The 2005 Novation Protocol was published Sept. 12 by the International Swaps and Derivatives Association partly as a result of the pressure which regulators have put upon their regulated institutions to cut backlogs of trade confirmations, and partly as a result of the evolution of market practices whereby novations are not effected legally, despite the intention of the parties involved.
Background
Before the Protocol, contracting parties wishing to trade derivatives relied on the terms of one of the forms of the ISDA Master Agreements. Section seven of the Agreement clearly states that no transfers of the Agreement, or any interest or obligation thereunder, by either party may occur without the prior written consent of the other party. It is the obtaining of this prior written consent which is the key to effecting a legal novation. Further, English law provides that to execute a novation no rights or obligations under the old agreement are transferred but instead the old transaction is simply cancelled and new, economically equivalent rights and obligations come into effect between the transferee and the remaining party. In other words, a new contract is substituted for an existing contract and the existing contract is discharged.
In order to understand the effect of the Protocol, it is important to be familiar with the parties and sequence of events involved in transferring a trade by way of novation. For example, take a credit derivative trade (the Original Trade) which has been entered into between two parties--the Remaining Party (typically a dealer) and a Transferor (typically a hedge fund). Later the Transferor decides to novate the Original Trade to a third party, the Transferee (typically a dealer). This results in a trade between the Transferee and the Remaining Party (the New Trade). The marked-to-market price of novating the Original Trade to the Transferee shall be agreed between the Transferor and the Transferee, immediately after the Transferor cancels the Original Trade and the Transferee books the New Trade with the Remaining Party as its counterparty. Seemingly, a novation has successfully occurred; but has it?
Existing Bad Market Practices
In the above scenario, each of the three parties may have been guilty of contributing to the evolution of bad market practices. The Transferor may have failed to get the Remaining Party's prior written consent to both the novation of the Original Trade and the entering into of the New Trade with the Transferee, or the Transferee may have booked the New Trade with the Remaining Party as its counterparty without first confirming this with the Remaining Party. And finally, the Remaining Party, when it discovers a novation has already occurred, may have back-dated its books to the purported Novation's trade date and may have merely changed its counterparty's name on the Original Trade ticket rather than cancelling it and rebooking a new trade.
If a legal novation has not been properly executed, the Agreement states that such transfers would be void resulting in the fact that the Original Trade would still be valid and binding between its original contracting parties. Therefore, problems would arise if a party wrongly believed that it had legally novated a trade to a third party and as a result, had cancelled that trade and its corresponding hedge in its books and then finds out, usually after a credit event has occurred, that it is being called upon to settle a trade for par as seller of protection.
The Protocol's Procedures
The Protocol, which comes into effect Oct. 24, 2005, sets out, in effect, a set of clear best practice procedures for all three parties to follow in order to achieve a legal novation of a credit derivative or an interest rate transaction. Rather than amending the Agreement, as is the purpose of ISDA Protocols, the Protocol enhances the Agreement by setting out the steps which should be taken to obtain the Remaining Party's prior written consent.
The key points to note about the Protocol are:
* When the Transferor agrees with the Transferee (whether orally or otherwise) a marked-to-market price to novate an Original Trade, the Transferor and the Transferee are legally bound by the terms of such novation subject only to evidence of the Remaining Party's consent being received by the Transferee not later than 6p.m. that day (Transferee time);
* It is the Transferor's obligation to obtain the Remaining Party's consent to the novation, which consent shall be requested, and received, by an exchange of electronic messaging (e.g. Bloombergs or e-mails); the form of which is set out at the back of the Protocol. The Transferee should be copied in on this exchange but it is still the Transferor's obligation to ensure the Transferee has received a copy of such consent;
* When the Transferee receives evidence of the Remaining Party's consent, the Transferee must confirm, by electronic means, the details of the New Trade with the Remaining Party;
* If the Remaining Party's consent has been received by the Transferee, in electronic form, by 6p.m. that day (Transferee time), the Original Trade shall be cancelled and the New Trade shall be booked between the Remaining Party and the Transferee;
* If, for whatever reason, the Remaining Party's consent has not been received by the Transferee, in electronic form, by 6p.m. that day, a New Trade shall be booked between the Transferee and Transferor that day, which will effectively act as a hedge for the Transferor;
* If the Remaining Party's consent is given or received the next day, the New Trade still remains valid and binding unless all three parties then agree to novate the Original Trade that day; in which case the Protocol procedures shall need to be followed again with a new on-market price agreed between the Transferor and Transferee. In addition the New Trade, booked the day before, will need to be cancelled upon the successful completion of the novation; and
* The Remaining Party will still send out a Novation Confirmation to be signed by all three parties evidencing the occurrence of the novation but failure to execute this document will not affect the validity of the novation itself.
Early indications show that the Protocol has been well received by the dealers (and their regulators); to date approximately 47 dealers have submitted their adherence letters to ISDA. Response from the hedge funds, however, has been slow; only four hedge funds have similarly responded to ISDA. The feeling amongst the hedge fund community seems to be that the 6p.m. deadline for obtaining the Remaining Party's consent is too restrictive and they would prefer to revert to obtaining such consents orally. Only time will tell if the Protocol is successfully adopted by the majority of market participants, but one thing is certain: market participants are now aware of the legal principles of transfers by way of novations. While the Protocol's procedures may be inconvenient for some in the short term, adherence to these procedures will introduce certainty to the markets and will eliminate a large amount of needless risk.
This week's Learning Curve was written by Virginia Laird, director in the legal and compliance department at Credit Suisse First Boston in London.
