Implementation of the 2002 International Swaps and Derivatives Association equity derivatives definitions will expose derivative users to legal and basis risk and could result in temporary lapses in trading. The new definitions will likely benefit the market by increasing standardization, which then reduces legal basis risk, but in-house lawyers said they are bracing for a period of chaos while the definitions are implemented.
"There needs to be some consensus [about implementation], because in its absence the market could see an increase in unconfirmed trades," said Tim Hailes, senior equities lawyer at JPMorgan in London. ISDA recently asked houses if they wanted the trade group to set a mutually agreeable date to start using the new definitions. But firms rejected the idea because they are all at different stages in the adoption process.
For example, Goldman Sachs is prepared to use the new definitions by the end of this month or early February, JPMorgan needs until March or April to make sure that all of its systems are ready for the changes and Dresdner Kleinwort Wasserstein is in the middle, with plans to begin using the new definitions by the end of February or early March.
The legal risk largely stems from unsigned confirms as the trade confirmations are used to resolve disputes and will not be valid if they are not signed by both counterparties. In-house lawyers said they will try to avoid having unsigned confirms by using the 1996 definitions with amendments if a dealer or client is not ready to use the 2002 documents. The biggest concern would be trades where there are numerous counterparties used to offset risk, said Nick Knight-Evans, counsel at BNP Paribas in London. In that case, if some confirms use the new definitions and some use the 1996 ones, there will be basis risk.
Glen Rae, v.p. and general counsel at Goldman Sachs in New York and chairman of ISDA's North American equity derivatives definitions working group, said the firm is concerned about basis risk and he stressed that it underlines the importance of firms speaking to each other as early as possible. He is in the process of compiling a list of contacts at each bank to facilitate the process.
