Over the counter (OTC) derivative transactions – mainly plain vanilla FX and interest rates derivatives and to a lesser extent commodity derivatives – are becoming increasingly popular on the Bulgarian market.
Market practice when only Bulgarian parties are involved is to use various local master agreements governed by Bulgarian law. Such local agreements often follow the key principles and standards of international financial documentation, such as the 2002 ISDA Master Agreement (the “ISDA MA”), which governs all legal, operational, and credit risk aspects. For cross-border transactions, market participants normally use the ISDA MA, while taking into account certain specific aspects of Bulgarian law. The most important issue for banks in both local and cross-border OTC derivative transactions is to receive a clean opinion on the enforceability of the close-out-netting mechanism under Section 6 (e) of the ISDA MA, since the ability to net allows the banks to allocate capital only against the net figure they would have to pay on close-out rather than the gross amount under the transaction.
In this respect the International Swaps and Derivatives Association (ISDA) has obtained legal opinions (on which its members may rely) from various jurisdictions confirming the effectiveness of close-out netting in such jurisdictions updated on an annual basis. So far, however, there is no such ISDA opinion concerning close-out netting in Bulgaria. Indeed, apart from some special legislation protecting netting when the counterparty is a bank, Bulgaria has neither general netting-friendly legislation nor Supreme Court case law confirming the enforceability of close-out netting.
Nevertheless, market participants have found several methods to make their close-out netting arrangements effective. In one such method, participants in Bulgaria request the provision of financial collateral (linked to the derivative transaction), thus bringing into play the netting mechanism under the EU Financial Collateral Directive as transposed in Bulgaria. That netting mechanism may be negotiated as being applicable to any mutual obligations of the counterparties, including their obligations under the derivative with respect to which a financial collateral arrangement has been entered into. Thus, the mutual obligations under a derivative may be effectively netted in case of a termination event under the relevant derivatives agreement.
In this respect we believe it is sufficient to grant a small fixed amount as financial collateral to secure the potential (and thus uncertain) future obligation of a bank’s counterparty to pay amounts (if any) under a derivative. The parties may agree that the financial collateral will be updated on certain dates to take into account fluctuations in the underlying assets (e.g., interest rates or foreign currency exchange rates) which would require the counterparty to provide additional financial collateral if necessary. Alternatively, the parties may agree that the collateral will secure only a portion of the bank’s exposure under the derivative (up to the amount of the collateral that was effectively provided) in which case there would be no need to update the amount of the financial collateral in the future.
The idea that provision of financial collateral under a derivative may effectively protect a netting arrangement is not expressly confirmed by case law. However it enjoys widespread support among Bulgarian law firms and local banks, and a growing number of derivative transactions are made in reliance on the mechanism. Especially active in this respect are the large local banks that are subsidiaries of financial institutions from other EU Member States.
Nevertheless, legislation expressly protecting the enforceability of close-out netting in case of insolvency of the banks’ counterparties would certainly give more comfort to the banks. As derivatives are often used by such counterparties to hedge against important financial risks like interest rate and currency rate risks, a general statutory protection of netting, supporting the derivatives transactions, may prove beneficial for the credit and financial industry as a whole.