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Hedging Loans: An Overview

Often loan transactions will require the borrower to hedge some or all of the term facilities. Our Debt Capital Markets & Listing and Structured Finance & Securitisation teams review some key factors for parties to consider in these transactions.


Loan transactions will often require the borrower to enter into a hedging agreement covering a certain proportion of the term facilities. These hedging terms seek to mitigate against interest rate fluctuation and/or adverse exchange rate movements. As a result, this can stabilise cash flow and help the borrower and lender manage their respective risks more effectively. Hedging can be achieved using various financial instruments, with derivatives being one of the most common methods.

Ts and Cs of the hedge

The terms and conditions of the hedge under the loan agreement will typically be housed in either the loan agreement or in a separate hedging letter. Common terms provided for are:

  • The form of hedging transaction, typically an interest rate swap or similar
  • The relevant hedging ratio, dictating the minimum and maximum percentage of the facility amount to be hedged at any given time
  • Eligibility requirements for the hedge counterparty, although in practice it is often the lender or its affiliate
  • Hedge counterparty eligibility criteria, eg credit rating, for any future transfer and assignment of the hedge
  • The grounds on which the hedging agreement may be terminated, and
  • The form of the hedging agreement (typically the 2002 ISDA Master Agreement)

While the use of the ISDA Master Agreement brings clear benefits and efficiencies, hedging arrangements and contracts should not be shelved while the principal transaction is negotiated. The hedging terms, including negotiation of the hedging agreement, should be considered at the same time as the loan arrangements.

The primary reason for this is to ensure alignment between the ISDA Master Agreement and the terms of the loan agreement. Failure to sufficiently address these matters could defeat the hedging arrangement's purpose and increase each party's risk profile.

Successfully negotiating the hedging agreement

We have identified several key factors to consider when negotiating the hedging agreement in a loan transaction:

  • Ensure that the main economic terms of the hedging transaction match the loan. Particular consideration should be given to any amortisation of the loan, whether scheduled or unscheduled, and any partial close-out mechanism that may be necessary.
  • If the lending bank and hedging bank are to be the same entity acting in two separate capacities, ensure that this distinction is reflected in the loan documentation. This can be done by introducing definitions of ‘lending bank’ and ‘hedging bank’.
  • Consider whether the incorporation of additional representations, other than those already set out in the hedging agreement, is required.
  • Reconcile the termination provisions of the ISDA Master Agreement with the equivalent provisions under the loan agreement governing termination of the hedge. Ensure consistency between the hedging and loan documentation and avoid conflicting termination provisions.
  • Ensure that any payment waterfall specified reflects the commercial intention of the parties.
  • Review and address any regulatory obligations which the hedging transaction may give rise to and, to the extent necessary, take legal advice on applicable regulation.
  • Watch out for competing jurisdiction clauses and consider which should prevail in the event of a dispute.

Applicable regulatory obligations in derivatives transactions

As indicated, it is important to carefully consider any regulatory obligations that arise when entering into a derivatives transaction. For example, depending on the parties’ EMIR classification, there may be clearing and margin obligations applicable to the hedging transaction. Typically, transaction reporting and risk mitigation measures under EMIR will be applicable, and the parties should ensure that the necessary arrangements are made and, to the extent necessary, reflected in the hedging agreement.

While ISDA Master Agreements were previously governed by English or New York law only, Irish and French versions of the 2002 Master Agreement were rolled out in 2018. This move is intended to provide optionality for counterparties wishing to use an EU governing law in the aftermath of Brexit. Our Structured Finance & Securitisation team is continuing to see increased use of the 2002 ISDA Master Agreement governed by Irish law.

Conclusion

It is best practice to ensure that the hedging documents are negotiated and agreed before entering into a loan transaction. This helps to ensure proper alignment between the hedging agreement and the financing documentation. It also gives parties sufficient time to ensure they have properly considered the regulatory obligations which derivatives transactions often give rise to.

Our Debt Capital Markets & Listing and Structured Finance & Securitisation teams have extensive experience supporting clients with hedging agreements, including those arranged to support a loan transaction. Alongside our dedicated Financial Regulation team, we can also guide clients through the regulatory obligations which frequently arise in the context of hedging transactions. For more information and expert advice regarding any contemplated derivatives transactions, please contact a member of our team.

People also ask

Why are derivatives used in lending transactions?

Derivatives are used in some lending transactions to manage cashflow, by mitigating variables outside the control of the borrower. For example, Borrowers may use an interest rate swap to offset their exposure to interest rate rises.

What is an ISDA Master Agreement?

An ISDA Master Agreement is the standard document regularly used to govern over-the-counter derivatives transactions. The agreement, which is published by the International Swaps and Derivatives Association (ISDA), outlines the terms to be applied to a derivatives transaction between two parties, typically a derivatives dealer and a counterparty. The ISDA Master Agreement itself is standard, but it is accompanied by a customised schedule and sometimes a credit support annex.

What are the EMIR requirements for derivatives transactions?

A party’s obligations under EMIR are dependent on its counterparty category. Broadly speaking, this is determined by (i) entity type and (ii) the group-wide derivatives trading volume. Typical requirements under EMIR include risk mitigation measures, reporting of derivatives transactions and recordkeeping. Some entities whose trading volume exceeds a clearing threshold may also be subject to mandatory clearing and margin requirements.



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