Derivative financial instruments in international commercial turnover

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Introduction

Derivative financial instruments have been playing an increasingly important role in the global financial markets since the 1970s. Traded on the exchanges orprivately negotiated, financial derivatives enable parties to hedge against various risks arising from turbulences in the real or financial sphere of the economy. They also provide for the opportunity for active, speculative investing methods. As early as in 2002, in his letter to shareholders Warren Buffet described derivatives as “financial weapons of mass destruction”. Despite significant impact on the economy and accounting for almost 95% of the derivatives markets, privately negotiated financial derivatives received little attention from the lawmakers across the world until the 2008-2009 financial crisis. It was derivatives financing that led Lehman Brothers Holdings Inc. to file for the largest bankruptcy case in the history of the United States of America and magnified the impact of the crisis globally.

In the aftermath of the crisis, the cross-border systemic risk created by trading over-the-counter derivatives became the problem of the global dimension that required global response. Consequently, in various jurisdictions across the globe, including the United States of America and the European Union, respective laws aimed at increasing transparency and reducing credit and operational risks in the over-the-counter derivatives markets were enacted. This global legislative process resulted in the increased interest of the doctrine in derivative financial instruments. On the other hand, focus of legal scholars and practitioners, particularly in the countries not leading on the global financial markets, is merely on the regulatory landscape related to particular state and thus missing “big picture”. Moreover, exchange-traded derivatives appear to be omitted in the professional literature.

Keeping above in mind, this work is an attempt to provide for legal analysis of these aspects of financial derivative instruments that are relevant to the international commercial turnover, as well as to aspects, which receive little attention from the doctrine. Consequently, universal issues relevant regardless of the jurisdiction, such as legal nature of the financial derivatives, their types and functions, as well as use of standard documentation and trading and clearing rules are discussed. At the same time, author decided to make comparative analysis of Russian and European law on financial derivatives, including rules of private international law and enforcement of close-outnetting. The work is without prejudice to exchanged-traded derivatives and thus they are subject to discussion as much as over-the-counter contracts.

Professional relevance

Despite significant impact of derivatives on the global financial markets, including Russian financial system, it appears that the very nature of derivative financial instruments, their classification, as well as cross-border aspects of trading them remain more within the interest of economists rather than lawyers. One of the reasons for this situation may be the factor that in the international turnover most of over-the-counter derivatives are traded under the standard trading documentation, which is typically subject to English law or New York law therefore not leaving much for analysis for lawyers not qualified in these jurisdictions. Secondly, in most instances foreign state courts or international arbitration courts rather than Russian state courts are chosen by the parties to resolve disputes under financial derivatives contracts traded on the over-the-counter markets. Lastly, Russian derivatives market is not as developed as in case of jurisdictions such as the United Kingdom or the United States of America, both with respect to exchange-traded and privately negotiated contracts. As a result, judicial practice of Russian courts remains to be rather scant. Regardless of the above, in the view of the author, Russian counterparties shall be aware of basic rules governing derivative contracts, as well as legal mechanisms and techniques related to structuring them.

Furthermore, there are some vital aspects of cross-border derivative contracts traded by Russian counterparties that in any scenario require assessment from the perspective of Russian law. These include, among others, rules of private international law, as well as enforcement of close-out netting in Russia. The latter is a multistage mechanism providing for settlement of mutual obligations between the counterparties in case of event of default. It plays significant role in the international trade and particularly on financial markets. It should not be an exaggeration to say that international financial markets are currently fully dependent on effective application and enforcement of netting. At the same time, netting has not received enough attention in the Russian professional literature, particularly with respect to conflict of laws issues. Even among legal practitioners netting is often interchangeably referred to as set-off, which is fundamentally incorrect.

Purpose and objectives

The purpose of this work is to attract the attention of the professional community to the legal aspects of trading financial derivatives in the international turnover with particular focus on universal problems and rules of private international law. To achieve the above purpose the following tasks were set. Firstly, to provide for definition of financial derivative instruments, describe their legal nature, as well as to classify them and identify different functions they serve in modern trade. Secondly, to explain and emphasize the role of standard trading documentation and trading rules in trading derivative financial instruments. Thirdly, to analyse legal developments of conflict of laws rules on over-the-counter and exchange-traded derivative contracts both in the European Union and the Russian Federation, as well as to present similarities and differences in this respect. Fourthly, to analyse and present conceptual differences between various types of derivative financial instruments, including options, forwards (futures) and swaps, which are universal regardless of the jurisdiction. The aim was also to present different variations of each type. Finally yet importantly, to analyse rules on conclusion, performance and termination of cross-border derivative contracts subject to ISDA standard documentation. With respect to exchange-traded derivatives, trading rules of the Moscow Exchange and clearing rules of the National Clearing Center serve as examples. The aim of this part is also to analyse conflict of laws rules on close-out netting and regulation of its enforcement under Russian and EU law. Based on the above, conclusions on the possibilities for improvements in the field of private international law on financial derivative contracts, defining derivatives and regulation of close-out netting under Russian law shall be drawn up taking into account the experience of the European Union.

1. Derivatives: general issues

derivative transaction arbitrage

In 1997 the Group of Thirty published one of the earliest and widely cited definition of derivatives. According to Group of Thirty, derivative transaction is “a bilateral contract or payment exchange whose value derives, as its name implies, from the value of an underlying asset or underlying rate or index. Today, derivatives transactions cover a broad range of `underlyings' - exchange rates, commodities, equities and other indices. In addition to privately negotiated, global transactions, derivatives also include standardized futures and options on futures that are actively traded on organized exchanges, and securities such as call warrants.” This definition was originally supplemented with the list of derivatives divided into two groups: a) “derivative contracts” including options, forwards and futures and; b) “derivative securities.” The latter group included, among others, structured notes and stripped securities.

Descriptive in its nature this definition has been under justified criticism for being overly inclusive. It is so broad that it includes also instruments that contemporary market participants would not qualify as derivatives. In particular, it has been correctly pointed out that including under umbrella definition instruments not being bilateral contracts but rather instruments issued with the sole purpose of raising capital referred to as “derivative securities” can generate endless confusion as to the true nature of derivatives. Thus, if to take into account the aforementioned criticism, derivative is a transaction, and for the most part (excluding wholly theoretical examples) a bilateral contract, stemming from an underlying asset and deriving its value from that underlying asset. Derivatives underlyings may include payment obligations under a loan agreement, corporate bonds, shares, indexes, commodities, interest rate and even weather-related variables such as rainfall, temperature, snowfall, wind and frost. However, the list at hand shall not be considered exhaustive as any value, which may potentially change in the future can be an underlying instrument for derivative.

Derivatives play an important role in the economy but they are also source of certain risks. These risks were highlighted during the financial crisis of 2007-08, when significant weaknesses in the derivatives markets became evident. In particular, various pathologies related to derivatives traded on the unregulated market areconsideredkey factor that contributed to the global financial crisis. In response to these challenges, the G20 states reached an agreement on the basic directions of reforming derivatives market, which led to enacting respective legislation e.g. in the United States of America and in the European Union, or initiating the reform, which is still ongoing e.g. in the Russian Federation. In order to increase the transparency on the derivatives market and mitigate systemic risks, one of the objectives of new legislation was to address so far largely unregulated market of derivative contracts executed and settled outside stock exchanges. In connection with this, many regulators across the globe had to, inter alia, face a challenging task of providing for or reviewing legal definition of derivatives.

Definition of derivatives in the European Union law is set out in the Annex 1 Section C (4) - (10) of MIFID II. According to MIFID II, derivatives are following financial instruments:

“(4) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, emission allowances or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash;

(5) Options, futures, swaps, forwards and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event;

(6) Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market, a MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled;

(7) Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point 6 of this Section and not being for commercial purposes, which have the characteristics of other derivative financial instruments;

(8) Derivative instruments for the transfer of credit risk;

(9) Financial contracts for differences;

(10) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event, as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market, OTF, or an MTF;”

The EU's approach to defining derivatives uses an interesting pattern. The list starts with examples of most common derivatives contracts. Subsequently, the focus shifts to the settlement feature of the contracts. Thus, derivatives are generally contracts (including options, futures, swaps etc.) that: a) may be settled physically or in cash; b) must be must be settled in cash or may be settled in cash at the option of one of the parties. The definition provided by EU law is an attempt to draw a thin line between purchase and sale agreements for future delivery used for commercial purposes (to obtain particular commodity, e.g. oil) and strictly financial contracts concluded for risk transfer purposes, under which physical delivery is in theory possible, however, not required by the parties (also because they may not be even actually able to fulfill such obligation). Thus, it is assumed that if the physical delivery may be avoided at the option of one of the parties, the contract clearly has not been concluded for commercial purposes. Nevertheless, contracts for future delivery with obligation of physical settlement may still have risk transfer purpose, should the parties avoid the delivery by selling the position. Therefore, although the contract can be physically settled, such contractis deemed derivative, if is traded on the regulated market, OTF, or an MTF (with the exception of wholesale energy products traded on an OTF that must be physically settled) and if it is not for commercial purposes, but rather has features of other financial derivative instruments (e.g. is subject to regular margin calls). As a result, derivative nature of the contract prevails regardless of the actual intention of the parties to proceed with the delivery. Finally, EU's definition ends with pointing out innovative products including derivative instruments for the transfer of credit risk, contracts for differences and other so-called exotic derivatives (e.g. related to weather changes). Such instruments are derivatives if they may be settled in cash at the option of the party or must be settled in cash.

Based on the above, it appears that settlement criterion is vital to EU's definition of derivatives. Cash settlement is an evidence confirming derivative nature of the contract, even if settlement in cash may take place at the option of one of the parties. On the other hand, under EU law physical settlement is a proof of non-derivative nature of the contract, unless traded on a regulated market, MTF, or OTF.

In accordance with the Russian law, the derivative financial instruments an agreement, except for a REPO agreement, providing for one or several of the following duties:

“1)the duty of the parties or of a party to the agreement to pay sums of money on a periodical basis or as a lump sum, in particular when claims are made by the other party, depending on changes in the prices of commodities or securities, in the rate of an appropriate currency, interest rates, inflation rate, values estimated on the basis of prices of derivative financial instruments, values of the indices constituting official statistical information, values of physical, biological and/or chemical indices of the environmental condition, on the emergence of the circumstance proving a failure to discharge or improper discharge by one or several legal entities, by states or municipal entities of their duties (except for an agreement of surety ship and an agreement of insurance) or any other circumstance which is provided for by a federal law or by regulatory acts of the Central Bank of the Russian Federation (hereinafter - the Bank of Russia) and in respect of which it is not known whether it will occur or not, as well as on the alteration of the values estimated on the basis of one or an aggregate of several indices cited in this item. With this, such agreement may likewise provide for the duty of a party or parties to an agreement to transfer securities, commodities or currency to the other party or the duty to make an agreement which is a derivative financial instrument;

2) the duty of the parties or of a party under the terms defined when making the agreement, should the other party raise the claim, to purchase or sell the securities, currency or commodities or to make a contract which is a derivative financial instrument;

3) the duty of either party to transfer securities, currency or commodities to the other party for ownership at the earliest on the third day after the date of making the agreement, the duty of the other party to accept and pay for the cited property and an indication that such agreement is a derivative financial instrument.”

Above definition is supplemented by the Ordinance of the Bank of Russia No. 3565-U dated 16.02.2015 “On Types of Derivative Financial Instruments” (hereinafter: the Ordinance), which contains a list of underlying instruments of the financial derivatives and provides for types of derivative contracts, namely options, forwards, futures and swaps. Nevertheless, in accordance with Russian hierarchy of legal acts, Law on Securities Market shall take precedent over the Ordinance. Thus, in order to be classified as financial derivative instrument, the contract shall fall within definition as set out in Law on Securities Marketing the first place and only then can be further classified in accordance with the Ordinance. As a result, definition in the Law on Securities Market remains central to the qualification of the contract as derivative financial instrument.

Russian regulation of derivatives and legal definition as set out in the Law on Securities Market raises some concerns. At first, definition appears to cover the whole range of possible derivative products, point 1) generally refers to swaps and non-deliverable derivatives (including options and forwards), while point 2) and 3) describe deliverable options and deliverable forwards respectively. On the other hand, it is structured in the way that certain set of rights and obligations of the parties shall be stipulated by the contract in order to be deemed financial derivative. In this situation, even slight change in the scope of rights and obligations may lead to the contract not falling within definition of the derivative financial instrument, although in the essence it is of derivative nature. As an example, under point 3) of the definition, contract is a derivative financial instrument, if it provides for the obligation of one party to transfer the underlying asset not earlier than on the third day since conclusion of the contract and the obligation of the other party to accept aforementioned asset, however, only if it was expressly indicated that such contract is a derivative financial instrument. Therefore, if deliverable forward contract, which is in fact derivative in its nature does not clearly state that it is a derivative financial instrument, it shall not be deemed as such. Parties may wish not to indicate that the contract is a derivative transaction i.e. for tax related reasons. Moreover, in the professional literature it has been also pointed out that common deliverable currency swap contract consisting of two operations i.e. selling certain amount of currency (within three days) and buying back the same amount of currency after a certain period of time does not fall within any part of the definition of derivative financial instrument in the wording provided by Law on Securities Market.

As it follows from the above, Russian legal definition appears not to be flexible enough to cover all transactions derivative in their nature. It does not cover some rather common derivative transactions, needless to say, it may also not be relevant in case of new derivative products emerging on the fast changing financial markets. As compared to EU definition, it also does not refer to general umbrella group such as “financial contracts for differences”, which encompasses wide group of cash settled derivative contracts which may, however, formally not fall within other segments of the definition. One may argue that providing for precise definition and avoiding general, abstract terms is a measure aimed at increasing certainty of law, so the participants to the market may easily assess whether contracts they trade are or are not financial derivatives. On the other hand, example of forwards and futures clearly demonstrates that by using only objective and technical criteria (e.g. obligatory indication by the parties that contract is derivative financial instrument) Russian legislator allowed for situation, in which contracts clearly derivative in their nature might not be deemed derivative financial instruments. This in its turn opens door for abuses by the parties willing to circumvent the law. In this context, it appears that EU definition focusing on settlement criterion, referring to more abstract categories (e.g. commercial purpose) and providing for umbrella group supplemented by examples is more complex, however, better reflects the unambiguous nature of derivative financial instruments.

Based on the criterion of the method of the settlement of the contract, derivatives are physically settled or cash settled. Physically settled derivative contract results in the actual delivery of the underlying asset to the other contracting party (e.g. deliverable forward). Shall the parties to the contract not be interested in the actual delivery of the underlying asset but rather agree on the payment of the difference between the market value of the underlying asset and its price specified in the contract, such derivative is cash settled. Therefore, in the latter situation, parties do not even take into account actual delivery of the underlying asset and from the outset it is known that contract will be settled by payment of a single lump sum.

Regardless of the above, in the doctrine it is often emphasized that one of the crucial aspects of a derivative contract is that it is purely financial contract in its nature. Thus, although it is possible to classify derivatives based on the settlement criterion into physically settled and cash settled, a contract for the delivery of a commodity in the future at the price determined as of now would not be generally referred to as a “derivatives contract”, shall the parties intended that physical delivery actually takes place. The parties at the outset of the derivative contract intend no actual delivery of the underlying asset. This is the factor that “transforms” an ordinary forward or futures contract into a derivative contract. In a derivative forward or futures contract the delivery is intended to be settled by payment of a single lump sum, or some other special arrangement. As a result, in the professional literature, when referring to “derivatives contracts” most authors actually mean cash settled “financial derivatives contracts”. This approach is followed in this work.

Based on the criterion of the risk profile, derivatives are divided into symmetric and asymmetric risk profile contracts. Derivative has symmetric risk profile, should both parties have rights and obligations under contract (e.g. a futures contract). On the other hand, asymmetric risk profile derivatives create obligations only for one party, whereas the other has corresponding rights only. Consequently, only one party may (but does not have to) exercise its rights arising from a contract. The option is derivative contract with asymmetric risk profile.

Lastly, derivative contracts can be traded in one of two ways and, as result, may be classified based on the place of entry (venue) criterion. Firstly, they can be transacted on an exchange. Such contracts are referred to as an “exchange-traded" or “on-exchange” derivatives and are subject to the rules and laws governing transactions taking place on the exchange. The clearinghouse of the exchange interposes itself between the seller and the buyer, and acts as a central counterparty for all exchange-traded derivative contracts. In order to protect itself from insolvency, the clearinghouse requires parties to deposit an initial margin. Additional margin calls are also made based on movements in derivative prices. Most of the terms of exchange-traded derivative contracts are subject to strict standardization.

Alternatively, derivatives contracts can be entered into on the “over-the-counter” (hereinafter: OTC) market. An OTC derivative contract, contrary to exchange-traded one, is an individually negotiated tailor-made contract. Under OTC derivative contract parties can enter into the terms of their own choice, including the contract volume and maturity date. OTC derivatives account for almost 95% of the derivatives markets. They have a significant impact on the real economy, from mortgages to food prices. It has been widely believed that it was the lack of regulation and, consequently, control over OTC derivatives market that led to the global financial crisis in 2007-08.

No matter the type, market participants transact derivatives for three main purposes: hedging, arbitration and speculation. Hedging function of derivatives market is concerned with strategic risk management. Derivatives may serve as means to offset either a market risk, meaning the risk of financial exposure to negative price fluctuations in the value or an asset (e.g. commodity), or credit risk, meaning the risk of financial exposure due to deterioration in creditworthiness. In this sense, hedging is similar to insurance. In commercial terms, there are two types of hedging. Firstly, a corporate client with few concentrated financial risks may seek derivative product to protect against these risks by generating profit, if they materialize. For example, an airline carrier highly exposed to the fluctuations in the price of jet fuel may be willing to enter into swap contract, which specifies the volume of jet fuel volume, the duration of its existence (the maturity of the swap), and the fixed price and floating price (market price) for jet fuel. The differences between fixed and floating prices are settled in cash for specific periods (e.g. monthly or quarterly). As a result, air carrier is hedged against fluctuations in the price of fuel as long as the swap is in place between parties. In the event market price of fuel increases, the air carrier is paid the difference between increased price and the fixed price as agreed in the swap contract. Alternatively, financial institution transacting derivatives itself and having many outstanding derivatives at any time given and, typically, on different geographical and financial markets, may seek to protect against all its net exposures on the constant basis.

Arbitrage is the process of making profits from difference in the price of financial assets. Dealers (market makers) typically generate profit by entering into transitions based on counterparty demand and charging so called “spread”. Different financial markets have different tax and regulatory requirements and therefore result in different costs on the same transactions. Dealer makes profit out of these differences.

Lastly, speculation is the process of making profit solely due to price movements. In this case, profit is generated by correct anticipation of a directional price trend of an asset. Speculator may be opposed to dealer who is willing to transact on both sides of a marketplace. Speculation and speculators themselves are subject to controversies. It is often argued that speculators provide liquidity to the market. Thus, they make it easier for the others to find counterparties willing to enter into particular transaction. On the other hand, when price on the derivatives market might become “artificial” it may be a consequence of intensive speculation. Moreover, even though participants to the market may be divided this and other way (e.g. into hedgers, dealers and speculators), S. James correctly points out that differences may not be as profound as they appear to be. In particular, it is possible to view any participant as a speculator.

Rather than negotiating every transaction from the scratch, participants to international trade typically heavily rely on standard form contracts. This is the case across many industries including debt finance, shipping and others. Nevertheless, use ofa single set of standard form documentation is particularlywell grounded in the OTC derivatives markets. OTC derivatives are privately negotiated and, in this regard, can be contrasted with derivatives that are traded on an exchange, such as standardized nickel or natural gas futures traded on the Moscow Exchange.

Standard form contracts are credited with increasing legal certainty and efficiency of cross-border transactions. Standard terms reduce costs by allowing to avoid situation, in which a new, customized contract has to be drawn up for each transaction. Consequently, transactions may be concluded more quickly and more cheaply, which in turn promotes liquidity of the market. Moreover, standard terms promote good market standards and increase legal awareness since their widespread use facilities legal discussion globally and, as a result, increases the level of understanding of their meaning. On the other hand, standard terms used globally are typically a compromise between different views, which are possible to fall short of the consistency and the standards that bilateral, fully customized contracts can achieve. These drawbacks may be, however, to some extent mitigated in the adjustable part of the documentation. To conclude, it appears that advantages of standard transaction documentation prevail, which is also proven by the market practice.

In financial transactions, the master agreement that sets forth standard terms that apply to all the transactions entered into between the parties is in the center of standard documentation structure. Currently, a number of master agreements are available for cross-border transactions, particular jurisdictions and various types of financial contracts. In international turnover, master agreements are typically standardized forms recommended and developed by financial industry representative organizations, including e.g. ICMA and ISDA. They are good example of lexmercatoria i.e. a set of norms and rules of non-state origin governing private law relations in international commercial turnover. Repurchase agreements are typically subject to the ICMA's Global Master Repurchase Agreement, whereas for derivatives transactions the ISDA Master Agreement is standard form from global point of view. Moreover, in the context of derivatives, IFEMA is worth mentioning as a master agreement widely used for both forward and spot transactions on currency in the foreign exchange market. In many jurisdictions, domestic master agreements have been developed and used for purpose of trading OTC derivatives on the national level. By way of example, despite various obstacles, supporters of derivatives succeeded in creating RISDA i.e. a Russian language equivalent of the ISDA Master Agreement governed by Russian law.

OTC derivatives have a wide range of uses and users, nonetheless, most of cross-border OTC derivatives are governed by the standard documentation published by the ISDA. Thus, ISDA documentation enjoys nearly supremacy status on global markets, and it is widely cited as the paradigmatic example of a standard form contract that forms transnational law. ISDA Master Agreement has become the most widespread set of terms governing derivatives transaction since publishing its very first version in 1987. Before that time, other contractual terms, such as FRABBA or BBAIRS were in use. None of them, however, operated as a comprehensive master agreement for all relevant types of financial transactions. ISDA Master Agreement, on the other hand, can be used as a standard rules for all transaction based on exchange of cash flows, which has several advantages: it is administratively and operationally convenient for the users, it facilities cross-product netting and the structure ensures that default under one of the transactions constitutes a default of the others.

For scholars who have looked into the ISDA documentation more closely, a key factor behind its special status is the active role of the trade association ISDA itself. ISDA was founded in 1985 and currently has over has more than 900 member institutions from 73 countries. It does not only publish standardized documentation but also trains market participants and their lawyers, publishes legal opinions with respect to dozens of jurisdictions around the world and revises the provisions of its documentation in a dynamic way. The publicly available pages of the ISDA website are informative as to the trade association's wide range of activities. For example, ISDA has published legal opinions on the enforceability of the netting provisions in its documentation covering 75 jurisdictions and opinions on the status of its collateral documentation covering 56 jurisdictions. The opinions are typically updated on ayearly basis. This range of activities undertaken by non-governmental organization as well as impact of its works on the derivatives market practice lead to conclusion that ISDA is actually generating “privatized private law”, or at least plays key role in explaining this type of global private law.

The earliest official version of ISDA Master Agreement introduced in 1987 was entitled “Interest Rate & Currency Exchange Agreement". It was then superseded by the “1992 ISDA Master Agreement”, which remains to be in circulation. Nevertheless, currently the form used most commonly for documenting OTC derivatives is “2002 ISDA Master Agreement” (hereinafter: ISDA MA), which is generally the market standard and will be discussed further in this work. The architecture of ISDA documentation consists of four key elements:

· Master Agreement as the principal document;

· Schedule to Master Agreement, which particularizes or amends respective provisions of standard agreement. Contrary to Master Agreement, Schedule is typically negotiated, however, negotiations need to take place only once;

· Confirmation for particular transaction incorporating a set of ISDA definitions relevant to the transaction. It sets out the terms and conditions agreed between the parties for a particular transaction;

· Any applicable credit support documentation, which provides for the collateralization or the guarantee of payment to be made under specified transactions.

Regarding the legal power of each element of the ISDA documentation, Clause 1b of ISDA MA clearly stipulates that in the event of any inconsistency between the provisions of the Schedule, Confirmation and the other provisions of ISDA MA, Confirmation shall prevail over all other documents for the purpose of the relevant transaction and the Schedule shall prevail over the ISDA MA itself. In the context of the above, it has to be emphasized that 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. Therefore, single Master agreement makes it more efficient for the parties to manage and monitor risk exposure based on overall assessment of all the financial transactions entered between the parties, given the frequency and volume of such transactions. On the very general level, the ISDA MA includes:

· Representations made by each party to the other, including party's power to enter into derivative transactions and the resulting enforceability of derivatives agreement;

· Conditions precedent to each party's payment to the other party;

· Agreements on furnishing certain information to each other;

· Provisions on “Events of Default” which provide the non-defaulting party with right to close out all of the transaction entered into between the parties and subject to ISDA MA;

· “Termination Events”, which are events occurring without any fault on the side of the parties and giving one or both parties the right to close out all outstanding transactions;

· Rights and procedures to terminate the transactions upon occurrence of Event of Default or Event of Termination, which include methodologies for calculating single, net amount to be paid from one party to the other.

It is often advised that ISDA documentation i.e. ISDA MA, Schedule, Confirmation and Credit support documentation shall be read in conjunction with a number of other documents published by ISDA and which are incorporated either by industry practice or specific reference. Which documents are relevant in particular case depends upon the type of transaction involved, however, typically these are typically the 2006 ISDA Definitions and the User's Guide to the 2002 ISDA Master Agreement.

One of the most important features of a Master Agreement and series of transaction concluded subject to it its terms is that all the transactions constitute a single agreement. This approach is particularly important in the event of default by one of the parties. In the essence, it means that a default under one transaction is deemed default under all other transactions entered into between the parties. This “single agreement” principle is embed in the Clause 1c of the ISDA MA under which parties enter into transaction “in reliance on the fact that this Master Agreement and all Confirmations form a single agreement between the parties (collectively referred to as this “Agreement”), and the parties would not otherwise enter into any Transactions.” S. James correctly points out that this provision is not direct that all transactions subject to Master Agreement form a single agreement, but rather stipulates that such shall be the effect.

The User's Guide to the 2002 Master Agreement describes Section 1(c) as “a fundamental provision that is the basis for close-out netting”. The effect of the “single agreement” provision is to create a single net amount payable by one party to another on the termination of the relationship between the parties. This plays key role if one of the parties becomes insolvent. Solvent counterparty could otherwise be obliged to make payment of sums it owes to the insolvent party and, at the same time, it could not effectively claim sums owned to it by insolvent party. Without abovementioned provision there would be no reason that e.g. all of the interest rate swaps concluded between the parties, should be taken to form a single agreement with each individual commodity derivative or equity option. The rationale behind the “single agreement” approach is to allow for set off regarding the amounts owed between the parties and to determine one final net sum, it the contractual relationship between the parties is to be terminated. This issue is of paramount importance in case of cross-jurisdictional transactions when insolvency of the counterparty takes place. Under most of insolvency law models, unsecured creditor is precluded from recovering an amount owing to it from insolvent party under contracts, which are economically beneficial to the creditor, while it remains liable to settle outstanding payments under other contracts, which are not beneficial to the creditor. Thus, the risk for the solvent party is that it can could be forced to make payments in gross of all amounts that it owned to the insolvent party, but it would not have a right to either set off its liabilities against its receivables or, alternatively, to recover amounts owed by the insolvent party.

Keeping above in mind, the solvent party typically wants to be able to reduce parties' exposures to a single, net amount covering all transactions, rather than to allow insolvency administrator to “cherry-pick” only particular transactions to be settled. At the same time, even in legal systems allowing for set off in the course of insolvency there is typically a requirement for the amounts owed by the parties to be mutual obligations.

Single agreement principle seeks to create a link between these transactions so the mutuality is established. In the aftermath, it deprives the insolvency administrator of right to reject unprofitable derivative contracts while preserving profitable ones. One of the main reasons to incorporate concept of single agreement to ISDA MA was not only to create a link between the transactions aimed at mitigating counterparty insolvency risk, but more generally to address systemic risk across the financial system as whole.

Nevertheless, in the international doctrine there are some concerns as to whether “single agreement” approach may be always valid and legally effective. In particular, in relation to the Master Agreement when it appears to be linking otherwise unconnected transactions e.g. different types of transactions, entered into on different dates, through different offices. In such case, there are doubts whether “single agreement” approach may indeed provide for mutuality of debts typically necessary for insolvency set-off to take place. Moreover, e.g. in the English judicial practice there have been already cases which to certain extent undermine "single agreement” approach. These cases have not related specifically to insolvencies, however, may be alarming of to take into account that English law is most frequently chosen by the parties to govern ISDA MA and counterparties to international turnover typically also submit to the jurisdictions of the English courts. Thus, judicial practice of English courts on the interpretation of particular provisions of the Master Agreement that is subject to English law may have far-reaching consequences.

In relation to tax law, in Inland Revenue Commissioners v Scottish Provident Institution it was held that two option agreements were separate from collateral agreement created to secure aforementioned options, despite the fact that ISDA Master Agreement which has been in place between the parties provided for “single agreement” approach with respect to all of the documentation including collateral agreement. On the other hand, this decision did not focus strictly on the “single agreement” approach. The main issue in the case was related to artificial tax avoidance and the court did not consider in detail legal nature of standard contractual documentation. There have been also other cases, which confirm that for tax purposes the “single agreement” approach may be challenged as artificial, in particular in cases where derivatives are used for tax avoidance strategy.

On the other hand, in case BNP Paribas v Wockhardt EU Operations (Swiss) AG that was not tax related, the efficacy of “single agreement” has been confirmed. In this case, the parties had entered into three foreign exchange forward transactions under ISDA MA. Each transaction involved the sale by BNP to Wockhardt of at least 400,000 euros per month in exchange for American dollars at a fixed rate. Wockhardt failed to pay in respect to these transactions, culminating in BNP terminating the transactions and providing a statement of calculations showing set-off of the outstanding amounts owed between the parties and single net amount (“Early Termination Amount”) to be paid by Wockhardt. One of the points in Wockhardt's line of defense was that the “single agreement” provision in the ISDA MA was allegedly “artificial”. However, the Commercial Court judgment by Christopher Clarke J was supportive of the ISDA documentation architecture whereby the Master Agreement, Schedule, Confirmations and Credit support documentation are construed as constituting one single contract, under which breach in relation to one transaction can cause all other transactions to be terminated. Position confirming efficacy of “single agreement” expressed in BNP v Wockhardtjudgementso far has not been challenged by other English courts, save for aforementioned tax related cases, where derivatives transactions have been used in tax avoidance strategies.

Russian insolvency law seems to apply in a formal manner that does not cause serious concerns on the validity and legal effect of the “single agreement” approach. This is achieved by the relatively straightforward regulation. In accordance with Art. 63 item 1 and Art. 81 item 1 of the Law on Insolvency, as a rule, in case of commencing insolvency it is not allowed to terminate the debtor's monetary obligations by offsetting a counterclaim, if this violates the priority of satisfying claims of creditors. Thus, Russian law has developed very rigid regime that restricts satisfaction of creditors by offsetting a counterclaim against the debtor throughout the entire insolvency proceedings. Such a strict regulation is rather unusual as compared to e.g. Austrian, English, German or French law, which under certain conditions, allow for insolvency set-off. Therefore, even establishment of the mutuality of obligations between several financial transactions solely by the application of “single agreement” approach could have not effectively protect creditor in the light of Russian insolvency law because set-off is prohibited in any scenario.

Art. 63 item 1 of the Law on Insolvency was amended and starting from 11 August 2011, Russian law allows for a single exception from prohibition on insolvency set-off. Namely, this prohibition shall not apply to the termination of obligations arising from financial agreements and determination of the single net obligation. In accordance with Art. 4.1 item 1 of the Law on Insolvency, aforementioned financial agreements cover: a) agreements concluded under the terms of a master agreement (single agreement) and; b) agreements concluded on the terms of organized trading rules or clearing rules. Both types of financial agreement sallow for insolvency set-off in order to determine net obligation only upon meeting additional requirements that are analysed in details further in the Chapter III Section C of this work. At this point, however, the following may be concluded. Under Russian law, the goal of allowing for single net obligation covering all derivative transactions outstanding between the parties in case of insolvency is achieved in a formal manner. It is not necessary to analyse whether “single agreement” provision as referred to in the in the Clause 1c of the ISDA MA indeed establishes sufficient level of mutuality or real link between otherwise unconnected transactions because these factors are irrelevant to the termination of obligations arising from financial agreements and determination of single net obligation. Should the transactions be concluded by the same parties and governed by the same master agreement, which meets formal requirements specified in the Art. 4.1 of the Law on Insolvency, determination of single net obligation is allowed.

Financial derivative instruments are traded both on OTC markets and on stock exchanges. Globally, OTC market is definitely better developed. As of end-June 2016, the global size of exchange-traded derivatives (hereinafter: ETDs) market was slightly above 10% of the global derivatives market which itself follows a declining trend since 2008. In terms of notional amount outstanding, ETDs market is mainly composed of interest rate derivatives split into 60% of options and 40% of futures. Privately negotiated OTC derivative contracts are more suited to the needs of parties and allow for better matching of transaction entities - primarily institutional investors, such as banks or investment companies. On the other hand, standardized derivatives traded on stock exchanges offer greater transparency and risk reduction (at least as compared to non-cleared OTC derivatives). Moreover, the standardised nature of ETDs ensures their price competitiveness and liquidity. In case of ETDs, master agreements and supporting documentation do not apply. Instead, the stock exchange as the organiser of trading develops standard specifications, i.e., detailed characteristics of particular derivative financial instrument such as underlying assets, maturity, size of contract, terms of delivery etc. Standardised derivatives are then traded in accordance with the internal regulations of each particular stock exchange. Regulations have to comply with relevant legislation of the state where exchange operates and in most jurisdictions they require registration or approval by respective supervisory authority. Moreover, they typically contain, inter alia, special trading rules for executing trades on the derivatives market. By way of example, below are listed selected stock exchanges and their respective trading rules on derivatives:

· The London Stock Exchange - “Rules of the London Stock Exchange Derivatives Market”;

· The EURONEXT - “Rule Book I - Harmonised Rulebook”, which contains Chapter 5 “Trading Rules for Derivatives”;

· The Moscow Exchange - “The Moscow Exchange Derivatives Trading Rules”;

· The Warsaw Stock Exchange - Chapter 4 “Derivatives” of “The Warsaw Stock Exchange Rules” contains rather scant regulation and provides for powers of the Exchange Management Board to determine detailed exchange trading rules for particular derivative contracts. As a result, separate trading rules were adopted for each particular derivative product traded on the Warsaw Stock Exchange, e.g. “Trading Rules for a Scheme of Euro Futures Contracts”, “Trading Rules for Options on the Warsaw Stock Exchange Large-Cap Index WIG 20”, “Trading Rules for a Scheme of Futures Contracts on WIBOR Reference Rate”.