Additional Disruption Event definitions - Equity Derivatives Provision
2002 ISDA Equity Derivatives Definitions
Section 12.9(a) in a Nutshell™
Use at your own risk, campers!
Full text of Section 12.9(a)
Content and comparisons
Break these “Extraordinary Events” into four categories:
- Corporate actions on Issuers: (generally) benign but unscheduled matters of corporate structure concerning the management of specific underlying Shares, that change the economic proposition represented by those Shares, and not the equity derivative contract. So: Merger Events and Tender Offers;
- Index adjustments: Equivalent measures that relate to an underlying Index - collectively Index Adjustment Events. So:
- Negative events affecting Issuers: Nationalizations, Insolvency, Delisting of underlying Issuers;
- Additional Disruption Events: Events which directly impair performance and risk management of the Transaction itself. These often cross over with market- and Issuer-dependent events above, but the emphasis here is their direct impact on the parties’ abilities to perform and hedge the derivative Transaction itself. So:
- The Triple Cocktail: The Triple Cocktail of Change in Law, Hedging Disruption and Increased Cost of Hedging;
- Stock borrow events: Specific issues relating to short-selling (Loss of Stock Borrow and Increased Cost of Stock Borrow); and
- Random ones that aren’t needed or used: Two random ones that don’t brilliantly fit with this theory, and which people tend to disapply — possibly for that exact reason, but they are fairly well covered by the Triple Cocktail anyway — Failure to Deliver under the Transaction on account of illiquidity and, even more randomly, Insolvency Filing.
Sections 12.9(a)(vii) and 12.9(a)(iv) Loss of Stock Borrow
Loss of Stock Borrow is an Additional Disruption Event in the 2002 ISDA Equity Derivatives Definitions, and is fondly abbreviated, by this commentator at least, to LOSB. It pairs nicely with an Increased Cost of Stock Borrow, fish or chicken. See also 12.9(b)(vii) which deals with the tension between LOSB and Hedging Disruption.
- Where the Hedging Party can’t locate a stock borrow, the Non-Hedging Party has the option to source one that is struck at less than the Maximum Stock Loan Rate within two Scheduled Trading Days, failing which the Hedging Party can terminate the Transaction.
- Where LOSB and Hedging Disruption both apply and the same event could qualify as either, it will be treated as a LOSB (which has milder consequences for the affected party).
Loss of Stock Borrow under Synthetic PB: For synthetic prime brokerage, it is common for the PB to pass on its stock borrowing costs (well: it is a synthetic equivalent of a stock borrow and a short sale, after all, so this makes sense). It does this by subtracting the prevailing borrow rate from the floating rate it pays under the swap. Therefore the Non-Hedging Party wears the ultimate cost of the expensive stock borrow, so there’s no real need to impose a Maximum Stock Loan Rate (though prime brokers will typically impose one as a matter of course).
Comparing Loss of Stock Borrow and Increased Cost of Stock Borrow: There is a logical hand-off and interaction between Loss of Stock Borrow with Increased Cost of Stock Borrow:
- Under a Loss of Stock Borrow the Non-Hedging Party has a bit less flexibility in what it does: it must pony up (or procure) a stock borrow within 2 Scheduled Trading Days itself, or Hedging Party can terminate outright. Under Increased Cost of Stock Borrow, the worst that can happen is the trade is repriced to take in the higher rate. So ICOSB is the “gentler” provision from the Non-Hedging Party’s perspective.
- If the cost of a stock borrow exceeds the Maximum Stock Loan Rate it is deemed to be (as good as) impossible to borrow stock, so it is treated as a Loss of Stock Borrow, not merely an Increased Cost of Stock Borrow.
- If a counterparty wants to apply Increased Cost of Stock Borrow whatever the cost of an available bid — and given that it can pass the cost on, a synthetic prime broker might be happy to do this — the answer is to disapply Maximum Stock Loan Rate altogether. This means that any possible stock borrow rate, however astronomical, comes under Increased Cost of Stock Borrow, and Loss of Stock Borrow (which is slightly more onerous a termination right) only applies where there are no offers in the market at all.
Section 12.9(a)(ix) Hedging Party
Relevant in the context of Additional Disruption Events and hedging disruption, the Hedging Party will be the entity actually carrying out the hedging activity, if it isn’t the party to the ISDA Master Agreement itself. If no Hedging Party is specified, it defaults to the parties themselves.
Note also the related concept of the Determining Party, who is the person calculating the replacement cost of the Transaction following an Extraordinary Event (e.g. termination following a Hedging Disruption, Change in Law or Increased Cost of Hedging).
In this case there will be a string of intermediate hedging contracts — usually derivatives — but these may not behave in exactly the way that a real underlier would (in terms of market disruption, tax events, liquidity etc). and what the Equity Derivatives Definitions are meant to do is pass on the risk associated with the actual underlier.
So for example in the example pictured, Party A provide exposure to client, hedges that with a equity TRS to Hedging Party, which goes long the physical share. Now the Hedging Party, not Party A, has the risk of the physical assets. If there is a market disruption, or a tax event on the physical hedge this is reflected in the price that Hedging Party will have to pay to Party A, but it isn’t a market disruption or tax event directly on Party A itself (and in fact might not be – Party A might be domiciled in a jurisdiction benefitting from a different tax treaty with the jurisdiction of the underlier, for example). So in this case we need to reference the position as held by a person other than the counterparty to the swap.
Section 12.9(a)(xii) Non-Hedging Party
Not hugely controversial, you would think, but it does sort of imply that the Hedging Party is itself a party to the transaction - otherwise both parties are Non-Hedging Parties. But if so, then there's not really any need for the definition of Hedging Party at all ...
Section 12.9(a)(xiii) Maximum Stock Loan Rate
- especially since there is already an “Insolvency” event covering most of this).