It is tempting to think most market transactions have their own standard form agreements: if a deal can't be done under Isda (International Swaps and Derivatives Association) terms, it can't be worth doing. However, exchange-traded futures and options have only recently received their own standard terms, courtesy of the Futures and Options Association (FOA).
The reason is that derivatives exchanges are among the most heavily regulated markets and so the need for such contracts may not have been obvious. But if you are, say, a bank in New York or London, dealing on a client's behalf in an overseas futures market, you and your client may have less protection than you think. One of the problems is netting.
The way such a deal is done is by contacting a local broker in the overseas futures market and doing the deal through him. He would act either as agent or, more likely, as principal, executing a back-to-back deal on the floor of the exchange. The contract you receive is in the local language, subject to local law, and non-negotiable because it is in the form laid down by the exchange, or because it is in a standard form which was never negotiated.
Hitherto, most banks' practice when confronted with such an agreement is to bin it, file it, ignore it or - occasionally - to sign it. If a translation of the agreement is offered it usually turns out to be couched in regulatory rather than legal language. The local broker, after all, is simply seeking to subject you to the same terms under which he is allowed to do business by his exchange.
So far, so good - unless your local broker goes bust. At that point you are up against local insolvency law which can require you to keep your side of the bargain, for instance making a settlement payment, even though it will disappear into a black hole from which you are unlikely to receive any payments in return. At this point you reach for the applicable agreement and discover it contains what is called one-way netting: the local broker can net against you, but not vice-versa.
This is where the FOA has come to the rescue. The FOA master netting agreement was finalized earlier this year and is being implemented by users. It provides one-way and two-way netting, although the latter is preferred.
The timing is appropriate. Netting is at the top of banking lawyer's concerns, particularly in the foreign exchange market where it has prompted proposals ranging from Echo and Multinet to the G20 settlement bank. Futures exchanges are increasingly aware of the possibility of meltdown through member defaults. In the last few months the London Clearing House and the Board of Trade Clearing Corporation have arranged stand-by facilities which provide default insurance, illustrating the convergence between the capital and insurance markets in which exchange-traded catastrophe derivatives are playing an increasingly significant role.
Whether the FOA master netting agreement works when it is needed most depends on whether its provisions prevail in the event of a local broker's insolvency. The FOA is obtaining legal opinions from 36 jurisdictions, covering the principal financial markets, which confirm that it does.
However, the problem may lie in implementation. Local brokers may be prepared to sign the FOA agreement, but without abandoning their existing contract. What then happens is what English lawyers call "the battle of the forms" in which the parties argue over whose contract prevails, usually in court - which removes the commercial certainty which such contracts are supposed to provide.
The FOA agreement is written under English law. But the local broker's contract is under, for example, Spanish law and what happens on his default will be determined by the applicable Spanish insolvency law. Having a legal opinion which says the FOA agreement prevails in the face of Spanish insolvency law is fine - provided the FOA agreement is the only one governing the transaction. It may not be if, for instance, a previous course of dealing supports the application of the local broker's contract, which you were binning or filing. Isda has not had to cope with this sort of a problem because its terms were legislating in essentially greenfield situations where neither side had a vested interest in ensuring that its prior form of contract prevailed.
The FOA is aware of this. Its guidance notes acknowledge that "the agreement is intended to operate in addition to any general terms of business between the parties (customer agreement). It is important to ensure that there are no inconsistencies between the provisions of any customer agreement and the provisions of the [FOA agreement]. Any inconsistencies should be removed by amending the customer agreement. Even where no inconsistency is immediately apparent, the agreements should make it clear which of them will prevail if an inconsistency arises. If the [FOA agreement] does not prevail, this will limit the reliance that should be placed on it both for regulatory and credit risk assessment".
But the FOA agreement may not be accepted by the counterparty, the local broker, without modification. The guidance notes warn: "If the [FOA agreement] is materially modified, there is substantial risk that the legal opinions [saying that it works in the event of the local broker's insolvency] will not apply."
This does not mean the FOA agreement is worthless. On the contrary, it will work in those markets such as Chicago and London where the volume is greatest. But it may not be so easy to implement in those markets where perhaps the need is greatest.
"There is a temptation to assume that standard forms provide all of the solutions, but when you are trying to implement something like the FOA agreement globally, it is often not as easy as it looks," says Iona Levine, who heads the derivatives practice at Hammond Suddards and was previously at HSBC/Midland.
"I see the FOA agreement as only a partial stop-gap solution. I would like to see the industry go back to the drawing board, tackle the problem of the overseas brokers' local law agreements and completely rethink how they document cross-border transactions. For example, Isda was able to get overseas entities to contract on the basis of standard forms documents governed by New York, English or Japanese law. A similar Isda-style exercise should be attempted in these markets."