The next few months will be crucial for the over the counter equity derivatives market. Participants have a once-a-decade chance to clean up and simplify the market’s operating practices, in a way that could make trading more robust and efficient.

At issue is the documentation of trades, and the opportunity to achieve a degree of standardisation that the market has never enjoyed before.

This is not just an optional upside for the market, however. It is a requirement.

For several years regulators, led by the Federal Reserve Bank of New York, have been pushing the industry to become more standardised and automated.

Leading dealers signed a letter to the Fed, published on June 2, 2009, committing themselves to certain targets. Now they have got to deliver.

The industry has been frantically negotiating terms on an array of products, in an effort to agree Master Confirmation Agreements (MCAs). These are currently the key to increased electronic trade confirmation processing and therefore crucial to improving operational efficiency and control.

These efforts may well help the market meet some of its commitments, including making 50% of major dealers’ total trade volume electronically eligible by the end of 2009.

The International Swaps and Derivatives Association has rightly recognised, however, that this sticking plaster approach is not sustainable for the development of the industry, and that the time has come to revise and update the current set of definitions for this asset class.

2002: what went wrong?

It is clear from the way the market has developed since the publication of the 2002 ISDA Equity Derivative Definitions that fundamental mistakes were made during the negotiation of these terms, which ultimately led to the plethora of MCAs that now set the fractured tone for the market.

This article attempts to highlight these errors, as well as the disadvantages of using MCAs, and to propose ideas for how the 2010 ISDA Equity Derivative Definitions should be designed – first, to ensure that these mistakes do not recur and, second, to aid the industry with its current and future commitments to regulators to improve operational efficiency, control and transparency.

The critical mistake made in negotiating the 2002 Definitions was a collective failure to identify clear objectives. This was mainly due to a lack of representation from trading or operations, and resulted in too much of the focus being applied to the wrong areas.

The scope of the Definitions on many levels was far too narrow and did not reflect market trends.

Products such as variance swaps that have since grown in popularity were being traded at this time, and although they were in their infancy, the agreement of terms for these products could have been accelerated by including them in this document.

Additional provisions for exotics were limited to Bermudan options and barriers, which account for a tiny fraction of the market. 

When it came to underlying securities and to reference prices, the Definitions did not extend the scope in these areas at all, despite an obvious need to enhance them.

Derivatives on depositary receipts were traded actively by 2002 but no provisions were included. As with variance swaps, it was only when trading in depositary receipts grew rapidly in the first half of this decade that action was taken, resulting in the Partial and Full Lookthrough Depositary Receipt Supplement.

The 2002 Definitions also failed to cater adequately for indices that contained underlying assets traded on multiple exchanges, although the most actively traded European index, the Dow Jones Euro Stoxx 50, falls into this category.

As for reference prices, using the lookalike listed derivative price was again limited to indices, through the Futures Price Valuation mechanism, even though most of the European market hedges OTC share options with listed contracts.

Other reference prices used for valuation – such as opening levels, volume-weighted average prices and hedge execution prices – were ignored altogether.

Too much left to choice

Besides these failures of scope, the group negotiating the 2002 Definitions demonstrated a lack of understanding of existing and future operational needs, despite clear indicators in other asset classes (for example, SwapsWire had already entered the interest rate derivatives space in 2002). As a result, there were too many defined terms open to unilateral election.

Before these terms were published, disputes resulting from the elections that parties made for Share Adjustments and Extraordinary Events were rife.

The 2002 Definitions did nothing to rectify this, and indeed compounded the issue by introducing myriad new terms that also required elections, such as Index Adjustment Events and Additional Disruption Events.

The result was chaos. Banks issued confirmations containing elections that they had decided in-house without seeking any prior agreement from their counterparties.

This resulted in a large rise in unsigned confirmations and protracted negotiations, first bilaterally, and then subsequently regionally as a market, to agree a common set of default elections for each product. Ultimately the child of these discussions was the equity derivative MCA.

MCAs: the disadvantages

For the past five years Master Confirmation Agreements have been produced to rectify the issues highlighted above.

They enable equity derivatives to be electronically matched by ensuring that most terms are agreed in advance, thus reducing the trade confirmations to around 20 confirmable fields specific to each trade.

But although there are now agreed terms for many products and processing by electronic matching platforms is possible, the current MCA model has hindered the adoption of these standardised terms – and therefore of electronic matching – as much as it has helped.

The reasons for this are threefold. First, as MCAs are executed bilaterally and the parties need an agreed MCA in place before using the matching platforms with each other, there is a heavy reliance on getting these forms signed.

As the equity derivative market has more smaller players than other asset classes such as credit derivatives, it has been difficult for banks to find the time and resources to sign an MCA with each client, resulting in a significant missed opportunity percentage.

Second, as the MCAs are bilateral documents, banks will, depending on the type of counterparty they are facing, insert additional provisions into the ISDA standard forms.

This has slowed down the process considerably. Buy side clients have become wary of executing MCAs because many do not match the ISDA-published version and therefore have to be rigorously reviewed and negotiated by legal counsel.

Third, MCAs have grown organically on a regional basis. While this has the advantage of addressing specific regional concerns and trends, it has also multiplied the number of MCAs requiring execution for each product by a factor of four (one each for Europe, North America, Japan and Asia excluding Japan).

Therefore the amount of effort required to execute all current MCAs for one product with a single counterparty is significantly increased.

2010: the way forward

For the 2010 Definitions to be a success, the first step must be to identify the key objectives. What do we want to achieve?

The initial reference point should be the Fed targets. These commitments have proved across all asset classes to be the most effective tool for improving operational efficiency and reducing the operational and legal risk inherent in the OTC confirmation process.

Therefore these goals should be the primary drivers for the 2010 Definitions.

The latest commitments continue to strive for an ever-increasing percentage of OTC transactions to be confirmed electronically, and this trend will persist for some time to come. Therefore, the obstacles preventing this happening must be eliminated.

As indicated earlier, one of the major reasons not all eligible transactions are processed electronically is the current MCA process. Consequently, the 2010 Definitions must be constructed in a way that removes the reliance on bilateral side agreements.

The easiest way to do this is to revert to the traditional ‘single agreement, combined component’ approach.

A confirmation would be used that references the Master Agreement signed between the parties and the relevant ISDA Definitions, which, combined, give a single legal agreement that contains the parameters of the trade.

However, to facilitate electronic matching the confirmation will have to be a similar length to the MCA transaction supplement – containing only trade-specific economic details.

Therefore it is imperative that the vast majority of the terms are agreed up front in the Definitions, and that where defined terms have elections, default definitions are agreed.

One size doesn’t fit all

The good news is that much of the groundwork has already been done during the MCA negotiation process.

Rather than reinventing the wheel, the negotiators should use the terms and default elections in the existing MCAs as a basis for the 2010 Definitions.

What has become clear, though, during the past five years, is that the one-size-fits-all approach adopted in the 2002 Definitions does not work.

The aim should still be for most terms to be consistent for each product, as the core product should be fundamentally the same wherever is traded.

However, because in different regions the product may be traded or hedged in different ways, certain terms (such as Settlement Price, Share Adjustments, Extraordinary Events and Additional Disruption Events) may require different default elections to reflect these market divergences.

To cater for this we propose that the 2010 Definitions are split into two distinct sections: the core definitions booklet and an election matrix.

The core booklet should, like the 2002 form, contain each defined term. The aim in the negotiations should be to rationalise the product templates so that unnecessary differences in terminology, born from the regional MCA process, are eradicated and a global standard is achieved, bar certain region-specific elections.

These regional elections should then be listed in a matrix appended to the core booklet.

This should work in a similar way as the matrix approach does for credit derivatives. It should be updated periodically, allowing flexibility in the event of subsequent changes in direction, which have been evident during the past five years of MCA negotiation.

These default elections should also extend across all geographies. It is ridiculous, for example, that at the moment vanilla options cannot be electronically matched for African, east European, Middle Eastern or Latin American underlyings, or for most global or multi-regional indices.

We also believe it would be useful for this matrix to include an annex that lists, firstly, each stock exchange with its default Related Exchange, Clearance System and region and, secondly, the most liquid indices with their default Exchanges, Related Exchanges and regions.

This would provide transparency around these terms in an area where, surprisingly, mismatches still occur.

Learn from other markets

As for the provisions currently included in MCAs to cope with specific types of client, we propose two courses of action.

If the provision drives an asset class-specific election then it should form part of the election matrix. However, if the provision is not asset class-specific (for example, it concerns the Calculation Agent) or is included due to in-house policy (such as additional representations) then equity derivatives should take their lead from interest rate and commodity derivatives and this should be either negotiated as a direct amendment to the ISDA Master Agreement, or else negotiated as an annex linked to this agreement.

Standardise the exotic

The other main focus for the 2010 Definitions should be to standardise more products.

The June 2009 commitments go further than before in driving operational performance improvements and responding to regulators’ demands for reform and greater transparency around over the counter derivatives.

The key commitment to satisfy these demands is to establish a centralised trade repository to record all OTC equity derivative transactions, as is being done for other asset classes.

For this to work effectively, however, agreement needs to be reached on how to reflect each product currently being traded.

It makes sense to use the 2010 Definitions as an opportunity to standardise terms beyond the traditional options, forwards and equity swaps, to help engineer this step change.

Agreed templates already exist for many of these products (including variance swaps and options, dividend swaps and variance swap dispersions) and these should be included in the new set of terms.

Provisions should be standardised for other commonly traded products (such as correlation swaps, option dispersions and share accumulators) as well as exotic products, which still make up a significant percentage of the equity derivative market.

Some of the changes for exotics should be relatively simple. Functionality should be extended to cover options that use notional amount as a basis rather than number of options.

Provisions for some exotic features can easily be incorporated: forward start, Asian In, digital or binary payouts and FX features (quanto, composite and cross-currency).

Even other exotics, such as cliquets, lookbacks and rainbows, are not exceptionally complex. Furthermore, as many exotic structures are combinations of exotic features, it should be easier to agree standard templates for these structures.

Standardising these terms would lay a common foundation for confirming and reporting exotics that does not exist today, and in the process would satisfy regulatory demands for more transparency.

Seize the moment

The 2010 Definitions give the market a golden opportunity to rectify past problems, harmonise current templates, standardise new products and provide a sound framework for processing OTC equity derivatives, well into the 21st century.

Leaders of the industry must seize this chance to change the market, before change is thrust upon them.

Nick Fry is a director and Ed Osbaldestin a manager in Sapient Global Markets