What do the bankruptcy of Lehman Brothers, the COVID-19 lockdown and Russia’s invasion of Ukraine have in common? All three episodes highlight the fact that the process of closing out derivatives trades is antiquated, costly and prone to mishaps and delays. We think there’s a 21^st century solution, which is why we’re working on an industry notices hub to digitize the delivery and receipt of these critical termination notices.

Delivery of notices is an important part of the close-out process following a default or termination event under a derivatives contract. The ISDA Master Agreement stipulates these notices must be delivered by certain defined methods, using the company address details listed in the agreement. Delivery fires the starting gun on the process of terminating the trade, so delays and uncertainty over delivery or receipt can have significant knock-on implications.

This is what happened with Lehman Brothers International (Europe) (LBIE). At the time of its insolvency, the broker-dealer was headquartered in Canary Wharf in east London, having vacated its central London office four years earlier. If ISDA Master Agreements hadn’t been updated with the new address, then counterparties faced a choice: deliver to the listed address, even though it was no longer occupied, or deliver to the new address in Canary Wharf. A safe option might have been to deliver to both addresses, but this could have raised questions over which notice was effectively delivered and when.

Working with administrators of LBIE from PwC, we looked at a random sample of 255 terminated derivatives relationships and found that around 16% of corresponding notices had been delivered to the previous address (either exclusively or in addition to the new address). If this sample is representative of the entire portfolio – which included nearly 3,400 ISDA Master Agreements – then as many as 550 termination notices could have been sent to the old address. As well as creating uncertainty for senders of notices, a recipient that is unaware it has received a notice may miss the chance to take action to avoid a default or not realize it has become unhedged.

More recently, we’ve seen further examples of the challenges of physical delivery. In March 2020, when companies switched to remote working at the start of the pandemic, questions arose over how to ensure a notice was effectively delivered or monitor receipt when offices were empty or in areas subject to lockdown restrictions. Russia’s invasion of Ukraine in 2022 highlighted the difficulty of delivering notices in a hostile environment.

These problems are neither rare nor insignificant. Our analysis has shown that just a small delay in the delivery of a termination notice on a single medium-sized derivatives portfolio – for example, from Friday afternoon until Monday morning – could result in an uncollateralized loss of $1 million. This is based on a 99% value-at-risk calculation assuming a non-cleared derivatives portfolio with $10 million of initial margin. Longer delays, more volatile conditions and larger portfolios could result in even worse outcomes. That’s on top of the additional resource costs associated with conventional delivery methods, which would usually include paying a law firm to deliver the notice.

It’s time to bring the delivery of notices into the digital age. We’ve been developing a specification for the ISDA Notices Hub, which would enable the instantaneous electronic delivery and receipt of notices from anywhere in the world via a central platform. A high-level survey of our e-contracts counsels has found there would be no obvious impediments to using such a hub to serve notice in at least 53 jurisdictions. For those scenarios where physical delivery is still required, the hub would include a bulk update facility to keep address details up to date and avoid notices going to vacated offices.

The ISDA Notices Hub would be an effective digital solution to a significant problem, but we will need industry backing to bring it to fruition. Now we’ve quantified the problem and sketched out a solution, we’ll be seeking commitments of support from dealers and large buy-side firms before moving to the development phase. We very much hope we’ll be able to take this important initiative to the next stage and bring greater efficiency and certainty to the close-out process.

For more information about the ISDA Notices Hub, visit www.isda.org/isda-notices-hub/.

The ISDA AGM on April 16-18 will feature a session on managing market disruption and will include a discussion on the ISDA Notices Hub. Click here to register.

A training course on managing contract and operational risk during a termination will also be held in Tokyo on April 16. Click here for more information.