The over-the-counter interest-rate and currency derivatives market has continued to experience spectacular growth. From mid-2005 to mid-2006 alone, it is estimated that the notional amount outstanding of interest-rate and currency derivatives rose 25%, from approximately USD200 trillion to over USD250 trillion. To respond to market developments and to help promote further growth, the International Swaps and Derivatives Associationpublished the 2006 ISDA Definitions, updating its core definitions for OTC interest-rate and currency derivatives. This Learning Curve outlines the most noteworthy developments reflected in the 2006 Definitions.
Replacing The 2000 Definitions
The 2000 ISDA Definitions were designed to have a flexible structure that would enable ISDA to keep pace with market developments by publishing supplements that added provisions covering, for instance, new currencies and new floating-rate definitions. By 2005, however, it was clear that developments in markets and market practice meant that a thorough review of the 2000 Definitions would be worthwhile. The result of this review, which lasted over a year and involved dozens of ISDA member firms, was the publication of the 2006 Definitions. It is expected that the 2006 Definitions will quickly succeed the 2000 Definitions as the market-standard set of terms for documenting OTC interest-rate and currency derivative transactions.
Structure
Unlike the 2000 Definitions, which included an annex containing floating-rate definitions and related provisions, the 2006 Definitions are contained in a single document. This consolidated approach allows for convenience of reference while retaining the flexible structure of the 2000 Definitions, since ISDA contemplates that it will, again, publish amendments and supplements to the 2006 Definitions on its Web site. When parties incorporate the 2006 Definitions into a document, they are presumed to incorporate the 2006 Definitions as amended and supplemented through the date of their agreement. If, therefore, the parties are happy to incorporate all amendments and supplements to the 2006 Definitions published by ISDA through that date, there is no need to refer to amendments or supplements in the relevant document. If, however, they wish to exclude one or more amendments or supplements, they can, of course, specifically provide for this.
Swaption Straddles
The 2006 Definitions incorporate and refine swaption straddle provisions that were first published in one of the supplements to the 2000 Definitions. Swaption straddles are transactions consisting of two swaptions, each relating to a different underlying swap. Under one underlying swap (called an underlying payer swap), the buyer is the fixed-rate payer, and under the other (called an underlying receiver swap), the buyer is the floating-rate payer. Where the swaption straddle is European-style, the buyer, on the expiration date, may exercise only one of the swaptions. Thus, the buyer effectively has the right to enter into a swap on specified terms as either the fixed-rate payer or the floating-rate payer.
The 2006 Definitions also include provisions relevant to American- and Bermuda-style swaption straddles. As with European-style swaption straddles, on the expiration date the buyer under an American- or Bermuda-style swaption straddle may exercise only one of the swaptions. The distinctive feature of these styles of swaption straddles, however, is that if the buyer exercises one of the swaptions on a day during the exercise period prior to the expiration date, it may still exercise the other swaption on a subsequent day in the exercise period.
In addition to providing definitions and provisions relating to swaption straddles, the 2006 Definitions include an updated form of confirmation that parties can use to document a swaption or a swaption straddle.
Mark-To-Market Currency Swaps
The 2006 Definitions also contain new definitions and provisions relating to mark-to-market currency swap transactions. Parties can use these types of currency swaps to periodically eliminate exposure arising from movement in the relevant currency exchange rate. Under a mark-to-market currency swap, the currency amount for one party--known as the variable currency amount--is subject to adjustment at the beginning of each calculation period while the currency amount for the other party--known as the constant currency amount--remains constant. The adjustment in the variable currency amount is determined by reference to the constant currency amount and the then-prevailing currency exchange rate for the currencies involved. In addition, on each payment date, an amount is payable by one party to the other calculated by reference to the amount of any such change in the variable currency amount. This mechanism thus eliminates, on an ongoing basis, exchange-rate exposure arising from the beginning of one calculation period to the beginning of the next. The 2006 Definitions also include a form of confirmation for a mark-to-market currency swap.
Matrices
The ISDA Settlement Matrix for Early Termination and Swaptions, which was originally published for use with the 2000 Definitions, is to be refreshed for use with the 2006 Definitions. As we write, ISDA is also working on finalizing the terms of a new matrix, the 2006 ISDA Definitions MTM Matrix for Mark-to-Market Currency Swaps.
The Settlement Matrix and MTM Matrix will each specify, for certain types of transactions, a range of standard elections for terms and provisions that would otherwise be negotiated and included in the related confirmations. Where a matrix applies to a transaction, these standard elections will be deemed to apply and the parties will not need to define the relevant terms in their confirmation unless they wish to make an election that differs from that specified in the matrix.
The Settlement Matrix is deemed to apply to (i) transactions that feature optional or mandatory early termination provisions and (ii) swaptions, in each case where they involve a currency that is included in the Settlement Matrix. Similarly, the MTM Matrix is deemed to apply to mark-to-market currency swaps that involve a currency pair that is included in the MTM Matrix. As with other presumptions contained in the 2006 Definitions, parties to a relevant type of transaction are free, if they so wish, to exclude the application of either matrix in their confirmation.
ISDA intends to update and/or expand each matrix from time to time and to publish each new version on its Web site. Parties should note that when they enter into a transaction to which a matrix applies, the version of the matrix that will be deemed to apply will be the most recently published version of the matrix as of the date on which they enter into that transaction. Parties who wish to apply the terms of an earlier version of the matrix can provide for this in their confirmation.
Rate Options
Many of the rate options--floating-rate definitions--contained in Section 7.1 of the 2006 Definitions have been amended, in many cases to take account of Reuters' acquisition of the Telerate service. Additionally, a number of new definitions have been included, partly to provide market participants with alternative definitions for a particular floating rate, each one referencing a different information vendor. As in the various predecessors of the 2006 Definitions, each rate option continues to refer to only one information vendor or other source in order to ensure certainty in the case of dispute. Further, parties to a transaction remain free to define their own floating rate option in a confirmation and, where they specify one of the rate options included in the 2006 Definitions, to amend the terms of that rate option in the confirmation.
Day Count Fractions
The 2006 Definitions include some changes to the day count fraction definitions that were contained in the 2000 Definitions. Many of the changes are intended to clarify the way in which a day count fraction is intended to operate in practice, but two new day count fraction definitions have also been introduced. The new day count fractions are "Actual/Actual (ICMA)", which is based on Rule 251 of the statutes, by-laws, rules and recommendations of the International Capital Market Association, and "30E/360 (ISDA)", which is designed to yield the same results in practice as the "30E/360" day count fraction included in the 2000 Definitions ("30E/360" is retained in the 2006 Definitions but has been amended in order to try to reflect usage by other organizations and software vendors).
Key Changes
* New coverage for swaption straddles and mark-to-market currency swaps
* Application of Settlement Matrix and MTM Matrix
* New currencies added
* Day count fractions refined; "Actual/Actual (ICMA)" added
* Rate options updated and expanded
* Arrears setting concept added
* FRA yield discounting added
* Simplified approach for settlement rate on automatic exercise or fallback exercise
| David Vincent |
| John Berry |
This week's Learning Curve was written by John Berryand David Vincent, associates in the derivatives and structured finance group at Allen & Overyin London.
