Understanding corporate finance: derivative contracts: documentation
The importance of documentation
A company that wishes to deal in exchange-traded futures or options will need to transact the trades through a broker unless it is itself a member of the relevant exchange. Initially, the company will need to put documentation in place with the broker, as well as the exchange and the clearing house. From then on the primary documentation held by a company in relation to the trades that it executes will be the confirmation notes that it receives from its broker.
The situation is somewhat different with over-the-counter (OTC) contracts. A derivative contract is governed by the same general principles of law as any other kind of contract. In order to avoid disputes, both parties need to be clear about their rights and obligations under the contract. This could be achieved by each party engaging lawyers to draw up a contract (and this does sometimes happen), but generally it is more convenient, as well as cheaper, for standard terms to be used. The use of standard terms also lessens the risk of misunderstanding, because there is an extensive body of legal opinion on what they mean.
The most widely used standard documentation is that produced by the International Swaps and Derivatives Association, Inc (ISDA), although other standard agreements, such as those produced by the British Bankers’ Association, also exist. See CFM13100.
Where a company has entered into an OTC contract - for example, a company has bought a swap (see CFM13230) from a bank - you will typically see three steps in the transaction:
- The company negotiates the terms of the swap with the counterparty over the phone, and a verbal agreement is reached. Provided that the offered terms are clear, and the company unequivocally consents to them, the contract comes into being at this stage.
- It is usual for a written confirmation of the terms to follow, normally within 24 hours, and for both parties to sign this. The confirmation may elaborate on the terms agreed verbally.
- The parties exchange and sign any remaining contractual documentation at a later date. It is very common for the parties to a swap to execute an ISDA Master Agreement. This is something they need only do once - the terms continue to apply to all subsequent transactions.
The terms of a master agreement can apply to transactions which took place before it was signed. You may see cases where the confirmation specifies that the transaction will be subject to a master agreement yet to be executed, and the agreement is actually signed at a later date. This is normal. The derivative contract still comes into existence at the date of the verbal agreement, even if there is a delay in completing all the paperwork.
It is possible for a derivative contract to be made wholly verbally, without any documentation. However, it would be very unusual, even between connected parties (such as companies in the same group).
Any company which enters into an OTC derivative contract runs the risk of losing money if the other party defaults. It is common for one or both parties to protect themselves by asking for collateral and/or guarantees from the other, which will be the subject of separate legal agreements.