Under swap contract two parties agree to periodically exchange series of payments over time using predetermined pricing mechanisms. As a result, parties periodically exchange pecuniary equivalent of one asset for the pecuniary equivalent of another asset. It is for the parties to decide on terms of swaps i.e. how each asset will be valued on each of exchange dates. In other word, swaps contract can be considered a number of forwards exercised over fixed period. The basic idea behind swaps contract is that the parties exchange onerous obligations for more favorable obligations creating a space for comparative advantage. As an example, bank selling interest rate swap to the corporate client allows the latter to fix interest rate paid to the third party under the loan with floating rate interest (e.g. LIBOR + 100 basis points). In its turn, bank profits from transaction by charging a fee and because it can obtain funding more cheaply than the corporate client does. Features of swaps contracts have made it a powerful tool for risk management, effective refinancing of obligations, as well as for taking speculative positions on different markets. Swaps are typically cash settled and historically have not traded on exchanges. Instead, parties have entered into swaps by the means of direct negotiations on the OTC market. If the particular class of swaps is not subject to mandatory clearing, both parties to the agreement perform and look to for performance of the contract directly taking each other's credit risk.

Swap contracts form a very large group that can be classified according to different criteria, including the underlying instrument on which the contract is based, the duration of the contract, the start of the contract, the end of the contract, depending on the nature of the basic amount (liability swaps or assets swaps) etc. However, the basic and most important division of swap transactions is the division into classic swap contracts, forming the first-generation of derivatives and new forms of contracts belonging to the second-generation of derivative instruments. Three basic types of swaps contracts belonging to the first-generation of financial swaps are:

· currency swap (FX swap);

· interest rate swap (IRS);

· cross-currency interest rate swap (CIRS).

The second-generation of swaps consists of contracts that are a modification of classic swaps or a modification of other financial instruments and include, among others, equity swap, credit default swap/total return swap, commodity swap, catastrophe swaps. The list of the second-generation swaps is not yet closed. New types of swaps contracts are still emerging because there are de fiction restrictions on structuring them. Below are presented some of the most common swaps contracts.

Interest rate swaps are good example of swaps contracts aimed at management of risks. In a classic form, they allow parties to benefit from different credit statuses. Under interest rate swaps, two parties exchange interest payment obligations on debts denominated in the same currency. Interest rate swaps are typically structured as floating rate in exchange for fixed interest rate, however, they can be also done by reference to different floating rates.

Parties to currency swaps (also referred to as foreign exchange swaps) undertake obligation to perform series of exchanges of currency at dates agreed in advance, often on periodic basis (e.g. every month). As contrary to interest rate swaps, in currency swaps principal amount is commonly exchanged either at the end or at the outset of the transaction. Cross-currency interest rate swap is a combination of both aforementioned types of swaps i.e. typically it operates like an interest rate swap between two currencies. The interest rates paid in two currencies could be fixed, may be floating rates or, alternatively, one could be floating rate and the other fixed rate.

Equity swaps are another kind of swaps contracts in which there is exchange of cash flows, of which at least one depends on performance of particular equity (stock) or, what is more common, stock index. As a result, parties' payments depend on the difference of appreciation or depreciation of particular equity or index. This type of swap provides a means for a party to obtain an exposure to an equity without owning the equity. Moreover, it allows owner of an equity to hedge its exposure to an equity it holds. In the most common equity swaps there are two floating amounts. One party pays to the other party a floating rate reference, e.g. LIBOR, multiplied by a principal amount on each payment date. In its turn, the other party pays percentage gains in price of a specific equity multiplied by the principal amount.

Commodity swaps reflect the same pattern as other swaps i.e. a series of payments are exchanged between the parties, however, at least one of the payments is referenced to the price of a particular commodity (e.g. oil, gas, gold). Commodity swaps may be used to hedge against risks related to fluctuations of a commodity, which is of paramount importance for the operations of the particular entity seeking such hedge (e.g. airline carrier hedging against fluctuations in price of oil). Even though, generally swaps are based on the relevant price of the underlying assets on a specific day, it is common for commodity swaps to be based on an average value of particular commodity over time. This allows removing the negative impact abnormal changes in the price of commodity. On the other hand, commodity swaps are also used for taking strictly speculative positions.

Credit default swap (also known as “total return swap”) is the most common credit swap and in the economic sense, it is similar to insurance contract. In a credit default swap, the buyer of the contract (protection buyer) pays a fee and in return, the contract seller (protection seller) agrees to provide credit protection to the buyer with respect to specified principal amount of the reference asset (e.g. bond) that shall be paid by particular entity (e.g. bond issuer).Shall the credit event occur (e.g. partial or full default on the bond), the protection seller pays the protection buyer the amount it should have received from the reference asset less fee. On the other hand, the protection buyer shall pay the protection seller amount actually received from the reference entity (which in case of full default equals zero). Thus, in the essence, the protection seller for a fee is insuring the buyer's income from the reference entity.To certain degree this transaction resembles a standard insurance contract, where the insured pays a premium to an insurance company in return for a legally binding promise to compensate losses should the insured event occur. Although such comparison of credit swaps to insurance contracts takes place quite often, from legal point of view that credit swaps are not insurance contracts. Insurance contracts in most of developed jurisdictions may be concluded only with the insurance company being a professional and highly regulated organization required, inter alia, to maintain a specific level of reserves in case insured event occurs, which is not the case for the seller of credit swap. Moreover, a person buying protection under insurance contract shall typically have an "insurable interest” (e.g. to own the property being insured), whereas the buyer of a credit default swap does not necessarily need to be, and in many instances is not, the owner of the financial instrument for which the credit default swap provides protection. In other words, in credit swap direct risk exposure is not necessary. Therefore, unlike insurance contracts, credit default swap allows taking strictly speculative position. Lastly, and as consequence of aforementioned argument, under insurance contract insurance company is compensating losses incurred by the insured, while the buyer of the credit swap is entitled to payment even if he incurred no actual losses. Taking into account differences, M. Todd Henderson correctly emphasizes that there is little or no sense at all in regulating credit derivatives as or like insurance contracts, regardless of whether they are used for hedging, although such attempts were already taking place.

Lastly, swap option (also known as “swaption”) is worth mentioning. It is an option on a swap. It gives the buyer right, but not the obligation, to enter into a specified swap contract at a future date. In this case, the asset underlying the option contract is another derivatives product in the form swap. Under swap optionborrower can buy protection against the effect of a general rise in interest rates through the purchase of an option to enter into an interest rate swap. Swap options play an important role in the management of corporate debt, in particular callable debt.

3. Conclusion and performance of obligations under cross-border derivatives

Conclusion of derivative contracts differs significantly depending on whether on-cleared OTC contracts or ETDs are concerned. Non-cleared OTC cross-border derivatives are typically concluded based on the standard documentation. Predominantly, ISDA MA governed by English law, however, IFEMA is also frequently usedfor forward and spot transactions on currency in the foreign exchange market. Keeping this in mind, further in hereby Chapter relevant provisions of ISDA standard documentation are analysed with additional references to IFEMA where appropriate.

Master Agreement is not a transaction by itself but is rather applied to govern any number of transactions falling within its scope and between the parties to it. Conclusion of the key document in the ISDA's documentation architecture, i.e.ISDA MA, is no different from conclusion of any other contract. Due to importance of this document, counterparties typically exchange executed hard copies in written form. Nevertheless, in accordance with Section 9(e)(i) of ISDA MA, Master Agreement and any amendments to it “may be executed and delivered in counterparts (including by facsimile transmission and by electronic messaging system), each of which will be deemed an original.” At the time of conclusion of ISDA MA, counterparties make to each other a number of representations. In accordance with Art. Section 3 of ISDA MA these include:

“(a) Basic Representations.

(i) Status. It is duly organised and validly existing under the laws of the jurisdiction of its organisation or incorporation and, if relevant under such laws, in good standing;

(ii) Powers. It has the power to execute this Agreement and any other documentation relating to this Agreement to which it is a party, to deliver this Agreement and any other documentation relating to this Agreement that it is required by this Agreement to deliver and to perform its obligations under this Agreement and any obligations it has under any Credit Support Document to which it is a party and has taken all necessary action to authorise such execution, delivery and performance;

(iii) No Violation or Conflict. Such execution, delivery and performance do not violate or conflict with any law applicable to it, any provision of its constitutional documents, any order or judgment of any court or other agency of government applicable to it or any of its assets or any contractual restriction binding on or affecting it or any of its assets;

(iv) Consents. All governmental and other consents that are required to have been obtained by it with respect to this Agreement or any Credit Support Document to which it is a party have been obtained and are in full force and effect and all conditions of any such consents have been complied with; and

(v) Obligations Binding. Its obligations under this Agreement and any Credit Support Document to which it is a party constitute its legal, valid and binding obligations, enforceable in accordance with their respective terms (subject to applicable bankruptcy, reorganisation, insolvency, moratorium or similar laws affecting creditors' rights generally and subject, as to enforceability, to equitable principles of general application (regardless of whether enforcement is sought in a proceeding in equity or at law)).

(b) Absence of Certain Events. No Event of Default or Potential Event of Default or, to its knowledge, Termination Event with respect to it has occurred and is continuing and no such event or circumstance would occur as a result of its entering into or performing its obligations under this Agreement or any Credit Support Document to which it is a party.

(c) Absence of Litigation. There is not pending or, to its knowledge, threatened against it, any of its Credit Support Providers or any of its applicable Specified Entities any action, suit or proceeding at law or in equity or before any court, tribunal, governmental body, agency or official or any arbitrator that is likely to affect the legality, validity or enforceability against it of this Agreement or any Credit Support Document to which it is a party or its ability to perform its obligations under this Agreement or such Credit Support Document.

(d) Accuracy of Specified Information. All applicable information that is furnished in writing by or on behalf of it to the other party and is identified for the purpose of this Section 3(d) in the Schedule is, as of the date of the information, true, accurate and complete in every material respect.

(e) Payer Tax Representation. Each representation specified in the Schedule as being made by it for the purpose of this Section 3(e) is accurate and true.

(f) Payee Tax Representations. Each representation specified in the Schedule as being made by it for the purpose of this Section 3(f) is accurate and true.

(g) No Agency. It is entering into this Agreement, including each Transaction, as principal and not as agent of any person or entity.”

“No Agency” representation is deemed applicable only should the parties indicate it in Schedule. Above representations are deemed to be repeated by each party on each date on which a particular transaction is entered into and, in the case of the “Payee Tax Representations”, at all times until the termination of Master Agreement. It is therefore crucial to ensure that the representations remain accurate on the day they are given and on each day, they are repeated or deemed to have been repeated. Representations are aimed at creating a legally effective and robust contractual relationship. In many instances, there will be no right to recover damages, should the representations be inaccurate. However, representations create justified expectation that the responsible person acting on behalf of counterparty will look into issues representations set out and satisfy himself on these issues. Counterparties can also agree on “Additional Representations” in the Schedule or Confirmation for particular transaction. The Schedule is executed at the same time as the Master Agreement, and it contains choices made by the parties with respect to various terms of the Master Agreement (including, inter alia, governing law and jurisdiction of the courts) accompanied by any additions and amendments to the Master Agreement. Thus, contrary to Master Agreement, Schedule is typically negotiated but such negotiations need to take place only once.

Even though it may come as a surprise, subsequent execution of Master Agreement after the transactions were already entered into is common in market practice. This is the aftermath of dynamics of the derivatives markets, where decisions on entering into particular transaction have to be often taken instantly, while negotiation of complete ISDA documentation including Schedule to ISDA MA may be long-lasting process. From legal point of view, conclusion of particular transactions without executed Master Agreement and Schedule in place is extremely undesired situation. It creates a whole spectrum of risks and legal uncertainty related to exact rules governing transaction. By way of example, in the absence of parties' express choice on this matter, law applicable to the transaction may need to be determined in accordance with relevant private international law. Analysis of far-reaching legal implications of the absence of binding Master Agreement and Schedule in place while entering into particular derivative transactions exceeds scope of this work. Therefore, for purposes of this Section it is assumed that counterparties duly executed ISDA MA and Schedule prior to entering into derivative transactions.

Confirmation sets out the terms and conditions agreed between the parties for a particular transaction and, incorporates a set of definitions applicable to particular transaction. Therefore, this document is negotiated or, more precisely, is the outcome of negotiations. ISDA has published several standard form Confirmations setting out the issues requiring agreement for common types of transactions. There may be a significant number of transactions entered into between the same counterparties and Confirmations respectively, whereas typically, there will be one Master Agreement and Schedule in place. Apart from Schedule particularizing or amending ISDA MA provisions and Confirmation on particular transactions, one or both parties may require collateral to be posted to support party's exposure form transactions under ISDA MA. ISDA has published a form of collateral agreement that sets out standard terms for posting of collateral, namely Credit Support Annex. It allows parties to make various elections with respect to their collateral arrangements. Entering into particular derivative transactions is intrinsically connected with Confirmation. Section 9(e)(ii) of ISDA MA stipulates that:

“The parties intend that they are legally bound by the terms of each Transaction from the moment they agree to those terms (whether orally or otherwise). A Confirmation will be entered into as soon as practicable and may be executed and delivered in counterparts (including by facsimile transmission) or be created by an exchange of telexes, by an exchange of electronic messages on an electronic messaging system or by an exchange of e-mails, which in each case will be sufficient for all purposes to evidence a binding supplement to this Agreement. The parties will specify therein or through another effective means that any such counterpart, telex, electronic message or e-mail constitutes a Confirmation.”

From the above it follows that parties are bound by the terms of the derivative transaction, i.e. enter into derivative contract, should they agree on the terms of such transaction. At the same time, derivative transactions are often negotiated and entered into by telephone, electronic messaging systems (e.g. Bloomberg), fax or telex. This is possible because counterparties are practically not limited as to the form of concluding the contract. They may agree on essentialianegotiiof the transaction "orally or otherwise”. However, even in such situation the parties shall as soon as practicable enter into Confirmation envisaging terms and conditions of the transaction, which suggest that producing Confirmation is mandatory. Therefore, in the doctrine the legal nature of Confirmation appears to be ambiguous as the ISDA MA is not clear on its status. Kalabaugh G.E. states that in the light of contrary information, Confirmation is not a contractual document as such but rather confirmatory evidence of an existing transaction. Moreover, also its name suggests, that Confirmation merely “confirms” the terms of transaction that counterparties already entered into. In many instances, Confirmation is a clear evidence that parties reached an agreement on terms and conditions of particular transaction and, as a result, that the contract was concluded. However, shall there be discrepancies between the terms of the transaction originally agreed in the course of negotiations and the terms in Confirmation produced by one of the parties, original transaction terms shall override Confirmation. This is because in accordance with above view Confirmation is not a contract but merely an evidence that may be challenged.

Conclusion of derivative contracts on exchanges is very different from OTC market. Exchange-traded options and futures are carried out in contracts on fixed terms (e.g. amounts, dates, underlying assets, minimum price movements) and, as result, the field for negotiations is limited to the minimum. All ETDs are concluded and settled based on the respective trading rules, clearing rules and other documents unilaterally developed by an exchange and a clearinghouse. Moreover, the result of dealing on the exchange is that all contracts are subject to mandatory clearing. Under EU law, all transactions in derivatives concluded on exchanges are cleared by a CCP. In the Russian Federation, ETDs may by concluded only if the other party is a CCP. Thus, although the parties will agree on the contract with the use of stock exchange infrastructure, CCP will then interpose itself between the two parties, becoming the seller to the buyer and vice versa. Parties will be required to make margin payments directly to the CCP. At the same time, only registered members of the exchange are allowed to contract with CCP. A non-member is obliged to deal through the broker, who requires margin payments and will typically hedge its position by concluding back to back transaction. The general, simplified procedure for concluding ETD contract is demonstrated below on the example of The Moscow Exchange Derivatives Trading Rules (hereinafter: MOEX Trading Rules).

Trading members willing to enter into contract place their orders i.e. submit offers for executing a derivatives trade or trades. Orders fall into respective categories, of which “buy orders” and “sell orders "are two most common ones. Orders are placed by automated workstation connected to the trading system and then submitted and processed by the trading system before and after the start of trading. Submitted orders are also processed in the trading system during the trading session. Trading on the derivatives market of the Moscow Exchange is conducted every day except for Russian public holidays and days-off and is divided intothree trading sessions. As a rule, The Moscow Exchange shall register all orders submitted by trading members. Registration in the MOEX Trading Rules is referred to as “announcement”. In accordance with Article 7.11 of MOEX Trading Rules, orders shall include detailed information on desired transactions, which includes, inter alia, type of offer (buy or sell), price (for futures), premium size (for options), option or futures contract code (designation). This information allows for grouping orders into “opposite” ones in the trading system, selecting best offers and matching them. By way of example, the best active buy order is the order with the highest price (for futures), or with the largest premium (for options). If there are several active orders, which meet these conditions, then the best order is the one that was announced earlier. Derivative contract is concluded by matching two opposite orders at the same price.

To comply with mandatory clearing requirement under Russian law, in accordance with Article 7.13 of MOEX Trading Rules, orders shall be regarded as the offers addressed to the Central Counterparty National Clearing Centre (hereinafter: Clearing Centre), which carries out the functions of CCP and provides clearing services in the derivatives market of the Moscow Exchange. At the same time, exchange interacts with the Clearing Centreand both entities exchange documents and information. Moreover, Art. 11.1 of MOEX Trading Rules provides that: “Derivatives Trades are executed through Clearing Centre's acceptance of the offers received as a result of announcing the Orders that contain these offers to execute Derivatives Trades.” At the same time, save for ensuring performance under derivatives contracts, “the Clearing Centre shall only accept an offer to enter into a derivatives contract, provided that there is an opposite active Order that is the best buy order or the best sell order accordingly.” Exchange registers all derivatives trades executed during a trading day in the trade register. Finally yet importantly, all the derivatives trades executed during trading are deemed to be executed in Moscow.

Derivative contracts are either physically settled (deliverable) or cash settled. Therefore, the principal obligation is to deliver the underlying asset for a sum of money agreed at the outset of the contract or exchanging payments or, in case of swap contracts, exchanging series of payments. In this respect, Section 2(a)(i) and (ii) of ISDA MA clearly sets forth parties' obligation to make delivery ot payment, as well as specifies rules on making payments:

“2. Obligations

(a) General Conditions.

(i) Each party will make each payment or delivery specified in each Confirmation to be made by it, subject to the other provisions of this Agreement.

(ii) Payments under this Agreement will be made on the due date for value on that date in the place of the account specified in the relevant Confirmation or otherwise pursuant to this Agreement, in freely transferable funds and in the manner customary for payments in the required currency. Where settlement is by delivery (that is, other than by payment), such delivery will be made for receipt on the due date in the manner customary for the relevant obligation unless otherwise specified in the relevant Confirmation or elsewhere in this Agreement. 2 ISDA® 2002.”

Obligation to make each payment or delivery is subject to conditions precedent set out in Section 2(a)(iii) of ISDA MA, of which first and foremost is that no event of default or potential event of default with respect to the other party has occurred and is continuing. Events of default are discussed in greater detail in Chapter III Section C below, however, at this point it requires emphasis that non-payment is not an event of default until notice of non-payment is given to the defaulting party and payment is not made within prescribed time limit.

At the same time, according to S. James: “A vital aspect of a derivative contract is that it is primarily a financial contract. (…) What makes it a derivatives contract is the expectation (and possibly a contractual term to the effect) that physical delivery of the commodity will not actually take place but that the contract will be concluded by payment of a sum of money, the difference between the contract price and the market price at the relevant time.” Keeping above in mind, in case of “proper” derivative financial instruments expectation is that the settlement will take place by making a payment or payments of agreed amounts. Under one derivative contract, save for option, both counterparties are obliged to make payments to each other. Moreover, there may be a number of derivative contracts concluded between the same parties and governed by one master agreement. Thus, in order to facilitate the process of settlement of obligations under financial derivative contracts, parties typically agree on so-called “netting” of payments.

In the conventional sense, netting shall be understood as the method of determining the amount of obligations by aggregation, combination and set-off of two or more obligations. Essentially, it means that the parties have agreed that, when they transact with each other there will at any time be just one amount owed by the party whose cross-claim is worth less than the one his counterpart. However, some types of netting have features that significantly expand the above definition. Several legally distinct forms of netting can be distinguished, namely payment, novation and close-out netting.

Payment netting (also known as settlement netting) takes place during the regular business of two parties and involves combining offsetting cash flow obligations between them on a given day in a given currency into a single net payable or receivable. Its main purpose is to reduce settlement risk and facilitate efficient settlement. As it operates prior to a default or termination event, its enforceability does not generally need special protection by legislation.

Novation netting is similar to payment netting in that it is principally intended to reduce settlement risk and operates prior to a default only. By the virtue of novation netting, if the parties enter into a transaction, which gives rise to an obligation for the same value date and in the same currency as an existing obligation, then the two obligations are cancelled and simultaneously replaced with a new obligation for the net amount. Novation netting developed originally in the foreign exchange market as a risk reduction technique, but that usage fell away when close-out netting was first recognized as eligible in 1994. Nevertheless, until today it remains relevant to multilateral netting arrangements operated by central clearing counterparties and clearing houses. Just like payment netting, because it operates prior to default, novation netting does not require special interest of the legislator when it comes to its enforcement.

Close-out netting is a contractual termination of obligations mechanism applied when events of default occur in relation to one or several parties to financial transactions concluded in organized trades or in the over-the-counter market. The events of termination or default may be circumstances related to the actions of the parties, or events of a general economic nature. Under close-out netting mechanism set out in a netting agreement, following an event of default or termination event, the following three stages occur:

· Early termination - the transactions are terminated by notice of the non-defaulting party or, in certain circumstances, automatically;

· Valuation - the terminated transactions are valued at their current mark-to-market value at or about the time of early termination;

· “Set-off”- offsetting of aggregated mutual obligations is conducted and net balance equal to the difference between the aggregate values of terminated transactions is calculated.

Thus, close-out netting replaces the entire set of obligations of a certain type between netting participants with a single net obligation, which is the difference between the cost requirements of the parties.

Apart from above, definition of netting is set forth in the legislation of various countries. For example, Russian law provides for its own definition of netting. According to Art. 2 point 11 of the Law on Clearing, netting is a full or partial termination of the obligation, admitted to clearing, by offset and (or) in another manner established by the clearing rules. Aforementioned definition is wide enough to accommodate all three forms of netting.

V.V. Dragunov concludes that netting, from a legal point of view, is in fact specific subtype of contractual set-off with a complex implementation mechanism, often combining elements of various contracts. Moreover, in financial transactions, the terms “set-off” and “netting” are often used interchangeably although they are not exactly the same thing. The source of this confusion may be the fact that both set-off and netting can result in the same economic outcome i.e. reduction of the amount of mutual obligations. Despite the general economic result and focus on reducing the total amount of cash payments, netting and set-off by the operation of law differ significantly for a number of reasons. A.S. Selivanovsky correctly points out the following differences from the perspective of Russian law:

· Firstly, in case of set-off by operation of law there is no need for conclusion of an agreement applying set-off. The right to set off is embedded directly law. On the contrary, to apply netting, parties shall enter netting agreement or include the relevant provisions on the netting in the agreement (for example master agreement). Without netting agreement, netting is simply not applicable. This difference applies to all forms of netting;

· By set-off by operation of law only existing, matured claims are terminated. As a result of netting, both matured as well as non-matured obligations may be “transformed” into one new monetary obligation. This difference applies to all forms of netting;

· In order to apply statutory set-off, claims shall be of the same type. This is also the case of payment and novation netting. Under these forms of netting only monetary claims in the same currency are netted. It is not possible to have claim on delivery of security netted against monetary claim. However, under close-out netting, all claims (despite of their type) may be subject to termination;

· By set-off, only mutual, reciprocal obligations are terminated. In multilateral netting, not only mutual obligations, but also non-mutual obligations cease to exist. This difference applies to all kinds of netting;

· For the set-off by operation of law to be applied, a statement of will of at least one of the parties is required. On the other hand, netting agreement may provide for the obligations of the parties to be terminated automatically, without additional statements, notifications, etc. This difference applies to all kinds of netting.

Taking into account above observations, it is clear that netting is fundamentally different from set-off the operation of law, and therefore interchangeable use of these terms is generally wrong. In particular, with respect to close-out netting it shall be emphasized that it is a sui generis contractual method of termination of obligations developed by participants to financial markets and thus, it is independent from legal institutions such as offset, novation or compensation. This approach allows for covering all stages of close-out netting, whereas “set-off” is in fact only final stage of netting. This conclusion has far-reaching consequences and inter alia means that in order to determine law applicable to netting in the absence of the choice of the parties on this matter, conflict of laws rules typical for set-off and envisaged in e.g. Art. 17 of Rome I or Art. 1217.2 of Russian Civil Code shall not apply.

In practice, both the netting provisions and provisions on financial transactions form a part of single master agreement. By way of example, in IFEMA all three forms of netting are stipulated. Under Section 3.2 of IFEMA providing for settlement (payment) netting, if more than one delivery of a particular currency is to be made on any date between the parties to the transaction, then each party shall aggregate the amounts of currency to be delivered by it and only the difference between these aggregate amounts shall be eventually delivered by the party, who owns the larger aggregate amount. In case the aggregate amounts are equal, no delivery of the currency shall take place. Under Section 3.3. of IFEMA, by the virtue of novation netting, if the parties enter into a currency transaction in the foreign exchange, which gives rise to an obligation for the same value date and in the same currency as an existing obligation, then upon entering in to such transaction the existing obligations shall be immediately cancelled and simultaneously replaced with a new obligation for the net amount. In such case, the value date remains the same. If the aggregate amounts that would otherwise have been deliverable by the parties are equal, no new obligation shall arise. Lastly, Section 5 of IFEMA provides for application of close-out netting, which takes places in case of occurrence of an event of default, including, among others, involuntary or voluntarily commencement of insolvency proceedings against one of the parties to the foreign exchange transaction.

On the other hand, in the ISDA MA there is only settlement and close-out netting. There is no novation netting envisaged by ISDA MA Section 2(c) of ISDA MA provides for netting of payments, stipulating that if on any date amounts would be otherwise be payable by each party, in respect of the same transaction and in the same currency, then on such date each party's payment obligation shall be considered automatically satisfied and discharged and replaced by one net amount, which is the difference of aggregated amounts owned by each party to the other party. Section 6 of ISDA MA Agreement stipulates close-out netting, which just like in IFEMA may be exercised on the basis of notice delivered to the defaulting party or automatically depending on the particular event of default.

With respect to ETDs, which are subject to mandatory clearing, provisions on netting are set forth by the trading rules of respective exchanges or by clearing rules of clearinghouses. By way of example, relevant rules on netting of obligations arising from derivative contracts entered into on the Moscow Exchange are set out in Clearing Rules developed and published by Clearing Centre, which in this situation acts as CCP. Clearing Rules provide for procedure for settlement of obligations in case of termination of the clearing member's admission to the clearing services, bankruptcy of the client of the clearing member and in case of withdrawal of Clearing Centre's banking license. In other words, Clearing Rules envisages close-out netting with respect to three aforementioned situations.

After presenting various forms of netting, the differences between statutory set-off and netting and practical examples of netting provisions, it shall be pointed out that it is a close-out netting and controversies around it that attract a special attention of legislators, lawyers as well as regulators and participants to the financial markets. In order to understand the peculiarities of close-out netting and contemporary criticism of this institution by some of the representatives of the doctrine, one shall have a closer look at its functions and practical problems related to exercising close-out netting.

In the last few decades, close-out netting has become an important and effective contractual mechanism in the international financial markets, being used to manage and minimize credit risk. Without any doubts, netting plays a positive role when the solvent parties are considered, therefore there is not much dispute in the doctrine over payment and novation netting. However, the situation changes significantly, once insolvency of one of the parties to the netting agreement takes place. It is the situation of insolvency, as already presented above, that is commonly indicated as event of default under master agreement allowing for application of close-out netting. When the risk in the form of insolvency of the contractor materializes, the role of close-out netting in reducing systematic and counterparty risks becomes most dominant. Nevertheless, the essential features of the mechanism of contractual close-out netting clash with some of the most fundamental principles of the insolvency processing's, such as preservation of assets of the debtor to the benefit of the creditors and equal treatment of equally ranked creditors (paripasssu principle). In order to resolve these inconsistencies, in many jurisdictions special legislation on close-out netting has been adopted, which is mostly the result of global harmonization of law process being a natural consequence of the fact that close-out netting is a standard mechanism provided for by the contracts concluded on the international financial market.

Events of default are possibly the most important part of any financial agreement. They role is to determine whether and when a party has right to bring the contract to an end. The function of events of default is to provide parties with certainty or ability to create certainty by serving notices. Broadly speaking events of default occur where one of the parties is at fault. ISDA MA sets forth eight categories of events of default, namely:

· Failure to Pay or Deliver;

· Breach or Repudiation of Agreement;

· Credit Support Default;

· Misrepresentation;

· Default under Specified Transaction;

· Cross Default;

· Bankruptcy, and;

· Merger Without Assumption.

Parties may also specify additional events of default by amending the Schedule or in the Conformation. The mere occurrence of above situations as a rule does not per se allow for termination of the agreement. Ordinarily ISDA MA requiresa notices to operate its provisions. In such case, the non-defaulting party shall deliver to the defaulting party notice specifying the event of defaultand that the termination procedure is then begun. The awareness of the parties on the facts described in the notice does not excuse a party from delivering that notice. Thus, notices are precondition for termination of the agreement in accordance with its terms. Moreover, certain events of default can only occur once a specified grace period has elapsed. On the other hand, parties in the Schedule may decide to apply automatic early termination in case of event of default. In case of automatic early termination, there is no need to notify the defaulting party. If parties did not specify in the Schedule automatic early termination and an event of default occurred and is continuing, the non-defaulting party, in accordance with Section 6(a), is entitled to designate the “Early Termination Date” in respect of all transactions.

In Section 5(b) ISDA MA additionally provides for so-called terminations events. Generally, the difference is that in case of event of default there is a party, which is at fault, whereas termination event is outside a party's control. Parties affected by the event are thus referred to as “affected parties”. Similarly, to evets of default, and subject to limited exceptions, termination events will only give rise to the right to terminate ISDA MA once the non-affected party delivers a notice of the relevant event to the other party. ISDA MA provides for five termination events, however, parties are free to designate additional termination events in the schedule. The standard five termination events include:

· Illegality;

· Force Majeure;

· Tax Event;

· Tax Event Upon Merger;

· Credit Event Upon Merger.

Termination means that the party, which is not at default, puts an end to the obligations under Master Agreement. The effect is termination of all transaction under Master Agreement. Non-defaulting party is not given right to terminate only some of the transaction and leave the others outstanding. Termination procedure set forth in Section 6 of ISDA MA requires identification of the early termination date, on which the appropriate party (calculation agent) identifies the present value of all outstanding transactions. In making valuation, the contractually agreed calculation method is applied. In the process of valuation, the replacement costs of each transaction under the agreement are calculated. Following valuation, the calculating party translates those values into termination currency to determine net, final amount that replaces all payments obligations in full. Determination of net balance means that positive values and negative values are netted against each other. Thus, all amounts owed between the parties are reduced to single net sum, which represents a full satisfaction of all transactions. This termination mechanism is the close-out netting as discussed in Chapter III Section B and consisting of three stages: early termination, valuation and set-off of all outstanding payment obligations to single net amount.

Events of default (although not always reoffered to as such) and provisions on close-out netting following those events are also stipulated in the clearing rules of respective clearinghouses. In case of derivative contracts concluded on the Moscow Exchange, Art. 59-61 of Clearing Rules provide for three events, which lead to termination of transactions and application of close-out netting, namely: termination of the clearing member's admission to the clearing services; bankruptcy of the client of the clearing member and; withdrawal of Clearing Centre's banking license. By way of example, under art. 60.1 of Clearing Rules in case of revocation of the banking license of the clearing member's client or introduction of any bankruptcy proceedings in respect of the client, the clearing member is, save for some exceptions, entitled to apply to Clearing Centre to calculate net obligation or net claim of a clearing member under trades, executed at the expense of funds of such client. Shall the application not be refused, one final net amount is determined with respects of all transactions, executed using funds of the defaulting client. If calculation resulted in determination of net obligation, net obligation it is recorded as the debt of clearing member and is performed using collateral of a clearing member recorded under proprietary settlement accounts and also collateral for stress and default funds contributions. As a result of setting net obligation or net claim, a clearing member may also obtain a margin call, i.e. claim of the Clearing Centre in respect of a clearing member on the security for the fulfilment of obligations, arising from trades, executed between the Cleaning Centre and the clearing member.

Legal mechanism of close-out netting is often in opposition to the general principles governing insolvency proceedings. These inconsistencies can potentially result in close-out netting not being enforceable and thus not fulfilling its function of minimizing credit risk. In order to resolve the situation of conflict between the close-out netting mechanism and fundamental rules governing insolvency, under the slogan of securing the stability of financial markets, global process of adopting amendments to the national legislation providing for enforceability of close-out netting in insolvency took place. At present, 54 jurisdictions including, inter alia, United Kingdom, United States, Russian Federation, have enacted legislation securing enforceability of close-out netting. Significant role in the process of convincing national legislators plays afore-mentioned ISDA, which not only develops standard form master agreements and model netting laws but also actively lobbies for netting legislation. Other worth mentioning institutions playing significant role in promoting netting legislation are UNCITRAL and UNIDROIT. Continuing process of adopting legislation providing for enforceability of close-out netting in the insolvency and its successful international harmonization of close-out netting law leads some of the representatives of the doctrine even to the conclusion, that currently we are facing “the demise of the principle of equal treatment of business actors".

Regardless of the assessment of the adoption of netting legislation and providing for exceptions in the insolvency laws securing enforceability of the close-out netting, the following shall be noticed. Master Agreements including close-out netting mechanism are often used in a cross-border transactions. These agreements are generally not per se tied to any particular applicable law and therefore provisions on governing law are typically included. In practice, law chosen by the parties is usually in favor of either New York or English law even if none of the parties is located in the USA or the United Kingdom. Since the close-out netting is applied in the event of default, which includes insolvency of the contractor, the question of the law governing the relationship between the parties to the master agreement is of utmost importance. This is particularly true in the case where there is a risk that parties' relationship may not be governed by the law chosen by the parties, but rather by the mandatory provisions of the insolvency law of the jurisdiction, which did not adopt legislation providing for enforceability of the close-out netting. Taking into account the importance of this issue, the question of law governing close-out netting is of primary importance.

First of all, close-out netting agreements and financial transactions covered by them are in general no different from other types of commercial contracts. Thus, as a general rule of private international law embedded in the legislation of most of jurisdictions all aspects of the validity, performance and the interpretation of the close-out netting arrangements, as well as the consequences of possible breaches of contract and the termination of the obligations resulting from the contract, are covered by the law applicable the contract - that is, lexcontractus. This approach is supported by the Art. 1215 of the Russian Civil Code providing for the scope of applicability of the law governing the contract and Art. 1210 of the Russian Civil Code providing for the choice of law on the law with regards to law governing the contract, as well as by IFEMA (Section 9.1 - Governing Law) and ISDA MA (Section 13 - Governing Law and Jurisdiction) and single agreement principle allowing to apply the governing law of the master agreement to transactions concluded on its basis. In jurisdictions that recognize the principle of party autonomy in private international law, including the Russian Federation and EU, the lexcontractus for netting agreements is determined by the choice of law made by the parties. At the same time, parties predominantly choose English law or New York law as the law applicable to master agreements governing international derivatives transactions.

Nevertheless, as soon as insolvency proceedings are initiated against one of the parties to the netting agreement, the lexforiconcursus comes in as mandatory law applicable in addition to the lexcontractus, potentially overriding contractual arrangements contravening the applicable insolvency law. Moreover, there is a variety of potential fora, referring to criteria such as: place of incorporation of financial institution; its center of main interest; its headquarters; its branches; or its assets, related to the close-out netting agreement, which are located in foreign jurisdictions. As a result, conflict between the lexcontractus and lexforiconcursus is inherent in any cross-border situation where several potential fora are possible. Thus, issue to be solved by private international law is whether the enforceability of close-out netting in insolvency proceedings is governed either by the lexcontractus, or by the lexforiconcursus. Unfortunately, it seems to be no clear answer to the above question. Even national legislation of netting-friendly jurisdictions and EU law remain relatively ambiguous in this regards.