The Law of Derivatives

Simon James

• Publisher: Informa Law from Routledge
• Year: 2014
• ISBN:
  9781317811305
• Edition: 1
• Topic: Derecho
• Subtopic: Derecho mercantil

This volume focuses on the legal risks arising in English law in the course of derivatives transactions. It discusses the following issues: the legal risks arising in the negotiation and conduct of derivatives transactions; the regulation of the derivatives market; the capacity to enter into derivatives transactions and the standard term upon which this is done; the consequences of default by a counterparty; and the standard terms on which derivatives are entered into, particularly the ISDA Master Agreement.

Chapter 1

Derivatives

1.1 Introduction

In early seventeenth-century Holland, particularly 1634 to 1637, tulipomania took hold. Demand for tulips massively exceeded supply and prices soared. Inevitably a futures market emerged, and tulip bulbs were bought and sold whilst still in the ground. The bulbs were traded by people with no intention of taking delivery, and bulbs could be involved in lengthy contractual chains. In February 1637, buyers evaporated and the bubble burst. Litigation followed which took a number of years to resolve.¹

Derivatives, therefore, are not new.² Tulip futures might have been a very early example of derivatives trading, but the Chicago Board of Trade was founded as long ago as 1848, and introduced standardised contracts around 1865. The scale, use and range of available derivatives has, however, expanded enormously since the beginning of the 1980s. ISDA has estimated that the total value of outstanding off-exchange interest rate swaps alone was $682.8 billion in the second half of 1987 but had reached $22,291 billion ten years later. The reasons for this expansion are doubtless myriad but probably include the breakdown of the system of fixed exchange rates established after the Second World War and the greater volatility of interest rates caused by inflation, both of which created more uncertainty. Derivatives met the need to reduce exposure to these risks, but once the genie was out of the bottle, their nature and application has been limited only by imagination.

The public focus has tended recently to be on cases where participants in the derivatives market have lost large amounts of money as a result of their activities—from the burghers of the Netherlands to Orange County, Procter & Gamble, Gibsons Greetings, Barings and others. It is unquestionably easy to lose money on derivatives, and those who do so probably wonder why they entered the market at all. The market would not, however, survive if these examples were typical of experience in the derivatives markets. People enter transactions in the derivatives markets for a variety of reasons but, in very broad terms, the market consists of those seeking to hedge the underlying risk, those trading in derivatives and those who speculate with a view to profit. Those seeking to hedge risk might, for example, wish to borrow in six months’ time and be concerned that interest rates will by then have risen, raising the cost of doing so. Various strategies, including the use of swaps and/or options, could be used to hedge against this risk and lock in interest rates at or near the present level. Those trading are largely banks who buy and sell derivatives with a view to profiting from the activity, whether by taking a view as to future movements, by buying and selling derivatives with a spread between the two prices or by seeking arbitrage opportunities. Speculators enter the market with a view to profiting from price movements. Speculators have the advantage of providing liquidity to the market, making it easier for others to find counterparties for the transactions they wish to enter into.

Though participants in the derivatives market can be divided in this, and other, ways, the differences may not be as profound as any division might suggest. Speculation tends to have a bad name, but it is possible to view anyone in the market as a speculator. For example, if a producer will have a commodity to sell in six months’ time and wishes to lock in the price now through a futures contract, that amounts to speculation that the price will fall—if there were no risk of the price falling, there would be no reason to enter the futures market because the commodity producer would be no worse off, and could be better off if the price rose, by not doing so. If the price does rise, the producer has lost the gain he would have made as a result of that rise. This is, however, called hedging rather than speculation because of the interest in the underlying commodity. The producer might, however, change his view in the course of the six months before the commodity is available. If so, he might reverse the earlier hedge at a profit or loss, so becoming exposed again to market movements. This puts him back into the position he was in before entering the market, and could be called hedging, removing the hedge or speculating that prices will rise. The reality is probably that anyone entering into a derivatives transaction is doing so in order to make money or to avoid losing it, though some do it for its own sake and others as an adjunct to another business, usually in relation to an underlying variable.

1.2 What are Derivatives?

1.2.1 Derivatives generally

A derivatives transaction is, according to the Group of Thirty,³

“a bilateral contract or payments exchange whose value derives, as its name implies, from the value of an underlying asset or underlying rate or index. Today, derivatives transactions cover a broad range of ‘underlyings’—exchange rates, commodities, equities and other indices.”

A vital aspect of a derivatives contract is that it is primarily a financial contract. For example, a contract for the delivery of a commodity in the future at a price determined now would not be generally referred to as a derivatives contract if the parties intended that physical delivery should actually take place. Forward and futures contracts are, however, usually included in any definition of derivatives where the expectation is that physical delivery will not take place, whether that is because physical delivery is not possible, because the contract is to be settled by the payment of a single lump sum or because of another reason. Further, the derivatives market is now such that the value of the underlying asset might derive from its derivatives, rather than vice versa.

One regulator, the SFA, defines derivatives in its rules as “options, futures and contracts for differences”,⁴ addressing the type of contract rather than its nature. It further defines each of these three parts by reference to paragraphs 7–9 in Schedule 1 to the Financial Services Act 1986, which in turn defines the instruments caught by financial regulation in England. This approach does not, however, necessarily catch all transactions that would now be called derivatives. For example, a fundamental technique in developing derivatives is to strip out one aspect of a broader transaction and trade in that alone; so, for example, a commodity forward strips out the risk of price movement, and allows trading in that without the other aspects of a physical commodity transaction, such as delivery and quality risk. This has been applied to, for example, credit risk to create credit derivatives, and will doubtless be applied elsewhere.

What follows is a brief thumbnail sketch of the general types of derivatives transactions, but the use to which derivatives and derivative techniques are put is limited only by the imagination of those developing them.⁵

1.2.2 Forwards and futures

Forward and futures contracts are agreements to buy and sell in the future on terms agreed now. So, for example, an agreement to buy a quantity of copper in six months’ time at a price fixed now would be a forward or futures contract. What makes it a derivatives contract is the expectation (and possibly a contractual term to the effect) that physical delivery of the commodity will not actually take place but that the contract will be concluded by payment of a sum of money, the difference between the contract price and the market price at the relevant time. Forwards and futures are in general for periods of up to about three years, though they can be for longer.

Forward and futures contracts can be entered into with regard to any commodity, but also with regard to intangible matters such as currencies, interest rates, and stock indices. For example, a very common type of contract is a forward rate agreement (an FRA), an agreement to apply a fixed rate of interest on a notional principal sum for a specific period in the future (for example, an agreement to pay interest at 7 per cent for a period starting six months in the future and ending 12 months in the future⁶). The contract would be settled at the start of the interest period by the payment of a sum representing the difference between the actual interest rate for that period and the fixed rate (though since interest is normally paid at the end of an interest period, the payments are discounted to take into account early payment⁷).

The reason for entering into a forward or futures contract could be pure speculation, but it could be to hedge an underlying risk. For example, an investor might anticipate the receipt of funds in the future but be concerned that the particular stock he has in mind to buy might have risen by the time the funds are due. In that case, the investor could buy a futures contract in the relevant stock, i.e. the right to buy the stock at the futures market price.⁸ If the price is above that level at the relevant time, the buyer would receive a payment equal to the difference, but if below he would have to pay the difference. If the investor was interested in a basket of stocks, he could buy a futures contract based on, say, the level of the FT-SE 100 share index rather than an individual share.⁹

1.2.2.1 The difference between forwards and futures

Futures are bought and sold on an exchange, whereas forwards are purely bilateral contracts arranged between the parties. The result of dealing on an exchange is that although parties will agree a contract directly, often in a pit where face to face dealing takes place,¹⁰ the contract will be accepted by a clearing house (in the case of, for example, LIFFE, the London Clearing House, which is independent of LIFFE and owned by major banks). The clearing house will then be interposed between the two parties, becoming the buyer to the seller, and the seller to the buyer.

By being interposed as a party to all contracts, the clearing house takes the credit risk on the parties, relieving each party of the need to investigate each other’s credit standing and enabling them to rely on the high credit standing of the clearing house. In return for this, the parties must make margin payments. These are usually an initial margin payment, commonly seen as the maximum amount that the relevant contract price could move in a day, and daily variation margin payments. Initial margin is security for performance of the contract, and can commonly be deposited in cash or certain securities. Variation margin payments are of the difference between the contract price and the market price each day, and can be made either by the clearing house to the party or vice versa depending on the direction of the movement in the prices. By taking margin payments, the clearing house hopes to insulate itself against default by the counterparties.

Only members of the relevant exchange contract with the clearing house. If someone wishes to deal in futures and is not a member of an exchange, he must deal through a broker who is a member of the exchange. The broker will act as principal as against the non-member, requiring margin payments, and will generally hedge its position by entering into a back to back transaction on the exchange. The non-member does in these circumstances take credit risk on the broker, and vice versa. Where off-exchange transactions are concerned, the parties each take credit risk on the other, and do not in general make margin payments.¹¹ They are free to agree whatever terms they wish, but these might, for example, include the provision of security for the obligations of one of the parties.

Further differences between forwards and futures are that futures are carried out in contracts of fixed terms (e.g. dates, amounts and minimum price movements¹²) whereas off-exchange contracts can be on whatever terms the parties agree. Futures exchanges will in general only offer contracts in which there is high liquidity, which often leads to low bid-offer spreads. As a result of this, it is usually easy to close out a contract by entering an equal and opposite contract. Closing out a forward contract depends on the willingness of the other party to do so; if the other party will not agree, it is necessary to find another party which is prepared to enter into an equal and opposite contract, but this entails taking credit risk on that party as well as on the party to the original transaction. There are also procedural differences—for example, interest rate futures prices are quoted not in terms of a percentage interest rate but as a price, the relevant annualised interest rate subtracted from 100.

1.2.2.2 Forwards’ and futures’ prices

The prices of forwards and futures are not a prediction of what the price will be at the relevant date in the future but are calculated on a “cash and carry” basis. The price is principally the spot price plus the cost of carry (i.e. storage costs, if relevant, and interest foregone minus the yield on the asset in question), though other factors such as commissions, spreads, and credit risks might be taken into account.¹³ If prices were calculated on any other basis, an arbitrageur could make a guaranteed profit. For example, if a commodity futures price was above this level, a profit could be made by buying spot and selling futures or forwards; if prices were below this level, a guaranteed profit could be made by selling spot and buying futures.¹⁴ For interest rates, if it were possible to borrow for three months at 8 per cent, lend for six months at 9 per cent, and buy a futures contract starting three months in the future and lasting three months also at 9 per cent, it would guarantee a profit of 1 per cent for the first three months with no risk over the second three months. The futures price is essentially the price which prevents this kind of guaranteed profit and, as such, is implied by the yield curve.¹⁵

1.2.3 Swaps

Futures or forward contracts invariably entail only one payment in settlement of the liabilities involved¹⁶ whereas swaps entail a series of payments, and can be seen as a number of forward contracts stretching over time. For e...