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Approaching Terminal Complexity? ISDA Publishes JMP


On 3 May 2016 The International Swaps and Derivatives Association (ISDA) launched the “ISDA Resolution Stay Jurisdictional Modular Protocol” (the “JMP”).  The JMP is designed to enable market participants to comply with regulations in a number of jurisdictions which, broadly, require banks to obtain consent from their counterparties for the inclusion of statutory stays on early termination rights within financial contracts executed between those parties.  In doing so it seeks to address, in part, the continuing problem of “too big to fail” – enhancing cross-border enforceability of contractual stays and so strengthening the ability of regulators to resolve failing banks.

The Protocol

The JMP creates an overarching framework through which adhering parties can amend in-scope documentation in accordance with jurisdiction specific requirements.  At a high level, the JMP amends “Protocol Covered Agreements” executed between “Module Adhering Parties” and “Regulated Entity Counterparties”.  The more granular jurisdiction-specific requirements – for instance, defining the concept of a “Protocol Covered Agreement” within the context of a particular jurisdiction – are left to ‘Jurisdictional Modules’, to which counterparties can adhere on an individual basis.

When amending its “Protocol Covered Agreements”, a party can adhere to the JMP in its capacity as (a) a “Module Adhering Party”, (b) a “Regulated Entity”, or (c) both.  As such, the following definitions are key to understanding the operation of the JMP:

“Protocol Covered Agreements”

“Protocol Covered Agreements”: any type of agreement that is within the scope of relevant stay regulations.

“Module Adhering Parties” and “Regulated Entity Counterparties”

  • “Module Adhering Party”: a party which is willing to amend its in-scope financial contracts via adherence to the JMP. A Module Adhering Party can be either a buy-side firm or a regulated sell-side firm but, in the main, this group will be represented by buy-side firms to a greater extent.  Adherence can be as principal or agent and on behalf of all or some only of a firm’s underlying clients, with the ability to make different elections for different groupings of those clients;
  • “Regulated Entity”: a party which is also willing to amend its in-scope financial contracts via adherence to the JMP. In practice, a Regulated Entity will be a regulated sell-side firm which is subject to contractual stay requirements in a particular jurisdiction.  However, a Regulated Entity may also adhere to a Jurisdictional Module as a Module Adhering Party in order to satisfy the regulatory obligations applicable to its counterparties that are also Regulated Entities.   It is expected that parties that have adhered to the ISDA 2015 Universal Protocol will generally also adhere to the JMP in order to comply with applicable stay regulations; and
  • “Regulated Entity Counterparty”: a Regulated Entity which is identified (whether individually or by virtue of its membership of a particular set) by a Module Adhering Party as a firm with which the Module Adhering Party has in-scope documentation which it is willing to amend via adherence to the JMP.

The Module

Parties achieve jurisdiction-specific compliance by adherence to one or more ‘jurisdictional modules’.  Each module is tailored so that only the amendments required by the stay regulations of the jurisdiction in question are made to the particular type of agreements (known as “Covered Agreements”) covered by those stay regulations.  As such, each module will firstly define, and then amend, a Covered Agreement differently depending on what is required by the underlying stay regulation.  Rather than amend existing clauses of Covered Agreements, modules will introduce new clauses that govern when certain rights under those agreements can be exercised.  In preparing modules, ISDA will follow the text of finalised stay regulations to the greatest extent possible.

The first module to be finalised is the “UK (PRA Rule) Jurisdictional Module” (the “UK Module”).  This enables firms to comply with Prudential Regulation Authority (“PRA”) requirements that prohibit certain UK-regulated banks from trading with a counterparty under an agreement not governed by EEA law, unless that counterparty has agreed to be bound by stays on termination rights under UK law.  The definitions under the UK Module are tailored to be consistent with PRA Policy Statement 25/15.  As such, under the UK Module:

  • “Regulated Entities” means, broadly, “BRRD Undertakings”[1]; and
  • “Covered Agreements” includes all “third-country law financial arrangements”.

The new provisions introduced by the UK Module mean that if a “crisis prevention measure”,  “crisis management measure”, or “recognised third-country resolution action” is taken in relation to a Regulated Entity Counterparty or any “member” of the same “group” as such Regulated Entity Counterparty, the Module Adhering Party is entitled to exercise “termination rights” under, or rights to enforce a “security interest” in connection with, the Covered Agreement, only to the extent that it would be entitled to do so under the “Special Resolution Regime” if such Covered Agreement were governed by UK law.  The amendments take effect from:

  • 1 June 2016 if, broadly, both parties are Regulated Entities; and
  • 1 January 2017 otherwise.

Additional modules will be published for other jurisdictions as the requirements in those jurisdictions are finalised.

Identification of Regulated Entity Counterparties

A Module Adhering Party that is subject to regulation in a jurisdiction can identify itself as (a) a Regulated Entity with respect to the module for such jurisdiction and (b) as being a member of a G-SIB group.  Doing so allows ‘buy-side’ Module Adhering Parties with respect to that module to “opt in” and so amend in-scope documentation with respect to the Regulated Entity.  For their part, ‘buy-side’ Module Adhering Parties can identify one or more “Regulated Entity Counterparties” in a protocol adherence letter in order to facilitate the process of counterparty matching.  A “Regulated Entity” which is an “Adhering Party” is bound to amend any Protocol Covered Agreements in relation to which it has been identified as a “Regulated Entity Counterparty” by a “Module Adhering Party”.  Buy side firms have one of three options when identifying “Regulated Entity Counterparties” with which they are willing to amend in-scope documentation.  They can identify:

  • “All Regulated Entities”: indicating a willingness to be bound to amend in-scope documentation with all Regulated Entity Counterparties (both existing adherents and future adherents);
  • “All G-SIBs”: indicating a willingness to be bound to amend in-scope documentation with all “Regulated Entity Counterparties” which are members of any G-SIB group (both existing adherents and future adherents); or
  • “Entity-by-Entity”: indicating a willingness to be bound to amend in-scope documentation with individually identified Regulated Entity Counterparties. This is achieved by sending the Regulated Entities in question notice of the election to treat them as such (a “Module Adherence Notice”).

Operation of the JMP

Amendments made by the JMP apply to existing liabilities under existing Covered Agreements (i.e. retrospectively) and to new transactions entered into under existing Covered Agreements (i.e. prospectively), even though the former may not always be a regulatory requirement (as is the case in the UK).  Note, however, that JMP amendments will not apply to wholly new agreements entered into after the date that both parties adhere to a particular module.  As such, it will be up to those parties to ensure that templates are updated to include provisions which will implement the necessary amendments.  The one partial exception to this rule relates to clients added to an existing umbrella master agreement after the date of adherence to the JMP.  Such clients will be added to the master agreement as amended, unless the parties agree otherwise.  Of course, as with many ISDA protocols, an adhering party is, between 1 October and 31 October in any year, entitled to deliver a notice to ISDA withdrawing its adherence from the JMP as of 31 December that year.  Whilst this will not revoke amendments already made, it will mean that the party in question is not bound by any counterparty which subsequently adheres to the JMP.

Approaching Terminal Complexity?

As with all ISDA protocols, the JMP is intended for use without negotiation or amendment.  This is a necessary constraining factor for any solution which seeks to provide an industry-wide compliance mechanism.  The inevitable downside is that adherents must accept a degree of complexity that would not be present in the case of a bilateral amendment.  However, the real risk lies not within the JMP itself.  With a little effort it is relatively easy to understand both the new mechanism for adherence and the amendments it seeks to implement.  The greater risk – at least for any firm with a reasonable size portfolio of in-scope agreements – lies in how to monitor compliance.

As they are finalised, ISDA will publish additional modules to which parties can adhere by way of separate adherence letter.  Given the current state of underlying regulation, the task of finalising additional modules is likely to take many months to complete.  As such, achieving overall compliance will inevitably be a staggered and extended process.  In addition, adhering parties will be required to monitor the JMP and its modules on two levels before it will be possible to conclude with certainty that a particular contractual arrangement has been successfully amended.  The first level involves monitoring counterparty adherence, in terms of understanding (a) the identity of counterparties, (b) whether any jurisdiction-specific definitional requirements have been satisfied in order to bring a particular counterparty in-scope for the purposes of a particular module, and (c) whether an in-scope counterparty has actually adhered.  The second level will require firms to monitor the status (finalised or otherwise) of the modules which would apply to their in-scope agreements.  As a pre-condition to this, it will be necessary to understand which agreements are actually in-scope – both as a matter of law and as a matter of fact – in relation to any particular module to which a firm intends to adhere.  This will not be a trivial exercise and the process is not helped by the fact that, at least in the case of the UK Module, the PRA ultimately leaves it up to the parties themselves to decide the answer to this question.

Although ISDA should be applauded for its efforts in relation to the JMP, the market – encouraged by regulators in this case – is becoming increasingly reliant on protocols as a tool to manage the industry-wide amendment of large portfolios of documentation in response to complex and changing regulatory requirements.  As a result, protocol data is becoming an increasingly important element for any firm wishing to form an overall view of its contractual rights and obligations.  Unfortunately, in terms of sophistication, current practices in the collection and analysis of protocol data lag well behind the protocols themselves.  Whether the risk associated with protocols is increasing at a greater rate than the benefits they offer, only time will tell.  We have not reached terminal complexity just yet, but one has the sense that the boundaries are beginning to be tested.  But be warned – WGMR compliance is next on the regulatory agenda.  This will require repapering of CSAs on a scale as yet unseen, both in terms of volume and complexity.  This may be the protocol to end all protocols.  Either way, we won’t have to wait too long to see.

[1] Operators of settlement and payment systems, exchanges, CCPs and other market infrastructure, as well as central banks and governments are excluded

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