Derivative financial instruments in international commercial turnover

In case of ETDs, respective trading rules are key regulation for trading derivatives on particular stock exchange as they determine procedure for execution of the derivative contracts. However, typically they are not the only documentation influencing transactions on ETDs. This is because currently, ETDs, as a rule, are subject to clearing. post-transaction management that ensures that transactions on an exchange will settle. Under Art. 2 point 3) of the Law on Clearing, clearing is “the determination of the obligations to be fulfilled, arising from the agreements, including as a result of the netting of obligations, and the preparation of documents (information), which are the basis for the termination and (or) fulfillment of such obligations, as well as ensuring the fulfillment of such obligations”. For ETDs market, indirect, central clearing provided by central clearing counterparty (hereinafter: CCP) is typical rather than ad hoc bilateral arrangements. For example, under Article 29 of MIFIR, which directly applies to all EU Member States, the operator of a regulated market (i.e. stock exchange) shall ensure that all transactions in derivatives that are concluded on that regulated market are cleared by a CCP.Also in the Russian Federation, central clearing for ETDs is obligatory. Under Art. 51.4 item 1 of the Law on Securities Market, participants to the organized trading are allowed to conclude contracts that are derivative financial instruments on the organized trading if the other party is a CCP.

Indirect clearing is a chain of contractual relationships and payments that enables a party not being a client of a clearing firm to trade a cleared derivative. CCP in its turn is a an entity (clearing house) separate from the stock exchange and designed to reduce and manage various risks (e.g. counterparty, settlement, operational, default risks) through performance of two primary functions i.e. settlement and clearing of transactions. Concisely, once two parties have executed a trade (entered into transaction), it is submitted to a CCP, which becomes the counterparty of the original buyer and seller, collects collateral deposits (also referred as “margin deposits”) and, consequently, serves as guarantor of the settlement of the transaction. Keeping above in mind, in order to fully understand legal implications of entering into ETD contract not only trading rules require analysis, but also relevant clearing rules adopted by entity performing functions of a CCP for derivative contracts entered into on a particular stock exchange.

Historically, central clearing has been associated mostly with ETDs, whereas OTC derivatives used to be largely unregulated and cleared typically based on ad hoc bilateral arrangements on the voluntary basis. This has changed in the aftermath of 2007-08 financial crisis. The heads of states and governments of the G20 reached an agreement in the aftermath of Pittsburgh summit in 2009 and initiated a reform of the derivatives market aiming to improve the transparency on the OTC derivatives markets, increase protection against market abuse and reduce systemic risks. One of the means of achieving these objectives has been adoption of regulations that require central counterparty clearing of standardized OTC derivatives. The very first of these regulations were adopted in the U.S. in 2010 (Dodd-Frank Act) and in the EU in 2012 (EMIR). Regulations, among others, set out comprehensive criteria for determining when standardised OTC derivatives require obligatory clearing. For example, under EMIR, the clearing obligation applies to contracts between any combination of financial counterparties and non-financial counterparties who exceed the clearing thresholds, subject to certain exemptions. Based on draft regulatory technical standards developed by ESMA, the European Commission decides whether a class of OTC derivative contract is subject to a clearing obligation (e.g. interest rate OTC derivatives classes such as basis swaps and fixed-to-float interest rate swaps denominated in the G4 currencies - EUR, GBP, USD, JPY) and from when the clearing obligation takes effect.In the professional literature, it is often emphasized that despite the announced great changes on the OTC derivatives market, the new regulations proved to be lenient. Although Russian Federation is one of G20 countries, as of now it has not yet adopted similar regulatory solutions. However, the Bank of Russia expects clearing of OTC derivatives with the CCP to be mandatory in the near future.

Despite the fact that cross-border OTC derivatives contracts are based on the standard documentation, which sets out rights and obligations of the parties in details, still there is a need for determination of the governing law. In this respect, it may be argued that all contracts with international element ought to have valid governing law clause. Shall the parties fail to effectively choose governing law, it is determined by the reference to the relevant private international law. Private international law, traditionally both in the common law system and the Romano-Germanic system of continental law, cover(at least)conflict of laws rules that allow determining law applicable to particular legal relationship complicated by the foreign element. Therefore, private international law governs, among others, the resolution of conflicts between different systems of law as to which jurisdiction's system of rules should apply in relation to a dispute. Typically, private international law of the court deciding the case is applied. However, e.g. in case of international arbitration views on which particular private international law should apply are more diverse. Regardless of the detailed analysis of the particular concepts, there is no doubt that norms of private international law are of paramount importance in the global financial markets, on which cross-border contracts are concluded on regular basis. Further in this Section issue of law applicable to derivative contracts will be analyzed from the perspective of EU and Russian private international law.

Section 13(a) of ISDA MA stipulates that the agreement is governed by and construed in accordance with the law specified in the Schedule. In its turn, standard Schedule offers a choice between English law and New York law, however, the latter shall apply without reference without reference to the choice of law doctrine. According to ISDA, “virtually all of the ISDA Master Agreements entered into between counterparties based in the EU or EEA are governed by English law. Counterparties typically also submit to the jurisdiction of the English courts”. It is worth noticing that both New York law and English law are common law legal systems. Thus, it appears that in case of OTC derivatives contracts in the international turnover, common law “prevails” over civil law system as a whole. In any case, as it follows from the wording of Section 13(a) of ISDA MA, standard OTC documentation promotes, no matter how limited in practice, express choice of law. On the side note, there are concerns that the United Kingdom's departure from the European Union, which took place on 31 January 2020, will reduce the use of English law derivatives documentation. In response to so called Brexit, in June 2018 ISDA published new Irish and French law governed versions of 2002 ISDA Master Agreement adding to the existing English, New York and Japanese law versions. New forms of ISDA MA are intended for those counterparties that may prefer to retain specific benefits of EU legislation and to have EU Member State court jurisdiction. These benefits are e.g. protections under certain EU national insolvency laws that require the governing law of the contract to be the law of EU Member State in order to receive those protections, as well as automatic recognition and enforcement of court decisions across the EU and European Economic Area. Whether these concerns prove to be justified remains to be seen, however, up to now English law has been most frequently chosen governing law for ISDA MA in international turnover.

The express choice of the parties on the governing law has several advantages. Firstly, choice of law adds certainty to the contractual relationship. Parties may in advance assess the approach and principles to construction which govern the contract. At the outset parties know how particular problem which might arise through their agreement will be treated. Secondly, express choice allows for avoiding dispute on the governing law itself. Shall the dispute between the parties arise, issue of law applicable to the contract may delay the time at which the court addresses subject matter of the dispute and, as a result, make litigation longer and more expensive. It has to be noted, however, that governing law clause applies only to the agreement itself. Thus, if a claim e.g. in tort is brought in relation to the agreement, that claim may not be necessarily governed by the law applicable to the contract itself.

In the EU in relation to contractual relationships affected by foreign element, including cross-border derivatives contracts, created on or before 17 December 2009, the governing law is determined by reference to the Rome Convention. On the other hand, for contracts created after 17 December 2009, the Rome I Regulation applies. Previous law will continue to have impact on the master agreements concluded before cut-off date as well as to confirmations of complex cross-border derivatives contracts with a long lifespan. In the context of the above, the question may arise what regulation shall apply to the particular derivative contract documented by Confirmation after 17 December 2009, if it is subject to the master agreement concluded before that date and providing for “single agreement” approach e.g. ISDA MA. In other words, what is the date of creation of the contract subject to master agreement in the light of “single agreement”? A. Hudson correctly points out that aim of the “single agreement” provision is to create link between otherwise unconnected transactions in order to allow for netting of obligations arising from all transaction concluded between the counterparties upon insolvency of one of the parties. In general, this provision should not influence analysis of the time at which a contract was created. As a result, if contract (e.g. currency swap) was documented by Confirmation after 17 December 2009, it should be subject to the Rome I Regulation rather than the Rome Convention, regardless of the time of concluding respective master agreement.

In case of contracts in relation to which issue of applicable law arises, the Rome Convention allows for express choice of law of the parties (lexvoluntatis). In accordance with Art. 3(1) of the Rome Convention “a contract shall be governed by the law chosen by the parties. The choice must be expressed or demonstrated with reasonable certainty by the terms of the contract or the circumstances of the case. By their choice the parties can select the law applicable to the whole or a part only of the contract.” Thus, the parties are free to choose any system of law they wish to apply to their contractual relationship. The law applicable to a contract by virtue of express choice shall govern in particular: interpretation; performance; within the limits of the powers conferred on the court by its procedural law, the consequences of breach, including the assessment of damages in so far as it is governed by rules of law; the various ways of extinguishing obligations, and prescription and limitation of actions; the consequences of nullity of the contract.

Moreover, under Article 2 of the Rome Convention “Any law specified by this Convention shall be applied whether or not it is the law of a Contracting State”. Therefore, the Convention is not restricted to the application of the legal systems of Member States of the European Union. This may be particularly important in case of cross-border derivatives contracts under ISDA standard documentation due to the possibility of application of the New York law. There is also no obstacle for parties to choose system of law, which has no connection with the subject matter of the contract. By way of example,New York law applies to the derivatives contract denominated in euros and entered into between Polish and French parties through their offices in Warsaw and Paris, should the parties expressly select New York law to be governing law. In case of OTC derivatives the parties typically insert their chosen governing law in the schedules to master agreements, confirmations and credit support agreement, which constitutes an effective choice of governing law. Therefore, choice is manifested in an express contractual provision.

The limitation on the fully effective choice of law is set out in the Art.3(3) of the Rome Convection stipulating that choice of law cannot prejudice application of “mandatory rules” i.e. rules of the law at the country which cannot be derogated from by the contract. This restriction applies where all the other elements of the contract relevant to the situation at the time of the choice are connected with one country only. In this situation, choice of law is not invalid, however, it is not fully effective. This provision is an attempt to prevent the situation where choice of law a tool for circumventing obligatory provisions of the law, which in principle should apply to the particular legal relationship. Moreover, Art. 7(1) of the Rome Convention allows courts to apply mandatory rules of “another country with which the situation has a close connection.” In the light of growing regulation in the sphere of derivative financial instruments, both abovementioned provisions seem relevant.

Should parties fail to choose the governing law, Art. 4(1) of the Rome Convention stipulates that the governing law shall be the law of the country with which the contract is most closely connected (lexconnectionisfermitatis).In the context of the above, it is important to notice that the connection of the contract with particular country is the deciding factor, not the connection of the parties with that country. Art. 4(2) of the Rome Convention in its turn establishes presumption that the contract is most closely connected with the country where the party who is to effect the performance which is characteristic of the contract has, at the time of conclusion of the contract, his habitual residence, or, in the case of a body corporate or unincorporated, its central administration. In the international doctrine is has been emphasized that above rules related to situation of lack of express choice of law are difficult to apply in case of some derivative contracts. In particular, possibility of identifying characteristic performance in case of e.g. cash settled swaps raises justified doubts. Under cash settled swap, either party could be obliged to make payment i.e. effect the very same performance and, as a result, none of them is characteristic. Regarding options, forwards or physically settled contracts, the buyer of the contract makes payment of premium, however, settlement by cash or delivery could be said to be material content of the contract. Moreover, A. Hudson emphasizes that in case of e.g. long-term swaps it may be difficult to identify relevant habitual residence and further problems arise with reference to the “conclusion of the contract”.

Keeping above in mind, there is a high possibility that characteristic place of performance may not be determined. In accordance with Art. 4(3) of the Rome Convention, aforementioned presumption does not apply if characteristic performance cannot be determined, and it shall be disregarded, if it appears that the contract is more closely connected with another country. When considering the closest connection with the country in the context of derivatives contracts, in addition to general contractual issues, e.g. the following factors may play role: the jurisdictions of the organization of the counterparties and branches engaged in the transaction, the stock exchange on which the underlying asset is traded, the location of the traders who created the contract, the currency in which the agreement is contracted, and the jurisdiction of the underlying reference entity.

On 17 December 2009 the Rome I Regulation entered into force and became binding in the Member States of the European Union without the need for its implementation. Above-mentioned act replaced the Rome Convention. Rome I applies to contractual obligations in civil and commercial matters in situations involving a conflict of laws. Thus, it has obvious impact on the cross-border derivative financial instruments, which are commercial contracts. Although the Rome I Regulation introduced several novelties, however, in many aspects, it is similar to the Rome Convention. Therefore, most of above conclusions on the Rome Convention in the context of derivative contracts remain relevant also in relation to the Rome I Regulation. Henceforth, the focus ismostly on the differences between these regulations that are relevant from the perspective of derivative contracts.

Just like in case of the Rome Convention, autonomy of the parties remains to be the central principle in the Rome I Regulation. This is manifested in the Art. 3(1) of the Rome I stipulating that “a contract shall be governed by the law chosen by the parties. The choice shall be made expressly or clearly demonstrated by the terms of the contract or the circumstances of the case. By their choice the parties can select the law applicable to the whole or to part only of the contract.” As a result, the choice shall be express or at least clearly demonstrated. Meeting above criteria should not raise serious problems in practice of trading OTC derivative contracts, which usually include governing law clause in the standard documentation. Under Art. 2 of the Rome I, parties may choose any law, including the law of a non-Member State (e.g. New York law).

Should the parties fail to make effective choice of law, Art.4 of the Rome I sets out rules on determination of the applicable law, which is a complex combination of predictability and flexibility. The Article 4 of Rome I is significantly different from Article 4 of the Rome Convention in terms of methodology and structure. In accordance with Art. 4(1) of the Rome I:

“To the extent that the law applicable to the contract has not been chosen in accordance with Article 3 and without prejudice to Articles 5 to 8, the law governing the contract shall be determined as follows:

a contract for the sale of goods shall be governed by the law of the country where the seller has his habitual residence;

a contract for the provision of services shall be governed by the law of the country where the service provider has his habitual residence;

a contract relating to a right in rem in immovable property or to a tenancy of immovable property shall be governed by the law of the country where the property is situated;

notwithstanding point (c), a tenancy of immovable property concluded for temporary private use for a period of no more than six consecutive months shall be governed by the law of the country where the landlord has his habitual residence, provided that the tenant is a natural person and has his habitual residence in the same country;

a franchise contract shall be governed by the law of the country where the franchisee has his habitual residence;

a distribution contract shall be governed by the law of the country where the distributor has his habitual residence;

a contract for the sale of goods by auction shall be governed by the law of the country where the auction takes place, if such a place can be determined;

a contract concluded within a multilateral system which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments, as defined by Article 4(1), point (17) of Directive 2004/39/EC, in accordance with non-discretionary rules and governed by a single law, shall be governed by that law.”

European legislator listed several basic categories of civil and commercial contracts and established respective presumptions on the applicable law with respect to particular categories. Thus, firstly, predictability aimed at “limitation” of the judge's discretion is favored over flexibility. Problems may occur with respect to delineation between the different types of contracts listed in points (a) - (h) of the Art. 4(1) of the Rome I. However, in the context of OTC derivative contracts this norm is of little importance because they apparently do not fall within any category of contracts. On the other hand, point (h) is relevant for ETDs and therefore this particular point is analyzed further in this Section.

Should the contractual relationship not fall within the scope of Art.4(1) of the Rome I, Art. 4(2) stipulates that: “Where the contract is not covered by paragraph 1 or where the elements of the contract would be covered by more than one of points (a) to (h) of paragraph 1, the contract shall be governed by the law of the country where the party required to effect the characteristic performance of the contract has his habitual residence.” Therefore, problems related to determination of both “characteristic performance” and in some cases also “habitual residence” described above with respect to the Rome Convention remain relevant for derivative contracts in the context of the Rome I. In particular, determination of characteristic performance under interest rate swap or contracts for differences is problematic. Moreover, even for physically settled contracts it could be still problematic to identify whether the performing party acts through its head office or the branch through which the particular transaction was concluded.

Article 4(3) and 4(4) set out general exceptions to the two previous provisions. Art. 4(3) of the Rome I stipulates that:

“Where it is clear from all the circumstances of the case that the contract is manifestly more closely connected with a country other than that indicated in paragraphs 1 or 2, the law of that other country shall apply.”

This “escape clause” provides for flexibility as a countermeasure to predictability achieved by listing categories of the contracts and establishing presumptions on the applicable law. It may be used by the court, should the particular presumption not work in accordance with its purpose. For contracts not on the list in the Art. 4(1) of the Rome I and where the characteristic obligation cannot be identified (contracts falling under Art. 4(4) of the Rome I), i.e. in some derivatives contracts without express choice of law, nothing has changed, as these contracts are still governed by the law of determined by lexconnectionis fermitatis. Therefore, above considerations on the factors that may establish connection of the derivatives contract with the particular jurisdiction remain unchanged under the Rome I.

Similarly to the Rome Convection, by the virtue of Art. 3(3) of the Rome I, effect of the choice of law is limited, if all other elements relevant to the situation at the time of the choice are located in a country other than the country whose law has been chosen. In this case, the choice of the parties shall not prejudice the application of provisions of the law of that other country which cannot be derogated from by agreement. This provision does not only concern overriding mandatory rules, but all imperative norms of the legal system with which situation is connected. In addition, Rome I limits effect of the choice of law of the third country, where all other elements relevant to the situation at the time of the choice are located in one or more Member State. Such choice does not exclude the application of imperative provisions of Community law (EU law) in the shape they have obtained in the aftermath of their implementation into Member State of the forum. Moreover, Art. 9(1) of the Rome I provides for detailed definition of overriding mandatory rules:

“Overriding mandatory provisions are provisions the respect for which is regarded as crucial by a country for safeguarding its public interests, such as its political, social or economic organization, to such an extent that they are applicable to any situation falling within their scope, irrespective of the law otherwise applicable to the contract under this Regulation.”

Under Art. 9(2) and (3) of the Rome I:

“2. Nothing in this Regulation shall restrict the application of the overriding mandatory provisions of the law of the forum.

3. Effect may be given to the overriding mandatory provisions of the law of the country where the obligations arising out of the contract have to be or have been performed, in so far as those overriding mandatory provisions render the performance of the contract unlawful. In considering whether to give effect to those provisions, regard shall be had to their nature and purpose and to the consequences of their application or non-application.”

It appears that both institutions i.e. limitations on the effect of the choice of law and overriding mandatory rules may be relevant for derivatives contracts, particularly in times when ETDs and OTC derivatives are subject to rigid regulation both on the EU and national level. With respect to overriding mandatory rules, M. Cremona and H-W Micklitz, point out that there is a number of EU secondary law that expressly indicate situations partially located in a third state that fall within their scope. As a result, these acts more broadly and unilaterally delineate their scope of application and “clearly reveal the EU's legislatures view on the relationship of its law with the law of other states.” Thus, relevant provisions of EU legislation with extraterritorial scope of application are regarded as crucial “to such an extent that they are applicable to any situation falling within their scope irrespective of the law otherwise applicable to the contract” within the meaning of Art. 9(1) of Rome I. Aforementioned authors provide examples of such EU secondary legislation in the field of law on derivative financial instruments, namely:

· the Regulation No 236/2012 on short selling and certain aspects of credit default swaps in Art. 1provides that it shall apply to: a) financial instruments traded on a trading venue in the Union, including such instruments when traded outside a trading venue; b) debt instruments issued by a Member State or the Union; c) derivatives that relate to aforementioned financial instruments or relate or are referenced to aforementioned debts instruments. Art. 10 in its turn makes it clear that notification and disclosure requirements apply to natural or legal persons domiciled or established within the European Union or elsewhere;

· Commission Delegated Regulation (EU) No 285/2014 supplementing EMIRsets out rules concerning the extraterritorial jurisdiction of EMIR. These rules specify the OTC derivative contracts, which shall be considered to have a "direct, substantial and foreseeable" effect in the EU and those that shall be deemed to have been designed to circumvent the application of EMIR. As a result, under certain circumstances OTC derivative contracts which have a counterparty from outside of the EU (e.g. from Russia) are subject to EMIR.

Lastly, as mentioned above, the Rome I provides for a novel regulation that did not have equivalent in the Rome Convention. Art. 4(1)(h) of the Rome I provides for the following conflict of laws rule:

“a contract concluded within a multilateral system which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments, as defined by Article 4(1), point (17) of Directive 2004/39/EC, in accordance with non-discretionary rules and governed by a single law, shall be governed by that law.”

This rather complicated rule applies if the parties failed to choose applicable law and if from circumstances it does not appears that, the contract is more closely connected with another country. However, in trading practice, applicable law clause is typically contained in general conditions or rules of the exchange or trading platforms. By way of example, Rules of the London Stock Exchange clearly stipulate that: “These rules shall be construed in accordance with, and governed by, the laws of England and Wales.” With respect to derivatives traded on the Moscow Exchange, clauses on governing law are included on the level of Specification, e.g. Section 4.1. of Natural Gas Futures Contract Specification provides that: “Parties to the Contract are liable for nonperformance or improper performance of the obligations under the Contract, as provided for in the Trading Rules, Clearing Rules, Admission Rules to Participation in Organized Trading of Moscow Exchange, and the laws of the Russian Federation.”

“Financial instruments" within the meaning of Art. 4(1)(h) of the Rome I are currently defined in Section C of Annex I to MIFID II. The definition covers broad range of instruments including, among others, derivative financial instruments. Recital 18 of the Rome I stipulates that “multilateral systems should be those in which trading is conducted, such as regulated markets and multilateral trading facilities as referred to in Article 4 of Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments”. Currently, “regulated market” and “multilateral trading facility” are defined in the Art.4(1)(14) and Art. Art.4(1)(15) of MIFID II respectively. Moreover, as of now Art. 4(1)(19) of MIFID defines “multilateral system”, which means any system or facility in which multiple third-party buying and selling trading interests in financial instruments are able to interact in the system. Analysis of the above definitions leads to conclusion that conflict of laws rule provided by Art. 4(1)(h) of the Rome I is relevant, inter alia, for ETDs.

In order to identify law of which country is exactly indicated, phrase “(…) and governed by a single law, shall be governed by that law” requires interpretation. The doctrine clarifies that it is the law of the state that regulates the market in which the multilateral transaction matching system operates, i.e. the law of the state in which the system is registered or in which it actually operates. In other words, it shall be the law of the state whose authorities supervise a given regulated market or a multilateral trading platform. In case of the electronic trading platform, it shall be the law of the seat of the system organizer from which he manages the system. Solution adopted in Art. 4(1)(h) of the Rome I is subject to heavy criticism. It is considered unnecessary from a practical point of view, leading to excessive regulation and too complicated. Moreover, method of legislation consisting of detailed "technical references" appears to be contrary to the spirit of private international law.

When considering rules of private international law relevant for derivative contracts, Russian law takes similar approach as the EU law. Art. 1210 item 1 of the Russian Civil Code favours principle of autonomy of will in international private law and stipulates that the parties to a contract may, when concluding a contract or subsequently, choose by agreement between themselves the law applicable to their rights and obligations under the contract. Choice of law shall be expressly stated or clearly follow from the terms and conditions of the contract or from the complex of circumstances of the case. The parties to a contract may choose applicable law both for the contract as a whole and for specific parts thereof. The parties to a contract complicated by a foreign element are free to choose as applicable law the law of a country that has no relations with the contract or its parties. Thus, e.g. Russian and U.S. parties to cross-border USD/RUB foreign exchange swap may choose English law to be applicable. Similarly to Art. 3(3) of the Rome I, Russian Civil Code limits effect of the choice of the parties and in Art. 1210 item 5 stipulates that:

“Where at the moment of the choice of applicable law by the parties to the agreement all circumstances relating to the merits of the relationship of the parties are connected with one country only, parties' choice of the law of another country cannot affect the effect of imperative norms of law of the country with which all circumstances relating to the merits of the relationship of the parties are connected.”

Moreover, RCC provides for “norms of direct application” which is a term narrower as compared to with “imperative norms” as referred to in Art. 1210 item 5 of RCC and in broad terms may be considered equivalent of overriding mandatory rules as referred to in Art. 9(1) of the Rome I. With respect to norms of direct application, Russian law provides for two different regulations depending on whether they are norms of Russian law or norms of law of any other country. This solution to certain degree reflects the approach of the Rome I expressed in Art. (9)(2) and Art. (9)(3), which distinguish between the effect of the application of overriding mandatory provisions of the forum and of the country where the obligations arising out of the contract have to be or have been performed. Under Art. 1192 item 1 of RCC effect of norms of direct application of Russian law must not limited, regardless of the applicable law. With respect to norms of direct application of other countries, they court may (but does not have to) take them into account, should the legal relationship be closely connected with this country and if according to its law such norms are the norms of direct application. Moreover, in this situation the court shall take into account the purpose and nature of such norms, as well as the consequences of their application or non-application.

Shall the parties fail to effectively choose applicable law, Art.1211 item 1 of RCC provides for the general rule. In this case, applicable law should be the law of the country where, at the time of the conclusion of the contract, the party who is to effect performance deciding for the content of the contract, has the place of residence or the main place of business. The main place of business should be understood as the place of economic activity, from where affairs of a legal entity or sole proprietor are maned. The main place of business does not necessarily coincide with the place of incorporation of the legal entity. Item 2 of Art. 1211of RCC in its turn provides for 19types of contracts for which it indicates the party who is “effecting performance deciding for the content of the contract”. However, none of the contracts in the list is relevant for derivative contracts. Article 1211 of the RCC in items 3-8makes exception to determination of applicable law based on the criterion of characteristic performance and provides for special conflict of laws rules with respect to several types of contracts, of which one is relevant for exchange-traded derivatives. Item 5 of aforementioned provision stipulates that:

“In relation to an agreement concluded at an auction, as a result of the competition or on the stock exchange, the law of the country where the auction or competition is held or where the stock exchange is located shall apply.”

In this case, legislator does not follow traditional classification of contracts and applies special conflict of laws rule to contracts, which are not named in the Russian Civil Code. The main feature of these contracts is the place and method of conclusion. Contrary to Art. 4(1)(h) of the Rome I on the providing for law applicable to contracts concluded within a multilateral system, Russian provision appears to be crystal clear with respect to contracts concluded on the stock exchange, which is relevant for ETDs. It is neither too technical, nor too detailed. The terminology used is rather “universal” and therefore provision reflects the spirit of private international law and old conflict of laws rule regarding contracts concluded on the exchange.

As it follows from above, in the Russian Civil Code, similarly to the Rome I, there is no special conflict of laws rule relevant for OTC derivative contracts. OTC derivatives contracts also do not fall within any type of contract listed in Art. 1211 item 2 points 1-18 of RCC. In this case, general rule related to criteria of “performance deciding for the content of the contract” and “place of residence or the main place of business” should apply. It appears that there is no significant difference between the term “performance deciding for the content of the contract” and “characteristic performance” as referred to in Rome I since even Supreme Court of the Russian Federation uses these terms interchangeably. Therefore, problems related to determination of “characteristic performance” in the context of some OTC derivative contracts discussed above in this Section remain to be relevant with respect to “performance deciding for the content of the contract." In some instances, “performance deciding for the content of the contract” may not be effectively determined. In this respect Art. 1211 item 10 of RCC requires analysis. This article provides for “escape clause”, which stipulates that:

“If it clearly follows from the law, the conditions or the essence of the contract or the complex of the circumstances of the case that the contract is more closely related to the law of another country than that specified in paragraphs 1-8 of this article, the law of the country with which the contract is more closely connected is applicable.”

From the literal interpretation of above provision, it follows that it should not apply with respect to situation, in which it was impossible to determine applicable law based on rules set out in items 1-8 of the Art. 1211 of RCC. Item 10 of the aforementioned article firstly requires to apply one of the conflict of laws rules set out in items 1-8 and only then to verify whether from the law, the conditions or the essence of the contract or the complex of the circumstances it follows that the contract is more closely connected with the law of another country. Therefore, it is a process of “balancing” and “comparing strength” of the connection resulting from respective conflict of laws rule set out in item 1-8 with the connection resulting" from the law, the conditions or the essence of the contract or the complex of the circumstances of the case”. In case of OTC derivative contracts with respect to which “performance deciding for the content of the contract” cannot be determined, conflict of laws rule provided by Art. 1211 item 1 of RCC is not applicable. Situation concerned is not subject to disposition of the Art. 1211 item 10 of RCC. In other words, aforementioned “comparison of connections” is impossible. On the other hand, it appears that practical consequences of this conclusion are rather limited. In accordance with Art. 1186 item 2 of RCC, if applicable law cannot be determined based on other provisions of Russian private international law, the law of the country with which the civil law relationship complicated by a foreign element is most closely connected shall apply. Thus, regardless of the precise legal basis, ultimately lexconnectionisfermitatisdetermines law applicable to OTC derivatives with respect to which “characteristic performance” or “the main place of business” of the party may not be identified.

As it follows from the above, Russian and European provisions of private international law relevant for derivative contracts are rater similar and de facto lead to application of almost the same conflict of laws rules. Both legal systems promote principle of the autonomy of will of the parties allowing for the express choice of the governing law. With respect to ETDs, should the parties fail to choose applicable law, Rome I stipulates that the law of the state whose authorities supervise a given stock exchange shall apply, while RCC points on law of the location of the stock exchange. However, in most instances, it is authorities of the country where the stock exchange is located that supervise that exchange.On the other hand, with respect to some categories of OTC derivative contracts (e.g. cash settled swaps)similar problems related to determination of characteristic performance may occur. Should application of the conflict of laws rule related to characteristic performance not be possible, ultimately lexconnectionisfermitatisdetermines the applicable law. Factors, which may influence the closest connection are not limited neither under Russian, nor under EU law. Thus, with respect to derivative contracts, inter alia,the following circumstances may be relevant: jurisdictions of the organization of the counterparties and branches engaged in the transaction, the stock exchange on which the underlying asset is traded, the location of the traders who created the contract, the currency in which the agreement is contracted or the jurisdiction of the underlying reference entity.

2. Options, forwards, futures and swaps

There are three principal derivatives techniques and types of derivative contracts respectively: the option, the forward (including futures) and the swap. Although derivatives become more and more mathematically complex and new variations of derivatives occur, at root and from legal perspective derivative contracts are based on the above three source techniques. Moreover, in the view of A. Hudson, all new derivatives will be predicated on fundamental principles originating from aforementioned three core techniques, even when applied to novel markets. As a result, legal analysis will remain similar regardless of new mathematical and commercial developments in structuring derivatives contracts. Above statement is to certain extent confirmed by the fact that the standard derivative documentation has not significantly changed as new developments emerged.

An option is a contract whereby one party grants the other party (option holder) a right, however not an obligation, to take a course of action i.e. the right to buy or sell the underlying asset. In what is referred to as “call option”, one of the parties agrees to sell asset, shall the other party (option holder) exercise its call option and, as a result, demand to buy this asset. On the other hand, in case of “put option” one of the parties agrees to buy an asset, shall the other party (option holder) exercise its option to sell asset. Option may require payment of cash in order to settle contract (“cash settled option”) or, alternatively, the parties may intend actual delivery of the underlying asset (“physically settled option”). Nevertheless, physically settled options are not financial derivatives contracts and, as a result, in international doctrine sometimes are not referred to as derivatives contracts at all.

As its name suggests, the option holder is given merely an option as to whether exercise or not to exercise the right arising from the contract. The choice to exercise the right under option typically depends on economic sense of doing so at the maturity date of the option. If the option holder exercises his rights, the other party is compelled to perform its corresponding obligation. By the virtue of the above, options belong to asymmetric risk profile contracts. By the contrast, the forward (including futures), as described below, entitle the right holder to receive payment specified in the contract but also compel the very same party to make a payment should the underlying asset generate the loss. The forward is in fact a contractual structure consisting of two bilateral options whereby there is two right holders and each of them may be compelled to perform obligation (make payment) to the benefit of the other party depending on the value of the underlying assets moving in one way or the other. Above conclusion confirms the observation that option theory is in the heart of the structure of derivative contracts - it underpins all other derivatives. Forward and swap derive analytically from the option. Conceptually, forward may be considered as series of options, whereas the swap is a series of forwards. From legal perspective, the vital difference is that option gives the right holder solely the right without corresponding obligation, whereas both forward and swap create corresponding obligations for both of the parties.

In order to obtain the right under the option contract (conclude contract), the buyer of the option is typically required to pay a small up-front payment to the seller to create option. This amount is called a “premium” and its level depends on the level of risk associated with the particular option, however, is significantly smaller than the profit the buyer expects to make due to transaction. The more complex or the riskier the transaction is, the higher the premium under option. Premium is typically paid at a time before the cash settlement amount is owned, however, it is also possible to have the premium paid on the same date as the cash settlement amount. Thus would, however, be considered rather unusual in an option transaction. Potential loss of the lump sum of the premium is in fact the only risk for the option buyer, should the option not be exercised because of economic reasons, i.e. when it would not to be advantageous for the buyer (or, as market participants often say - it when it is not “in-the-money”).

When considering option's structure it has to be noted that every option has its expiration date meaning last day on which rights under option may be exercised. In the context of the above, there are different periods, during which an option may be exercised. Which of the so called “styles” applies to the transaction is identified in the option contract (Confirmation typically). Under “European” option expiration date is the only date on which the option can be exercised. On the other hand, “American” option permits exercise on any date from the conclusion of the option contract until the expiration date. Lastly, “Bermudan” optionsallow for exercising them on specified days during the period from the conclusion of the option contract until the expiration date. Obviously, the risks for the seller of the American option are higher as compared to risks with a European option because American option can be exercised in the period of time during which the markets may change significantly.

Given the above features, the option contract typically specifies:

· underlying asset including, if applicable, its quality;

· quantity of underlying asset;

· type of the option - whether it is cash settled or physically settled;

· whether it is call or put option;

· so called “strike price” i.e. a price for the underlying asset at which the option may be exercised;

· style of the option (“European”, “American” or “Bermudan”).

Probably the most popular type of derivatives contracts is a forwards contract. In general, the forwards contract is an agreement to supply a particular security, commodity or other asset at a price on a set date (and often in a set place). The buyer under the forwards contract is obliged to pay the agreed price for the underlying asset whether or not the contract is in-the-money. Unlike the option, the forward obliges both of the parties to perform their respective obligations. Forwards contracts can be either “commodity forwards” or “financial forwards”, depending on the criterion of the underlying asset. A commodity forwards, as compared to financial forwards contract, calls for the delivery of a commodity not a security, currency, stock indices, interest rates etc. at a future date. In the doctrine, it is argued that forwards contract is converted into a derivatives contract when it is agreed that the physical delivery shall not actually take place and that the contract will be settled by the payment of the calculated sum of money being the difference between the market price at specified time and the agreed price.

Terms forwards and futures are often used interchangeably, however, forwards and futures contracts shall be distinct from each other. Typically, when traded in the stock exchange forwards are termed as “futures”, whereas forwards in the strict sense are contracted off-exchange between private counterparties. Thus, futures are sold and bought on an exchange, whereas forwards are bilateral, privately negotiated contracts. Nevertheless, the fundamental economic profile of both forwards and futures are identical. Futures are traded in accordance with trading rules of the particular stock exchange and are interposed by a clearinghouse. Instead of having direct obligations to each other, the seller and the buyer under futures contract have direct obligation to the clearinghouse, which in fact minimizes or even removes the counterparty risk under the contract. In the absence of a clearinghouse acting as obligatory counterparty to the transaction and lack of margin requirements, forwards are considered more risky instruments as compared to futures. On the other hand, under EU or U.S. law some classes of standardized forwards traded outside stock exchanges are subject to mandatory clearing by central counterparty. Thus, in this case forwards and futures become less distinctive from each other.

Another difference between futures and forwards is that futures being standardized products are transacted on fixed terms (e.g. amounts, dates) while forwards are privately negotiated. Exchanges will typically offer only futures contracts allowing for high liquidity. On the contrary, non-standardized OTC forwards allow for more flexibility, which is often of crucial importance to the parties. Both futures and forwards are typically for a period of about or up to three years, but they may be even for longer.