Over-the-counter (OTC) derivatives are traded between two parties, not through an exchange or intermediary. The size of the OTC market means that risk managers must carefully monitor traders and ensure that approved transactions are properly managed. When two parties enter into a transaction, they each receive a confirmation attesting to the details and referring to the signed agreement. The terms of the ISDA Framework Agreement then cover the transaction. Swap distributors are required, in accordance with documentation rules, to compress portfolios (i.e. net clearing positions to mitigate risk) with other swaps. However, swap traders are required to compress the portfolios of investment funds only at the request of those funds. Investment funds may not want to compress portfolios for a variety of reasons – they have a very small number of clearing positions or have complex agreements with different counterparties that make compression less useful. In the absence of a regulatory obligation on an exchanger to offer counterparties in investment funds an option to squeeze their portfolios, funds must request such a squeeze if they wish to compress portfolios. As compression is only available at the request of a fund, it does not fall within the scope of Protocol 2.0. The derivatives trading relationship between a hedge fund and a trader may also cover prime brokerage services, portfolio lending, redemption and securities lending operations. If so, the documentation requested by the concessionaire consists, in addition to an ISDA framework contract, of the agreements covering those other relationships. Whether other agreements already exist between the trader and the hedge fund when the ISDA framework contract is negotiated or the ISDA contract is only one agreement among others negotiated at the beginning of a new trading relationship, the conformity between similar provisions must be assessed in all agreements and provisions applicable in the event of disagreement.
The hedge fund will gain nothing if, for example, its carefully crafted provisions in ISDA contracts are repealed by provisions contained in a premium brokerage contract. An ISDA framework contract is the standard document used regularly to regulate derivative trading transactions. The agreement, published by the International Swaps and Derivatives Association (ISDA), outlines the terms applicable to a derivatives transaction between two parties, typically a derivatives dealer and a counterparty. The ISDA framework contract itself is standard, but it comes with an adapted schedule and sometimes a credit support schedule, both signed by both parties in a given transaction. Traditionally, most hedge funds have traded their ISDA master agreements on the defensive; They shall endeavour to limit the circumstances which could enable their counter-party to enter into trades following an event of default or termination. While hedge fund counterparties face particular challenges in trading against highly rated traders, they should strive to avoid overly broad provisions that could expose them to unnecessary default scenarios. In addition, in the context of today`s volatile markets, where «even the powerful have fallen», all participants in the derivatives market must take into account that the solvency of a counterparty can deteriorate seriously, unexpectedly and quickly and that they may have to negotiate all their trade agreements with a new set of assumptions. . . .