The LBMA Bullion Market Forum, Moscow – June 2004 Page 99

The Development of Documentation

Martin Stokes

Vice President, JP Morgan Chase

It’s a real pleasure for me to be here in Moscow and I do hope that in general you’ve found this Forum useful and interesting. I would also like to put on record my personal thanks to those individuals who have been involved in the translation into Russian of A Guide to the London Bullion Market. I know that it has entailed a significant amount of work for both NBL Gold and for Maria Gueguina and her team at the Central Bank and I would particularly like to mention their assistance.

The topic of documentation is rather a dry one for the final session – especially before lunch – but as you must all be aware, documentation has become an increasingly important focus in all the markets these days. Ignore it at your peril!

My own background is on the trading and marketing side of the bullion business, and you may ask why I am speaking today on the subject of documentation. The prime reason is that I missed the LBMA meeting when the programme of this seminar was being discussed – so when my name was proposed, there was no one to object. More seriously, I have been involved for over 12 years at the LBMA in trying to increase the transparency of the market and to expand the scope of standardised documentation; working to translate between the requirements of the legal profession and the needs of the market.

These days, you don’t even get a short e-mail note without a very long disclaimer. Therefore I’d better preface my speech with an important statement – I am not a lawyer – and this presentation is one from the perspective of a trader rather than a legal expert.

By the way, do you know that if you enter “lawyer jokes” into Google on the Internet, it returns 1.07 million entries? It’s clear that this is a profession that is a big target for humour. In my background research for this presentation, one of the best jokes I found was “how many lawyers does it take to change a light bulb?” The answer is only one, but there is some paperwork attached, as follows.

“Whereas the party of the first party known as lawyer and the party of the second party, known as light bulb do hereby and forthwith agree to a transaction wherein the party of the second part (light bulb) shall be removed from the current position as a result of failure to perform previously agreed upon duties, i.e. the lighting, elucidation and otherwise illumination of the

area ranging from the front door, through the hall, terminating at an area just inside the primary living area, demarcated by the beginning of the carpet, any spill-over illumination being at the option of the second part (light bulb) and not required by the aforementioned agreement between the parties. The aforementioned removal transaction shall include, but not be limited to, the following steps: 1) The party of the first part (lawyer) shall with or without elevation at his option by means of a chair, step-stool or ladder grasp the party of the second part (light bulb) and rotate the party of the second part (light bulb) in a counter clockwise direction, this point being non-negotiable.”

You get the idea. This document extends over several clauses and concludes “…the objective being to produce the most possible revenue for the party of the fifth part, also known as “partnership”. Lawyers – we need them, but let’s try to make things simpler!

Basically in the good old days in OTC markets, counterparts did business with each other purely

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The LBMA Bullion Market Forum – Moscow, 3-4 June 2004 Page 100

on the basis of personal trust and a handshake. Knowing your customer’s business and his character was of paramount importance. Documentation was usually a very simple letter outlining the expectations of both parties in a trading relationship. Broadly this was the situation when I started work in the City. Of course, clients liked these arrangements and in the main, business progressed smoothly. However, as communication improved, business became more international and speculative volumes grew, so the risks increased. The collapse of Herstatt bank in June 1974 and the ensuing chaos in the FX markets forced banks to look more closely at – and try to control – their precise position with clients and counterparts in a worst-case situation. As time went by, occasional bank failures and crises merely escalated this need to be certain of the parties’ rights and obligations – before, rather than after, the event.

However, these were competitive times and through this period, banks and trade houses in over-the-counter markets used documentation – or the absence of it – to gain an edge with clients. In some cases every trade was confirmed with a massive form of agreement and in others with virtually nothing.

Now I’ll let you into a secret. When I started my work for the LBMA in the field of standard documentation, it was solely in order to improve JP Morgan’s position in the market. As one of the earlier US commercial banks in the bullion market, our documentation was, to say the least, rather substantial. I would go to clients and present them with a stack of papers. The client would generally respond by saying, “Oh, I’m not going to read through and sign all that, and by the way, here’s the one pager that X bank or Y bank (or whoever my competitor was), has given me.” I had to level the playing field – and providing some standard documentation would hopefully achieve this.

Fortunately for me, around this time, players in the market were beginning to realise that all this painful bilateral legal work while being vitally important, was becoming more and more expensive and time consuming. Logically, if there are just ten players in a market, then each one has to look at nine separate pieces of bilateral documentation – so 90 separate negotiations. Naturally every in-house lawyer wants to show that he is valuable to his employer, so he is likely to raise some points of discussion, possibly even if they are not really important.

Further, as I have mentioned, in many cases at this time each trade may have been documented by very long confirmations – each one being the length of today’s Master Agreements – and in some cases, each party to the trade claiming exclusive rights and giving the other party little room for manoeuvre. Of course, each company claimed that theirs was the documentation which governed the trade – and every in house lawyer, like every football player wanted to play with home ground advantage. Clearly this situation couldn’t last.

In a recognised exchange such as NYMEX or the Chicago Board of Trade, there are specific rules that apply to all participants. These relate to such things as contract size, maturity dates, initial and variation margin levels, etc. In an OTC market, such items are all flexible – but the banks and trade houses have recognised that it’s not cost effective to negotiate every issue with every counterpart and client. What has happened in the bullion market (and others) is that participants have realised that there are some items that are common ground and therefore should be agreed by all players before the start of any trading relationship. The participants are not less competitive; they merely concentrate on competing more on the economics of trades rather than their basic legal structure and the rules of the game. Further, when you have agreed all the background to any transaction and also agreed a format of confirmation, it’s relatively easy to set up your back office process merely to fill in the blanks with the details of any trade in a short form of confirmation.

I suppose that the LBMA Good Delivery List of bars which are acceptable by all parties – and which Stewart Murray will discuss later in the programme – could be construed as a generally recognised document in our market. However, in a more conventional sense, our first steps in the direction of standardised documentation came with IBMA in 1994. This International Bullion Master Agreement did for bullion what had previously been done in the FX markets with IFEMA (the International Foreign Exchange Master Agreement). Clifford Chance were very helpful to us, and the document which we prepared has been used for many years by numerous participants in the market. I should explain that both IFEMA and ISDA are “terms” documents. This means that they merely seek to establish market practice in London – and therefore provide guidance to the English courts as to what should be done in the event of a liquidation.

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One of the most important principles is insolvency netting, which allows the non-defaulting party to net off all exposures and arrive at a single amount of currency, which is owed by him or due to him from the defaulting party. Lawyers often speak of “cherry picking” in this context – here they worry that a liquidator will seek to take all the outstanding trades that are making money and refuse all those which are losers. IBMA seeks to make the position of the non-defaulting party absolutely clear and to give him rights of liquidation netting. In its position as a “terms” agreement, and in its UK concept, IBMA did not require signature by the parties, as it provided, if you like, rules of the game which applied to everyone in London. We did however, provide a US version – and in that jurisdiction, bilateral signature was required.

As time went by, it was clear that IBMA worked well for those counterparts who had contact only in the bullion market. However, the larger banks and clients had trades in many other markets and products. IBMA only covered bullion, and we needed an overarching document that allowed netting of bullion along with all other all products and exposures.

Therefore in 1996/7 I spent long sessions once a week in a room with about 15 lawyers for about eight or nine months. Not my idea of fun, but at the end of the process we produced the 1997 Bullion Addendum to ISDA. This was done with the assistance of Allen and Overy and basically paid for by ISDA.

ISDA is wider ranging than IBMA and includes provisions to clarify the precise position of the parties to a trading relationship in a variety of areas. So for example, if a company becomes insolvent, does the non-defaulting party have the right to net off trades done with its subsidiary or parent or sister company? This must be mutually agreed – optimally, before trading takes place. What constitutes an event of default? What is the tax situation? It’s all in the documentation! An ISDA master agreement further requires that a bank establish the client’s precise position under the laws in the client’s own country. Local legal counsel must be engaged and asked questions broadly in two areas – the first whether the laws in that particular country allow the customer to engage in the trades which are being envisaged. The second is what will happen in the unfortunate case of a bankruptcy? For example, will the netting process be allowed by a local liquidator? The answers to these questions give the bank’s lawyers confidence or otherwise in how any client liquidation will proceed – and

this information feeds directly into the credit process.

Now this is not to say that credit will be refused; it just means that there is less confidence behind the bank’s rights in a worst-case situation. For example, I believe that in Russia, a lot of derivative contracts were not accepted by the local liquidators after the crisis because they were judged to be illegal gambling deals – therefore, unfortunately, there is not very much confidence in the international legal profession that such derivative contracts will be recognised in the Russian jurisdiction until there is a clear change in the law.

I do know that there are legislative changes coming to address this issue, but they are not here yet! You can do the deals on the basis of the good standing of your local customer – but better to be sure that you know the situation if there are any problems. Further, if an international bank holds margin from a Russian company and that company goes into liquidation, then strictly speaking, under Russian law, the liquidator can ask for that margin to be returned to the pot of assets that remains for all the creditors. Therefore the margin holder’s position may be no better than any other creditor. Now you might say that the bank is holding that margin or collateral in London or New York and the liquidator cannot come after it without a great deal of expense and effort. Well, perhaps… but many of the parties to these deals are large international companies with both a need to follow laws and also a wish to return to do business some time in the future. If they ignore local laws, they may find it very difficult to get back into the market.

Just as an aside – a very important point to note here from the bullion market’s perspective is that in general, assets held in a true custody relationship usually remain ring-fenced from a bank, even on the insolvency of a client. So generally, therefore, client balances of unallocated gold or silver which a client holds on account in London are not included in any netting process in an insolvency ruling. It’s important to understand that the ISDA documentation has been extensively tested – if I can use that word – in several real life situations.

This is not just hypothetical! In the UK, one of the major local government authorities, Hammersmith and Fulham, entered into many interest rate derivative contracts which were subsequently set aside by the UK courts. The banks lost a huge amount of money because they had not determined whether the local

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government had the capacity to enter into such trades – the legal opinion was ultimately that they did not. Similar examples in the US were the Orange County, Procter and Gamble and the Hallmark Card problems – all of which ended up costing the banks both money and reputation. The Far East and the Russian crises, the collapse of Barings’ Bank and more recently Enron and Parmalat have all served to sharpen the banks’ awareness of the need to establish their legal and netting rights in case of counter-party difficulties.

Of course, given increased concerns about both bilateral and systemic risks, the regulators of the markets have in more recent times taken a very close interest in documentation. So in the Basle regulatory pronouncements – Basle 1 and 2 – the quality of documentation which you have with your clients and counterparts feeds directly into the amount of regulatory capital which the banks must reserve. So the quality of your documentation has begun to impact the bottom line – and therefore to attract the attention of very senior people within organisations. I suspect that in future this issue ultimately will be a very strong and logical driver for more and more precise documentation – hopefully most of it in a standard form.

Now, I’d like to move on to cover other areas where the LBMA has done important work in the area of documentation.

As you may know we have established standard documentation to cover both allocated and unallocated accounts for bullion in London. Indeed these documents are currently being reviewed and updated. The adoption of these standard terms – with only minimal need for individual tailoring – removed a major area of bilateral negotiations. Once more, the documentation is transparent and fair and also provides a level of comfort insofar as its adoption reinforces the concept of market practice from a liquidator’s perspective.

Within the group of bullion clearing banks in London there is an agreement known as a Memorandum of Understanding. This document, in some part negotiated with the assistance of the LBMA, provides comfort for allocation and cross netting of balances across exchange accounts for credit purposes. So the banks concerned are very clear as to their rights and obligations. Apart from rules on allocation, there is an ability to offset gold and silver balances. Further, there is flexibility to allocate gold in non-good delivery form – i.e. kilobars – but only for credit and not for liquidity purposes. The

Memorandum is central to the smooth running of the loco London clearing system and is an important part of the documentary architecture of the market.

Currently there are two other items under discussion within the LBMA in the field of documentation for the future. The first is an attempt to create a standard document for consignment accounts, and the second is to respond to the requests of ISDA to update their commodities addendum. I hope that you will hear news of both in the coming months.

In summary, all market participants must be aware of the importance of documentation – and this importance will surely grow. The impact is in a variety of areas of credit – because increasingly, credit officers will only give trading lines if appropriate documentation is in place, they are sure that clients are able to engage in trades under their internal and national controls, and the bank knows its precise position in a liquidation situation. There is increased balance sheet impact and a need to provide increased regulatory capital if the legal position is not clear.

Finally there is the question of addressing systemic risk, because regulators want to be comfortable that all market participants are clear in regard to their rights and obligations in a worst-case situation.

However, some help is at hand. International associations, such as ISDA, provide significant assistance both to members and non-members. Please take time to look at ISDA’s website – www.isda.org – where you will find a great deal of useful information and educational material. Where possible, trade associations such as the LBMA will also work towards providing standard documentation for the benefit of all their members and associates. Please remember that it’s best to be sure of your position before engaging in the ever-more complex trades that these dynamic marketplaces have to offer. As you know, some of the best deals can fall apart if appropriate documentation is not in place. ■