The Possible Impact of COVID-19 on the OTC Derivatives Markets
As has been extensively reported by the media and health agencies across the globe, the outbreak of a respiratory disease caused by a novel coronavirus (also known as COVID-19) has now been detected in almost 70 locations internationally, including in the United States. The fact that the disease has caused illness, in some cases resulting in death, and sustained person-to-person spread, is particularly concerning. As such community spread is detected in more and more countries, the world moves closer toward meeting all three criteria of a pandemic, the worldwide spread of the virus.
Countries have responded in various ways to curtail the spread of the virus, including by restricting travel and establishing quarantines for affected persons (and in some cases, entire regions). In one recent example, the Chinese government ordered the shutdown of cities and factories and extended the Lunar New Year holiday. As COVID-19 continues to spread across the globe, other governments and local authorities may take similar actions, thus impacting their own local markets and businesses. Please see our related publication discussing more generally the steps that businesses may want to consider.
With respect to the OTC derivatives market, actions taken by local authorities in response to the spread of COVID-19 may have an impact on payments, settlement and pricing in respect of derivatives transactions. For example, government intervention or actions may cause an unscheduled bank holiday or an exchange, price source or settlement disruption, or may prevent parties from performing entirely. Industry standard documentation generally provides mechanics for adjustment or termination of a trade in such circumstances, and, thus, market participants should closely evaluate their trading documentation and related product definitions (e.g., ISDA 1998 FX and Currency Option Definitions, ISDA 2002 Equity Derivatives Definitions, etc.) to determine what impact such disruptions may have on outstanding trades.
In addition to the effect on individual trades, disruption to normal workflow and accessibility may impact counterparty relationships more holistically. For example, the ability to give proper notices to trading counterparties may become an issue, particularly for default notices where actual delivery (by overnight mail or courier) is generally required, including under the ISDA Master Agreements.
Another issue to consider is whether the virus will lead to widespread invocation of force majeure clauses in commonly used trading agreements. Notably, the 2002 ISDA Master Agreement (2002 ISDA) includes a “Termination Event” for force majeure whereas the 1992 ISDA Master Agreement (1992 ISDA) does not. However, the User’s Guide to the 1992 ISDA contains a similar “impossibility” provision which may be adopted by market participants. The 2002 ISDA “Force Majeure Event” applies after giving effect to any product-specific fallbacks or remedies that may be contained in relevant product definitions applicable to a particular transaction. It relates only to the relevant office of a party which is unable to make or receive a payment or delivery or comply with any material provision of the ISDA relating to a transaction and requires that the party (i) be prevented from performing or “it becom[ing] impossible or impracticable” for that party to perform due to the force majeure event or act of state, (ii) that the event be beyond the control of such party, and (iii) that the party could not, after using all reasonable efforts, overcome such prevention, impossibility or impracticability. If the Force Majeure Event is triggered, the parties are obligated to defer payments and deliveries during a “waiting period” for up to eight business days. Upon the expiry of the waiting period, either party may elect to terminate some or all “Affected Transactions” upon two business days’ notice.
However, it remains an open question whether trading counterparties will actually be able to rely on a force majeure or impossibility provision, particularly with respect to cash-settled transactions where performance may simply rely on the ability to access computer and/or payment systems, which can be accessed remotely. The more likely application of such a provision will be for physically settled transactions, such as for the purchase of oil, gas or other commodities.
While the financial, commercial and social impact of the COVID-19 outbreak has yet to be fully determined, derivatives market participants would be well served to perform assessments of its impact on their trading agreements and trading counterparts. It should be noted that both industry groups and regulatory authorities are also examining these issues on a real-time basis, and market participants should avail themselves of information and resources provided by such sources, as well as consulting with their legal advisors.
For More Information:
 2002 ISDA Section 5(b)(ii).
 Under Commodity Futures Trading Commission Rule 23.603, swap dealers are required to establish and maintain a written business continuity and disaster recovery plan that outlines the procedures to be followed in the event of an emergency or other disruption of its normal business activities and which is designed to enable the swap dealer to continue or to resume any operations by the next business day with minimal disturbance to its counterparties and the market.
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