Executing a Hedge
The Hedge Buying Process Explained
When you have finally decided on a derivative product you wish to purchase, what is the hedge buying process? The steps below provide a general, high-level overview of the Over the Counter (“OTC”) hedge transaction process with a bank*. CIRM facilitates every step of this process to ensure a seamless implementation for our clients.
The three stages are: Pre-Trade, Trade Execution, and Post-Trade and are applicable for the most common types of OTC hedge transactions.
We’ll use “ABC Entity” as the buyer of the hedge, and “XYZ Bank” as the seller/hedge counterparty.
Pre-Trade
Getting ready to trade requires “onboarding” with XYZ Bank in advance. This approval process can take as little as a few days to as long as a few months, depending on the bank and the type of entity that is purchasing.
Onboarding is typically broken out into two main categories: “Know Your Customer” (KYC) and Dodd-Frank adherence.
KYC Information
KYC consists of the collection of information about the purchasing entity that must be submitted. Banks may require different documents depending on their regulatory requirements, but the most common are listed below. Buyers may engage a consultant or advisor to assist in this process.
KYC document list for ABC Entity:
Dodd-Frank / Other
The Dodd-Frank Wall Street Reform and Consumer Protection Act requires additional representations that buyers and sellers must make before they trade (more paperwork!).
ABC Entity must typically provide U.S. Swap Dealers:
Either ISDA DF Protocol Agreement(s) or bilateral agreement(s) that allow buyers and sellers to make the appropriate representations to one another.
Other Pre-Trade:
Hedge Term Sheet: the hedge term sheet outlines the economic and legal terms of the derivative being purchased (product, term, index, strike, notional schedule, and specific ISDA provisions). This is provided in advance so XYZ Bank can model the trade to prepare it for purchase.
A term sheet can include other provisions such as minimum counterparty ratings, downgrade triggers and remedies, legal opinion requirements, etc. that are often components of required hedges.
Collateral Assignment: if the hedge will be collaterally assigned to the lender, the draft Collateral Assignment must typically be provided to XYZ Bank in advance for reviewed/approval.
ISDA Agreement: a separately negotiated ISDA Agreement Schedule is generally used for swaps, collars, floors, and other hedge products that entail ongoing financial obligations for the buyer. These separately negotiated forms are not normally used for OTC options.
Once XYZ bank has completed its KYC due diligence and Dodd-Frank adherence has been completed, ABC Entity will be notified that onboarding is complete, and XYZ Bank is ready to trade. The trade execution call is then scheduled.
Trade Execution
Many OTC derivatives transactions are executed by telephone.
The consultant/advisor typically reviews the terms of the trade with the XYZ Bank in advance and gets early indications on pricing leading up to the trade date. Given that pricing for hedges is constantly moving with the market, the final price that is quoted telephonically may be different than indicative levels provided. ABC Entity, XYZ Bank, and the consultant/advisor are on the phone together, with the call being recorded on XYZ Bank’s recorded line.
Once the live price is given, ABC Entity can do one of the following:
Walk away from the trade (perhaps to wait for a better day/price)
Attempt to negotiate the price in the moment, or
Verbally agree / execute the trade.
Post Trade
Hedge Payment: ABC Entity must typically pay the hedge premium within two business days (via wire) or risk defaulting on the hedge transaction.
Confirmation: Within a few business days post-trade, a confirmation is typically issued by XYZ Bank for the trade. If accurate, the confirmation is signed by an authorized individual (i.e., one appearing on the Corporate Hedging Resolution/Incumbency Certificate).
Additional Documents (if required).
Collateral Assignment. Lender’s counsel typically generates the Collateral Assignment for execution by Lender, ABC Entity, and XYZ Bank.
Legal Opinion. An opinion generated by XYZ Bank’s legal counsel that is generally available after payment and an executed Confirmation document is received.
MTM Notices: Each day XYZ Banks send a notice reflecting that day’s mid-market value of the hedge.
* This is intended as a general description for educational purposes only and should not be used as specific instructional guidance.