• Vsevolod Volkov

    Partner, EVERLEGAL



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Derivatives, Reforms and Reopening of Derivatives Market in Ukraine


A properly functioning derivatives market is a sign of a developed, mature and modern financial system. Although experts often describe derivatives as a “weapon of mass destruction” derivatives are, nevertheless, a very useful instrument to allocate, transfer and hedge financial risks. Risk transferors are usually lots of different entities from all sectors of the economy, while risk transferees are the considerably lower number of hedge providers, such as banks, hedge funds and other financial institutions. Numerically, derivatives do not create more risks than the market has but concentration of respective risks may have disastrous consequences in the event of default of the hedge provider, affecting many of its clients and many entities beyond. Creating a proper derivatives market will, therefore, require not only setting up a proper legal framework but also risk management requirements for hedge providers.

Countries from all around the world had been attempting to create a proper framework for derivatives since the 1990s. Ukraine is no exception. The first derivatives regulations were adopted by the Cabinet of Ministers of Ukraine in 1999. Those regulations were applicable to both organized and over-the-counter markets but derivatives were perceived more as a special type of securities rather than private contracts concluded on the basis of standard-forms. This perception was reinforced by currency control treatment of derivatives under Ukrainian currency control regulations which accorded them the status of “investment” and required an individual investment license from the National Bank of Ukraine whenever derivatives were entered into on a cross-border basis.

Adoption of derivatives regulations in 1999 did not lead to a derivatives boom in Ukraine. Between 1999 and 2008 there were only about 80 registrations of standardized contracts for trading at different exchanges, but even those standardized contracts were not actively traded. There were, however, Ukrainian banks that successfully offered their derivatives products over the counter based on an ISDA Master Agreement. Even such domestic over-the-counter contracts were not voluminous. At the cross-border level, hedging was achieved via synthetic structures, like back-to-back loans and others. This is partly explained by what was happening on the Ukrainian lending and foreign exchange markets. At the time, the National Bank of Ukraine implemented the policy of a fixed exchange rate for the Ukrainian hryvna, and there was no reason to hedge Ukrainian hryvna/foreign currency exposure. Ukrainian banks were also lending predominantly at fixed interest rates, removing the risks of interest rates fluctuations for borrowers, the floating Kibor rate existed from 2000 but it was scarcely used in bank lending practices. Since the credit crunch of 2008 even the limited over-the-counter derivatives market has almost ceased to exist in Ukraine, with the National bank of Ukraine prohibiting derivative dealings with foreign currencies and interest rates, both onshore and on a cross-border basis. This led Ukrainian corporates interested heading their financial risks to move their derivatives transactions to the level of foreign corporates structures of their groups.

Primary public complaints about the lack of a proper derivatives market in Ukraine before 2008 were targeting the poor derivatives legislation. In response to such complaints, the draft bill of Ukraine On Derivatives was submitted to the Ukrainian Parliament in 2007. That draft was prepared under the umbrella of the Ukrainian securities commission and, for this reason, focused mostly on creating an improved legal framework for organized trading of derivatives on stock exchanges. The draft bill was heavily criticized by advocates of the over-the-counter derivatives market, including International Swaps and Derivatives Association, and it did not even get to the first reading in the Ukrainian Parliament. Further drafts of the Law of Ukraine On Derivatives were submitted to the Ukrainian Parliament in 2008, 2010 and 2011 but without any success. The main concerns with the said draft bills were their silence regarding principal risk mitigating mechanisms for derivatives-related trade, such as simple agreement concepts, early termination and its protection from cherry-picking and claw-back remedies at insolvency, liquidation set-off and netting. The latter aspect became even more crucial after the Supreme Court stopped to support the validity and effect of the insolvency set-off.

Since 2008 Ukraine has undertaken to launch the derivatives market in Ukraine, and this obligation was further strengthened by the 2014 Association Agreement signed between Ukraine and the EU. The Ukrainian market has been waiting for the changes to come. Given unsuccessful prior attempts to develop derivatives regulations, the EBRD has allocated a grant to develop respective Ukrainian legislation and the National Bank of Ukraine has started its own procedures relating to liberalization of Ukrainian exchange controls and liquidity, accounting and other regulations for transactions with derivatives.

Since 2017 the National Bank of Ukraine has been promulgating respective regulations within its sphere of responsibility. In early 2018 the National Bank of Ukraine announced upcoming exchange control liberalization, which eventually came into effect on 7 February 2019. The replacement the individual currency license system with the ­e-limits system and direct permission to transact forwards, futures and swaps in relation to foreign currencies with a view to hedge exposures under obligations in foreign currency produced an effect almost immediately. On 28 March 2019 the Kernel Group and ING Bank Ukraine reported that they were the first to enter into hryvna/US dollar swaps. More transactions were reported after that and Ukrainian banks are currently actively releasing data regarding volumes of their derivatives offerings. This demonstrates that at least domestically, commercial entities and banks were less concerned regarding existence of proper legislative framework for derivatives and were more looking at lifting  currency control restrictions.

The process of developing derivatives legislation was running in parallel with preparations for currency control reform. With the support from the EBRD and other donors, the working group has developed the draft law of Ukraine On Capital Markets. Among other things the aim of that draft law was implementing and harmonizing Ukrainian legislation with respective regulations of the European Union, including MiFID II, MIFIR, EMIR. After a series of interactions and improvements it was finally approved by the Ukrainian Parliament on 19 June 2020 and came into effect as of 1 July 2021.

Under the Capital Markets Law, derivative financial instruments are clearly split into derivative securities and derivative contracts.

Derivative securities are defined as securities which evidence the right of its owner to claim from its issuer, in cases provided for in the prospectus, to purchase or sell the base assets and/or to fulfil the rights related to the base assets, as those are provided for in the prospectus, and/or to make a payment(s) depending on the index of a base asset.

A derivative contract is defined as an agreement the terms of which set the obligation(s) of either or both parties to such agreement in relation to the base assets and/or terms of which are set depending on the index of the base asset, and which also may provide for the making of payments.

An important addition for the functioning of the derivative contracts is the provision that such contracts may be entered into on the basis of a master agreement and specifications. It was via such a provision that legislators implicitly incorporated into Ukrainian legislation the “single agreement” concept so that all individual transactions entered into based on a master agreement may be viewed all together constituting one single agreement. The fundamental terms of the master agreement are to be approved by the Securities Commission and, for transactions to which banks are the parties, upon reconciliation with the National Bank of Ukraine.

One important factor which must be considered when entering into derivative contracts are that the law requires all transactions with financial instruments to be entered into with participation or intermediacy of an investment company. With respect to derivatives contracts, the only exceptions that would apply are when the bank is entering into an over-the-counter derivative contract with its client, entering into an over-the-counter derivative contract via qualified investors, execution of over-the-counter commodity related derivatives and in cases when a derivative contract is executed outside of Ukraine.

Incorporation of the netting concept into Ukrainian legislation is probably the biggest achievement of derivatives reform in Ukraine. Netting is defined as full or partial termination of obligations under derivative contracts, contract for party substitution, dealings relating to financial instruments, currency values or under commodity operations, and which is performed by means of set-off of mutual homogeneous claims and/or by novation of original obligations with a new obligation between the same parties and/or by termination of obligation by other means, which are provided for in the clearing rules. For the netting to be enforceable, the possibility of netting must be set either in the master agreement or in the text of the derivative contract. Netting will not be available if the parties did not provide for such possibility in their contract. The netting provisions in the Law of Ukraine On Capital Markets reinforce the validity of early termination so that all obligations may be circled under the netting arrangement irrespectively of their original maturity. In the netting arrangement the parties shall also agree on which party is responsible for the netting calculations and how the value of respective obligations shall be calculated in a homogeneous way. That is, so that the value of all obligations can be expressed in a single currency. Netting under derivative contracts in the event of insolvency is governed by the laws of Ukraine regulating insolvency in general and the insolvency of banks. In those cases, the netting shall be available as of the date of initiation of the respective insolvency proceedings and the parties do not have to wait for the formal declaration of insolvency. Neither the Law On Capital Markets nor insolvency legislation set any substantive requirement for netting conditions, and it appears that the parties are free to agree on such mechanics and they will be enforced under Ukrainian law.