensive] for the Hedging Party to “deal with its hedge”.
- Hedging Disruption: The Hedging Party can’t deal with, or recover the proceeds of a hedge.
- Increased Cost of Hedging: the Hedging Party would incur material additional costs in (a) dealing with its hedge or (b) realising its proceeds, excluding costs due to the deterioration of its own credit;
- Loss of Stock Borrow: The Hedging Party cannot maintain the stock borrow it needs to put on a short position on swap;
- Increased Cost of Stock Borrow: The cost to the Hedging Party of maintaining the stock borrow it needs to hedge a short position on swap exceeds the Initial Stock Loan Rate, being a kind of “at this point the pips squeak” kind of threshold for the dealer.
The parties’ rights as a result of each differ, and are set out in Section 12.9(b). Plenty more chat there.
However a Transaction is terminated the Determining Party (i.e., and not the Calculation Agent determines the Cancellation Amount, depending on whether Cancellation and Payment or Partial Cancellation and Payment applies.
- Change in Law is about the regulations governing the Hedging Party. There may be plenty of liquidity in hedge-appropriate investments, they may be inexpensive, but Hedging Party isn’t allowed to buy any of them.
- Hedging Disruption is about liquidity and the outright absence of assets to buy as a hedge. It’s perfectly legal to hedge, the financing costs of cracking out a hedge are tolerable, but no-one is selling a hedge.
- Increased Cost of Hedging: is about the cost to the Hedging Party of acquiring a hedge — not the asset price itself — your counterparty wears that, so what do you care? — but the costs to the Hedging Party of acquiring it: financing costs, capital costs, stamp duties, transaction costs and so on. Largely, it will be financing costs. If the market has gone all September 2018, suddenly credit spreads on on the Hedging Party’s financing operation are have gone through the roof, and when it lends out its hedges as collateral for upgrade trades Agent Lenders are haircutting them by how much did you say??
Regulator informal action
As long as there is no regulatory-approved alternative means of hedging (you know, futures, for example), then the JC says yes. The aspiration to maintain good relations with a body having power to regulate your operations, let alone a plausible apprehension of sanction (be it a monetary penalty, adverse publicity or the regulator barring you from operating in its market or just taking a dim view of your outfit) — provided it is sincere — is a reasonable commercial consideration which would prevent you from maintaining that hedge.
The bogus “why should I pay your hedging costs? I have no control over them” argument
Sniffy buyside counsel — especially hardcore ISDA specialists who are new to PB and don’t yet really understand it, might try suggesting a dealer’s hedging costs are its problem. This argument is bogus. Synthetic PB is just cash brokerage done with derivatives — the dealer hedges delta-one and has no skin in the game as it is simply executing a client order. The client would wear such costs in a cash trade — the dealer is an agent, after all — and the format of the transaction doesn’t make a difference. Okay: a swap counterparty is not in any legal sense an agent — that is axiomatic — but the trade is riskless principal, which is agency from an economic perspective.
- The dealer owes best execution. That means, (subject to contrary instructions) it has to interrogate all venues and get the best possible price.
- Under best execution rules the client may instruct the dealer to exclude certain venues and dealers.
- To comply with best execution, the dealer 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 dealer 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.
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)”, 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
- Note that the industry has moved towards omitting the increased cost component: see Change in Law for more information.
- “Dealing with a hedge” is shorthand for “establishing, maintaining or liquidating a hedge”.
- “recovering the proceeds” refers to a situation where the Hedging Party can’t get its hands on the proceeds of terminating a hedge due to circumstances beyond its control (e.g., local currency controls, market dislocation or even just counterparty default)
- see 12.8(f) for commentary.
- It is always sad to see an ISDA drafting committee pass up the opportunity to use and/or, by the way.