On 16 August 2020, the Law of Ukraine “On Amendments to Certain Legal Acts to Attract Investments and to Introduce New Financial Instruments” (the “Law“) became effective. The Law introduces a wide range of reforms, including a derivatives reform and a corporate bond reform. It also implements the “Markets in Financial Instruments” Directive 2014/65/EU, dated 15 May 2014, and introduces other significant changes for the Ukrainian capital market.
In this alert we provide a general overview of the derivatives and netting reform, briefly discuss procedure of close-out netting (the one of the key elements of the reform) and its enforceability pre- and post-insolvency and summarise the rules on security and title transfer collateral arrangements. We also touch upon certain local law issues relevant for the derivatives, such as capital controls, and describe our expectations as to the future developments in the sector.
The drafting of the derivatives reform was supported by the European Bank of Reconstruction and Development (EBRD), with Sayenko Kharenko as its Ukrainian legal counsel, and prepared in consultation with the International Swaps and Derivatives Association (ISDA).
Corporate bond reform and other changes introduced by the Law will be set out in subsequent alerts which will be issued separately.
Scope of derivatives and netting legislation
Effectiveness of the derivatives reform
While the Law generally entered into force on 16 August 2020, effectiveness of many blocks of the Law is deferred until future dates. In the context of the derivatives reform, on 16 August 2020 mostly basic provisions relating to close-out netting became effective. The full effectiveness of the derivatives reform will occur on 1 July 2021.
This alert describes the regime as at the date of full effectiveness, unless specifically stated otherwise.
Scope of the new Ukrainian derivatives market framework
The Law establishes a solid basis for operation of derivatives markets by introducing a detailed regulation and enhancing enforceability of derivatives, repos, securities lending, and transactions in securities, currencies, bank metals, gas, and electricity (the “eligible transactions“).
In particular, the newly adopted legislation provides for:
- open-ended general definition of derivatives and a list of defined specific types of derivatives
- special legal regime for close-out netting for derivatives and other eligible transactions and
- improvement of the enforceability of collateral arrangements under derivatives and other eligible transactions
- derivative products covered by the Law
The definition of derivatives under the new law is quite broad and open-ended. A derivative is defined as a contract the terms of which provide for an obligation of one or each of the parties with respect to an underlying asset, or the terms of which depend on the value of an underlying index, and may provide for cash settlement.
The Law also contains a list of definitions of main types of derivatives (such as swaps, forwards, futures, and options), with a variety of underlying assets (such as financial instruments, currencies, bank metals, commodities and services), both physically and cash-settled, and variety of underlying indices (such as prices, return, rates, indices, statistics and environment indicators). Spot market is generally limited to transactions which settle in T+2 or less, while transactions which settle T+3 or over would constitute derivatives.
The National Securities and Stock Market Commission, the Ukrainian securities regulator (the “Securities Commission“), is empowered to supplement the list of particular derivative transactions (to the extent they fall within the general definition), as well as expand the scope of underlying assets and indices in the secondary legislation.
Concept of close-out netting
Introduction of the concept of close-out netting for derivatives and other eligible transactions is one of the key novelties of the reform. In general, close-out netting is an ability of a party under a master agreement to close out some or all of transactions by netting their current values upon a default of its counterparty or other triggers provided for by contract.
From the legal perspective, close-out netting is defined in Ukrainian law as a process consisting of the following three steps.
- valuation: determination of replacement value of each derivative and other eligible contract
- termination: termination of each derivative and other eligible contract and
- determination of net termination amount: set-off of replacement values owed to a non-defaulting party against replacement values owed to a defaulting party
The Law allows to modify the termination and net amount determination procedures by contract.
Netting agreements and counterparties
The Law neither limits the types of contractual arrangements documenting close-out netting, nor the types of counterparties that may enter into such arrangements. Close-out netting may be carried out based on a master agreement (such as ISDA Master Agreement or ICMA Global Master Repurchase Agreement), any other agreement providing for close-out netting or clearing rules of a central counterparty.
The Law has also introduced a specific concept and broad definition of a master agreement, being an agreement that sets out the general terms and procedures for entering into and performance of derivatives or transactions with financial instruments, currency assets, repo transactions or commodity transactions. The Securities Commission is authorised to establish mandatory requirements to master agreements generally, and with the approval of the National Bank of Ukraine (the “National Bank“) – for master agreements where a bank is one of the parties.
General enforceability of close-out netting pre- and post-insolvency
Close-out netting regime is generally enforceable both pre- and post-insolvency, with the latter being subject to certain mandatory rules and limitations (see below).
Prior to insolvency, early termination in the context of close-out netting is not limited and should work as provided in the agreement.
For post-insolvency early termination, Ukrainian law requires mandatory automatic early termination with an early termination date being the day (the “insolvency date“) of opening the insolvency proceedings by a Ukrainian court (in respect of corporate entities) or declaration of insolvency, revocation of licence or certain other related actions by the National Bank (in respect of a bank) or Securities Commission (in respect of a licensed securities market participant).
Close-out netting regime in insolvency is also different depending on whether a defaulting counterparty is a bank or a non-bank corporate entity.
- a non-defaulting party must provide the Deposit Guarantee Fund, the Ukrainian bank resolution authority, with the list of transactions subject to close-out netting within three business days following the insolvency date and
- close-out netting must be completed within seven business days following the insolvency date
Non-Bank corporate entities:
- prior to 1 July 2021, close-out netting in insolvency will properly operate in respect of derivatives that are entered into with the participation of a licensed securities trader (broker) and
- starting from 1 July 2021, most of the derivatives that are financial instruments will arguably have to be executed through an investment firm, except where both parties to a derivative fall within certain types of qualified investors. These would include international financial organisations, foreign governments and central banks, the Public Debt Management Agency of Ukraine, the National Bank, licensed capital market participants, banks, and insurance companies, and foreign financial institutions that meet the criteria to be established by the Securities Commission. Failure to involve an investment firm will result in invalidity of the contract, rendering the close-out netting inapplicable
- insolvency clawback (invalidation) rules
For the over the counter (OTC) eligible contracts, the general clawback period is one month prior to the date of insolvency of a bank. For the OTC eligible contracts with the bank's related parties there is an extended clawback period of six months prior to the date of insolvency of the bank. The insolvency clawback (invalidation) rules do not apply to the exchange-traded eligible contracts.
An OTC derivative or other eligible contract entered into within the specified period may be declared void by the Deposit Guarantee Fund where:
- entry into such contract resulted in a bad faith preference to one or more creditors
- such contract was entered into by the bank in bad faith with the aim to decrease its insolvency estate or
- entry into such contract resulted in a bad faith increase of claims of a creditor against the insolvency estate
Non-Bank Corporate Entities
General insolvency clawback (invalidation) rules apply to derivatives and other eligible contracts entered into with Ukrainian corporate entities other than banks. These rules are quite strict in the context of derivatives and other eligible contracts, and close-out netting arrangements. Namely, the clawback period is three years and voidable transactions include numerous types of dealings which resulted in damages to the insolvent party or its creditors, whether or not carried out in bad faith.
While the Ukrainian courts would analyse each specific situation to decide whether to apply insolvency clawback (invalidation) rules, the broad textual wordings of such rule create certain legal certainty risks.
Calculation of net termination amount
Ukrainian law allows for a net termination amount to be determined in a manner specified in a document providing for a close-out netting, such as a master agreement.
Enforcement of net termination amount in foreign currency
Generally, parties to a contract are free to agree on any termination currency.
In case of enforcement of foreign arbitral awards – the Ukrainian courts would enforce the claims in a currency indicated in a respective foreign arbitral award.
In case of enforcement of foreign court judgements – the Ukrainian courts would convert the claims indicated in a respective foreign court judgement into the Ukrainian local currency (UAH) for the purposes of enforcement on an exchange rate set by the National Bank.
In case of litigation on merits in the Ukrainian courts – the Ukrainian courts would enforce the claims in a currency agreed in a contract.
Enforceability of collateral arrangements
Security collateral arrangements
Parties to a security collateral arrangement are entitled to elect it to be governed by Ukrainian law, or by foreign law if a foreign-element criterion is satisfied (including if one of the parties is non-Ukrainian). Ukrainian courts should recognise the validity of a foreign law-governed security collateral arrangement, assuming it is valid under the law governing the security agreement.
Where cash or securities are located in a Ukrainian account, a security collateral arrangement must be registered with the Ukrainian public register, notified to an account bank and/or reflected in the Ukrainian securities depository system, as the case may be, to ensure its priority (ranking).
Security collateral arrangements may be enforced both extrajudicially and in courts. Where cash or securities are located in a Ukrainian account, any enforcement would be subject to the observance of certain formalities under Ukrainian law. In particular, a collateral taker should send a notice of enforcement to a collateral provider and register information on enforcement with the Ukrainian public register. The notice of enforcement should specify a remedy period, the duration of which may be freely agreed by the parties in the security agreement. If the default is not remedied within the specified period, the collateral taker may proceed with enforcement (e.g. transfer of cash to its account, acquisition of title to securities, sale of securities to a third party or via an auction, etc.).
Title transfer collateral arrangements
Parties to a title transfer collateral arrangement are entitled to elect it to be governed by Ukrainian law, or by foreign law if a foreign-element criterion is satisfied (including if one of the parties is non-Ukrainian).
Ukrainian courts would recognise a title transfer collateral arrangement as effecting an absolute transfer of title to cash or securities with an obligation on a transferee to re-deliver the same or equivalent credit support, provided that such transfer is recognised as such as a matter of the governing foreign law.
Once the transferee receives an absolute title, no perfection actions are required to ensure that its title continues. The value of credit support balance could be included into the calculation of net termination amount.
Reporting, clearing and other regulatory implications
Trade repositories and OTC derivatives reporting
The Law provides for the establishment of trade repositories in Ukraine, which is expected to happen in future. A trade repository is an entity that maintains a centralised electronic database of OTC derivatives transaction data. By centralising the collection, storage, and dissemination of data, trade repositories enhance the transparency of information to the relevant Ukrainian authorities promoting financial stability and facilitating detection and prevention of market abuse.
In connection with the future establishment of trade repositories in Ukraine, the Law provides for introduction of generally accepted data standardisation techniques: legal entity identifiers (LEIs), unique product identifiers (UPIs) and unique transaction identifiers (UTIs). The Ukrainian regulators continue their work in this direction, as data standardisation would substantially facilitate their supervisory and oversight functions.
All OTC derivatives in Ukraine (other than wholesale energy product OTC derivatives) would need to be reported to a trade repository. Failure to do so would result in a fine up of to 10% of the OTC derivative value. If there are two or more unreported OTC derivatives within the same year, a fine may be up to 50% of their value.
Clearing of OTC derivatives and resilience of Ukrainian clearing system
Currently, clearing of OTC derivatives is not mandatory. However, the Ukrainian securities regulator has been authorised by the Law to adopt regulations requiring such clearing.
Recognising the increasing roles of Ukrainian central counterparties, the Law seeks to make the Ukrainian clearing system more resilient. In particular, the Law requires Ukrainian central counterparties to hold their account with the National Bank of Ukraine to eliminate commercial bank credit risk, and introduces prohibition to freeze and debit the accounts of Ukrainian central counterparties used to conduct settlements and to hold margins. A larger reform of the Ukrainian post-trade capital markets infrastructure is expected in the future to bring it in line with the EU's acquis.
Recognition of derivatives as financial or non-financial instruments
Not all derivatives will be deemed financial instruments. Currently, a key distinction between financial instrument and non-financial-instrument derivatives is that the former will arguably have to be executed through an investment firm, except where both parties to a derivative fall within certain types of qualified investors.
Whether a derivative is viewed as a financial instrument depends on its underlying asset, trading venue and means of settlement. More specifically, the Law provides a list of derivatives that are financial instruments, which is very similar to the one provided in Section C of MiFID II.
Generally, all non-commodity derivatives are deemed financial instruments.
When an underlying asset for a derivative is a commodity, factors such as trading venue and means of settlement must be taken into account. Any commodity derivative traded on a regulated market or a multilateral trading facility will fall into the category of financial instruments. Further, any commodity derivative which contains an option of cash settlement (other than by reason of default or other termination event) will also be categorised as a financial instrument. Physically-settled derivatives for wholesale energy products (i.e. gas and electricity) and commodity forwards, provided that they are not entered into on a regulated market or a multilateral trading facility, are not financial instruments. Categorisation of other commodity derivatives as financial instruments will need to be assessed on a case-by-case basis.
Certain local law issues
Capital controls relevant for cross-border transactions with Ukrainian counterparties
The most relevant OTC derivatives cross-border capital controls when transacting with Ukrainian banks are the following:
- Ukrainian banks are prohibited from entering swaps with foreign entities, where a Ukrainian bank exchanges Ukrainian local currency for foreign currency as the first leg of a swap and
- Ukrainian banks are prohibited from entering forwards with foreign entities, where a Ukrainian bank exchanges Ukrainian local currency for foreign currency (with a minor exception)
Cross-border capital controls when transacting with Ukrainian entities other than banks may be more severe, depending on the terms of a particular deal (e.g. a EUR 2 million annual cross-border limit may apply).
- cross-border transactions with the National Bank
Since transactions of the National Bank of Ukraine are neither subject to insolvency rules, nor limited by capital controls, it has been (and currently remains) generally able to enter into proper-style derivatives transactions even prior to the reform.
The Ukrainian central bank may carry out cross-border transactions with its gold and foreign currency reserves only with banks having a rating of A and above by international rating agencies. There are also certain limitations on the types of transactions that may be carried out. In particular, securities lending and credit default swaps, where the National Bank of Ukraine is a credit protection seller, are arguably restricted.
We expect the following developments in the future.
Intensification of secondary legislation
The Law explicitly lists the EU acquis, such as EMIR, MiFID II, MiFIR and CSDR, and requires the Securities Commission to adopt its secondary legislation with a view of implementation of the above EU acquis and the EU secondary legislation developed on that basis. Scope and complexity of the Ukrainian derivatives rules are expected to increase substantially.
Special attention should be paid to the upcoming reporting rules, given that OTC derivative reporting is completely a new thing for the Ukrainian market, and given that fines for unreported OTC derivatives are huge.
Currently, the definitions of derivatives in the Tax Code of Ukraine have not been updated to be entirely in line with the reform. While this may cause certain confusion in tax treatment, such issues may be addressed through clarifications of the relevant authorities.
Consensus (interpretation) building
Given the sophistication of netting issues, and their novelty for Ukraine, Ukrainian courts and authorities would likely need to undergo some period of consensus (interpretation) building and, potentially, trainings to make sure that the derivatives and netting rules are correctly and consistently applied by courts and other governmental authorities.
Jurisdictional legal opinions on Ukraine in relation to standard documentation
Following introduction of the derivatives reform, and in particular netting regulation, one of the important steps for cross-border transactions is jurisdictional opinions commissioned by international associations, such as ISDA, ICMA and EFET. Ukrainian stakeholders have been keen to promote issuance of such opinions as soon as possible, since they will facilitate dealing with foreign counterparties who require availability of the opinions to be able, among other things, to obtain regulatory capital reliefs against offsetting derivatives positions with the Ukrainian counterparties
Ukrainian law standard documentation
A Ukrainian law master agreement for derivative transactions (such as ISDA Master Agreement) or repo transactions (such as Global Master Repurchase Agreement) does not exist. The idea of development of Ukrainian law standard documentation has been discussed for the last several years and, given that the Law has been adopted, the development of such documentation is likely to intensify in the near future.
New market abuse rules
While the capital market framework has been upgraded and modernised to a completely new level, the market abuse rules adopted in 2011 remain largely unchanged. Given that the Law expressly mentioned the intention to implement the EU Market Abuse Regulation, we believe that approximation of the Ukrainian market abuse rules to the respective EU rules is on the horizon.
There are multiple factors implying that the Securities Commission will gradually increase its focus on the commodity derivatives. Since under the Law certain commodity derivatives are now recognised as financial instruments, we expect development of a deeper regulation of this area by the Securities Commission in the future. Furthermore, the Securities Commission has the intention to undergo a restructuring of its institutional framework to increase the capacity and effectiveness in relation to the Ukrainian energy commodity markets and commodity products organised trading.
Clarity as to notional cash pooling arrangements
The reform has been primary designed to achieve ISDA & GMRA opinions rather than the other types of contractual netting agreements. While certain textual wordings might be interpreted as covering the notional cash pooling arrangements and protection of netting thereunder, we do not believe that it is a strong position so far.
The netting is allowed and protected under “transactions with cash and currency assets”, but there is not enough certainty on whether this covers loan agreements enhanced by joint and several liability or guarantees of accounts.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.