COVID-19 Risks For Over-The-Counter Derivatives Markets

Law360 (March 19, 2020, 5:56 PM EDT) --
Akshay Belani
Akshay Belani
Abdulmajeed Alhogbani
Abdulmajeed Alhogbani
Brian Rogers
Brian Rogers
The outbreak of a respiratory disease, known as COVID-19, caused by a novel coronavirus has now been detected in 159 countries, areas or territories across the globe,[1] and has been designated by the World Health Organization as a pandemic.[2]

Countries have responded in various ways to curtail the spread of the virus, including by restricting travel[3] and establishing quarantines for affected persons, and in some cases, entire regions. In one example, the Chinese government ordered the shutdown of cities and factories and extended the Lunar New Year holiday.[4]

More recently, on March 13, President Donald Trump declared a national emergency, and in the following days added to travel restrictions on inbound travel from European countries,[5] including the U.K. and Ireland.[6] As COVID-19 continues to spread across the globe, other governments and local authorities may take similar actions, thus impacting their own local markets and businesses.

With respect to the over-the-counter derivatives market, actions taken by local authorities in response to the spread of COVID-19 may have an impact on the payment, settlement and pricing of over-the-counter derivatives transactions.

For example, government intervention or actions may cause an unscheduled bank holiday or an exchange, price source or settlement disruption, or may prevent parties from performing entirely. Some considerations with respect to certain asset classes of OTC derivatives are discussed further below.

Equity Derivatives

Most OTC equity derivatives transactions incorporate the International Swaps and Derivatives Association 2002 equity derivatives definitions. Under the equity definitions, an unscheduled exchange closure could be deemed a “disrupted day,” which can occur through (1) failure of an exchange to open, or (2) a market disruption event.[7]

A market disruption event can occur due to a trading disruption, exchange disruption or the early closing of an exchange. The equity definitions provide specific fallbacks during such disruptions wherein the prescribed valuation procedures for trades cannot be followed, such as delaying of valuation for up to eight scheduled trading days.[8]

FX and Currency Options

OTC FX and currency option transactions generally incorporate the ISDA 1998 FX and currency options definitions and for a number of closed-market currencies, standardized terms published by the Emerging Markets Trade Association.

A closure of a country’s banks and foreign exchange trading system, such as what occurred in China, could constitute a disruption event as defined in the FX definitions. Such events could result in delayed settlement of physically settled trades, the delay in exercise of currency option transactions and payment of premiums in respect of such options.

In response to China’s closure of its banks and foreign exchange markets, both ISDA and EMTA issued guidance for market participants whose trades were affected.[9]

Notably, the FX definitions include a material change in circumstance disruption event that could provide a catch-all ability for parties to terminate transactions upon the occurrence of an event not otherwise covered in the FX definitions and beyond the control of the parties makes it impossible for a party to: (1) fulfill its obligations under a transaction, and (2) fulfill obligations similar to such party’s obligations under that transaction.[10]

Note that the 1998 ISDA FX and currency option definitions also include a no-fault termination disruption fallback.[11] 

Commodity Derivatives

Most market participants trading in OTC commodities incorporate the ISDA 2005 commodity derivatives definitions into their transactions, which similar to other ISDA definitional booklets, provide, among other things, specific mechanics to adjust trades in circumstances where disruption events have occurred.

Unscheduled exchange closures in connection with countries’ responses to COVID-19 could result in price source disruptions in respect of particular transactions. Parties may specify the disruption fallbacks applicable to their transactions, provided that if none are specified, Section 7.5(d)(i) of the commodity definitions provides the disruption fallbacks and the order in which they apply.

ISDA Master Agreement

In addition to the effect on individual trades, disruption to normal workflow and accessibility may impact counterparty relationships more holistically. Both the 1992 and 2002 versions of the ISDA master agreement provide the overarching contractual framework between OTC derivatives counterparties under which parties may enter into transactions in numerous asset classes, including credit, equity, currency, interest rate and commodity transactions.

The ISDA master agreement governs the holistic credit and legal relationship between two OTC derivatives market participants. Thus, the agreement is specifically tailored to the particular circumstances between the parties.

The wider economic impact of COVID-19 will undoubtedly impact market participants in a number of ways, including from a credit risk perspective. Thus market participants may need to revisit their credit risk limits and controls vis-a-vis their trading counterparties in order to monitor or mitigate against defaults.

Further, depending on circumstances in the region, the ability to give proper notices to trading counterparties may become an issue, particularly for default notices where actual delivery by overnight mail or courier is generally required, including under the ISDA master agreement.

Impossibility, Impracticability, Frustration and Force Majeure

Market participants should also consider whether circumstances relating to the COVID-19 outbreak could constitute a force majeure or a similar event of default or termination event under certain trading agreements including the ISDA master agreement or other market standard master agreements.

Notably, the 2002 ISDA master agreement includes a termination event for force majeure whereas the 1992 ISDA master agreement does not. However, the user’s guide to the 1992 ISDA master agreement contains a similar impossibility provision which may be adopted by market participants.

The 2002 ISDA master agreement's force majeure event applies after giving effect to any product-specific fallbacks or remedies that may be contained in relevant product definitions applicable to a particular transaction.

It relates only to the relevant office of a party which is unable to make or receive a payment or delivery or comply with any material provision of the ISDA relating to a transaction and requires that the party (1) be prevented from performing or it becoming "impossible or impracticable” for that party to perform due to the force majeure event or act of state; (2) that the event be beyond the control of such party; and (3) that the party could not, after using all reasonable efforts, overcome such prevention, impossibility or impracticability.[12]

If the force majeure event is triggered, the parties are obligated to defer payments and deliveries during a waiting period for up to eight business days. Upon the expiry of the waiting period either party may elect to terminate some or all affected transactions upon two business days’ notice.

It remains an open question whether OTC derivatives market participants will actually be able to rely on a force majeure or impossibility provision. The provisions are narrowly tailored to circumstances where, due to a catastrophic event or through an act of state, presumably in response to a catastrophic event, performance is simply not possible. Thus nonperformance seems highly unlikely, particularly with respect to cash-settled transactions where performance by a party may simply rely on the ability to access computer and/or payment systems, which can be accessed remotely.

In addition, rules applicable to many swaps market participants have further mitigated such possible disruptions to the market. For example, under Rule 23.603 from the Commodity Futures Trading Commission, swap dealers are required to establish and maintain a written business continuity and disaster recovery plan that outlines the procedures to be followed in the event of an emergency or other disruption of its normal business activities and which is designed to enable the swap dealer to continue or to resume any operations by the next business day with minimal disturbance to its counterparties and the market.

Additionally, in the event a contract is silent on force majeure, certain jurisdictions (e.g., California and New York) also recognize a defense based on “frustration of purpose,” which releases a party from its contractual obligations where a supervening event substantially obviates/frustrates the purpose underlying the contract.

This doctrine applies when “the frustrated purpose is so completely the basis of the contract that, as both parties understood, without it, the transaction would have made little sense.”[13] Similar to impossibility, this doctrine requires that the frustration resulted from a change in circumstances that was unforeseeable and beyond the parties’ control.

It should be noted that, the frustration doctrine is unlikely to apply where performance under a contract would merely cause some degree of financial hardship.

Physical Commodities and Structured and Long-Term Arrangements

It seems the more likely application of the force majeure or impossibility provisions of the ISDA will be for physically settled transactions, such as for the purchase and sale of oil, gas or other commodities, including in connection with structured or other term supply and offtake arrangements.[14]

Although the above analyses apply with respect to physical commodities transactions, there is a greater likelihood of nonperformance in the context of physical commodities trading due to the physical delivery aspect. Additionally, longer-term arrangements often have separate force majeure provisions that apply to the entire arrangement, in addition to any force majeure or similar provisions that may be included in trade documentation and that may apply to individual trades.

In arrangements that have separate force majeure regimes with respect to individual trades and the arrangements as a whole, it is also important to analyze the relevant provisions that would govern in the context of the force majeure event (i.e., the terms of an individual trade or the term included in the framework for the arrangements as a whole).

While the financial, commercial and social impact of the COVID-19 outbreak has yet to be fully determined, derivatives market participants would be well served to perform assessments of its impact on their trading agreements and trading counterparts.

It should be noted that both industry groups[15] and regulatory authorities[16] are also examining these issues on a real-time basis, and market participants should avail themselves of information and resources provided by such sources.

Akshay Belani is a partner, and Abdulmajeed F. Alhogbani and Brian R. Rogers are associates at Stroock & Stroock & Lavan LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.







[7] Equity Definitions Section 6.3, General Terms Relating to Market Disruption Events.

[8] Equity Definitions Section 6.6, Consequences of Disrupted Days.


[10] FX Definitions Section 5.1(d)(viii), “Material Change in Circumstance.”

[11] FX Definitions Section 5.2(c)(ix), “No Fault Termination.”

[12] 2002 ISDA Section 5(b)(ii).

[13] PPF Safeguard, LLC v. BCR Safeguard Holding, LLC , 85 AD3d 506, 508 [1st Dept 2011].




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