Cross with borders?

By Joe Sweeting – Team Lead at DRS

So, you have cross-border concerns? Fret-not, you’re not alone! The modern derivatives market is inherently international, and this internationality brings with it a distinct set of cross-border concerns. Although many derivatives are used to hedge domestic risks, the contracts themselves frequently span multiple jurisdictions, engage multiple legal systems, regulatory regimes, and market infrastructures. Running in tandem are factors such as the global nature of financial risk, the concentration of liquidity in a small number of financial centres, and a market structure dominated by multinational dealers. And yet, despite this international participation the market remains dominated by two favoured choices of governing law: English and New York Law. This dominance, however, is logical. These legal systems provide predictability, commercial sophistication, and well-developed jurisprudence on contractual enforcement and, most important of all, close-out netting. Cross-border issues, therefore, are not peripheral to derivatives markets; they are central to understanding how these markets operate and where their vulnerabilities lie.

Cross-border and Close-out netting

To set the scene of our analysis of cross-border concerns, we must first consider the process of close-out netting: Close-out netting allows a non-defaulting party to terminate all derivative transactions under a master agreement, boiling them down into a single net payable or, if we are lucky, receivable sum.  In essence, following an Event of Default or Termination Event the non-defaulting party is able to:

• Terminate all outstanding transactions under the master agreement; and
• Convert all positive and negative replacement values into a single net payable or receivable value.

Continuing our review of more general principles, for netting to be enforceable, the contract must:

• be validly entered into;
• the parties must have legal capacity; and
• all transactions must fall within a legally recognized “netting set”.

Turning now more specifically to cross-border contracts, the effectiveness of close-out netting depends not just on whether the governing law of the contract is English or New York law, but on whether the counterparty’s insolvency and resolution regime will recognize that net claim. Without enforceable netting, each transaction can be treated as a separate claim in insolvency, which in turn can:

• multiply gross exposure;
• increase capital requirements;
• undermine collateral efficiency; and
• change the risk profile of the entire trading relationship.

Most critically, local insolvency law must permit termination and set-off; the less favourable alternative is the imposition of stays, liquidators’ powers to cherry-pick favourable transactions, or legal restrictions that override contractual rights. These risks are heightened in jurisdictions without formal netting legislation, in special resolution regimes for banks that impose temporary stays, and when dealing with certain entities such as public bodies or state-owned enterprises.

Furthermore, structural complexity arises when trading through branches rather than subsidiaries because the applicable insolvency law is often that of the parent’s home jurisdiction, rather than the contract’s governing law. This can create a mismatch between what the contract provides and what the court or regulator will enforce in a default scenario. The ISDA Master Agreement enables its users to elect, within the Schedule, the ability to transact through different offices around the globe, in addition to the home office of the contracting party(s).

This election neatly ties into our discussion regarding the enforceability of the contract: Where the parties elect to transact through multiple branches, it becomes necessary to establish enforceability of the master agreement on a branch-by-branch basis. Depending on the jurisdiction, a branch may not be legally recognised as forming part of the same legal entity as the head office for insolvency or enforcement purposes. The natural consequence of this separation is that we are then unable to identify the assets, obligations, rights or liabilities of that branch as being attributable to that party’s head office. In turn, we therefore may find that an insolvency practitioner in that jurisdiction is unwilling to recognise the branch is akin to its head office.

It’s not all doom and gloom, however! Market participants manage these risks through jurisdiction-specific netting legal opinions which determine whether a counterparty is eligible for netting and regulatory capital relief. They also structure relationships to book trades in netting-friendly jurisdictions and adhere to regulatory stay recognition protocols for bank resolution regimes. Finally, collateral arrangements serve as a practical safeguard by reducing gross exposure if netting is delayed or challenged in insolvency.

In essence, close-out netting in cross-border derivatives is only as strong as the weakest insolvency and regulatory framework in the structure, requiring a combination of legal analysis, contractual design, and operational risk controls to preserve its economic effect.

But what of the individual (transactions)?

The question of whether local law will uphold the terms of a contract need to be considered on two levels:

1. Will the local law uphold the terms of the contractual documents?

In the context of the ISDA Master Agreement, this will relate to the Master Agreement, Schedule, Credit Support Documents and other related protocols and definitions. If there are any parts of the contract which would not be valid under local law, the next question would be whether those terms would be open to amendment to bring them within local law. In addition, consideration needs to be given as to whether the contract as a whole would survive the inclusion of a particular clause which might not be upheld by local courts.

2. Will the local law uphold the terms of any individual transaction which is entered into?

Some jurisdictions may provide a list of transactions which are approved, and others may take the opposite approach and provide a list of those which are disapproved. Of particular concern will be the more exotic transactions, such as innovative derivatives which have not acquired common usage in the markets. The corollary question to this issue is whether the inclusion of a particular type of derivative which is overturned would impact other transactions entered into under the same documentation between the parties.

Re-characterising our woes

We must also consider the underlying risk that transactions documented under the ISDA Master Agreement and related Credit Support Annexes (CSAs) may be re-characterised by courts or insolvency administrators as secured lending or financing arrangements rather than outright transfers. This risk is most significant in insolvency proceedings, where statutory priorities, avoidance rules, and local insolvency law may override contractual terms, and where such re-characterisation could invalidate close-out netting and collateral enforceability, resulting in materially higher unsecured exposure, reduced regulatory capital recognition, and potential losses in counterparty insolvency scenarios.

As noted above, re-characterisation risk arises where a court or insolvency authority looks beyond the contractual form of an ISDA-documented transaction and determines its substantive economic nature to be that of a loan, security interest, or financing arrangement. In this context, it is important to note that the ISDA Master Agreement is structured as a “single agreement” to enable netting of all obligations upon default. As a result, where a court or insolvency practitioner seeks to look past this contractual form, we run the risk that, where transactions are re-characterised as separate financing arrangements, a court may:

• disapply contractual netting provisions,
• apply local insolvency set-off rules instead, and;
• convert a net claim into multiple gross unsecured claims.

The result of such changes being the material increase in credit exposure, coupled with a potential uplift in capital requirements. Additionally, as the mechanics of an English Law CSA result in the transfer of collateral via a title transfer (as opposed to being pledged as security), the risk in this context is the court re-characterises the transfer as a security interest. Here, if the interest is not perfected, or registered, in the relevant jurisdiction we run the risk that the collateral may be rendered void, or alternatively assets may be ‘clawed back’ into the insolvent estate – the key risk here being a loss of priority during insolvency proceedings over assets, or a complete inability to recover any shortfall.

A final consideration in the context of re-characterisation is that certain derivative transactions may be considered to be contracts for gaming or wagering; with many jurisdictions engaging stringent gambling controls, this form of re-characterisation introduces the risk that such transactions are simply declared unenforceable in law. The key factor to be examined in this context is the commercial context, or purpose, of each transaction: the more speculative the transaction is, or the more emphasis a transaction places on a specific outcome, the more likely the risk that a transaction be re-characterised as gambling is to occur. Conversely, where a transaction under the contract has a clear commercial purpose, the less likely it is that such a transaction would be re-characterised as wagering, and consequently the lower our risk of re-characterisation becomes.

Ultimately, then, we can comfortably conclude that re-characterisation presents a material threat to the enforceability of ISDA netting and collateral arrangements. With potential adverse impacts on credit exposure, recovery outcomes, and regulatory capital, continued legal oversight, jurisdictional monitoring, and disciplined documentation standards are essential to maintaining risk control.

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