ISDA Master Agreement
Encyclopedia
The ISDA master agreement is the most commonly used master contract
for OTC
derivative
transaction
s internationally. It is part of a framework of documents, designed to enable OTC derivatives to be documented fully and flexibly. The framework consists of a master agreement, a schedule, confirmations, definition booklets, and a credit support annex. The ISDA master agreement is published by the International Swaps and Derivatives Association
.
The master agreement is a document
agreed between two parties that sets out standard terms that apply to all the transactions entered into between those parties. Each time that a transaction is entered into, the terms of the master agreement do not need to be re-negotiated and apply automatically.
Although it is often viewed as a tool for bank
s and financial institution
s, the Master Agreement is widely used by a wide variety of counterparties
.
process can be burdensome, but once a master agreement is signed, the documentation of future transactions between parties is reduced to a brief confirmation of the material terms of the transaction.
The master agreement also aids in reducing disputes by providing extensive resources defining its terms
and explaining the intent of the contract, thereby preventing disputes from beginning as well as providing a neutral resource to interpret standard contractual terms. Finally, the master agreement greatly aids in risk and credit management for the parties.
In 1987, ISDA produced three documents: (i) a standard form master agreement for U.S. dollar interest-rate swaps; (ii) a standard form master agreement for multi-currency interest-rate and currency swaps (collectively known as the "1987 ISDA Master Agreement"); and (iii) the interest rate and currency definitions.
The 1990s resulted in major document production by ISDA, including (i) a revised version of the Swaps Code, known as the 1991 ISDA Definitions, drafted and replaced later by the 2000 ISDA Definitions; (ii) a revision to the 1987 Master Agreement resulting in the 1992 Master Agreement; (iii) the User’s Guide to the 1992 Master Agreement, drafted in 1993, explaining in detail each section of the 1992 Master Agreement; (iv) the Commodities Derivatives Definitions, drafted in 1993 and supplemented in 2000; and (v) the Annex, providing for collateral documentation, finalised in 1994, followed by its User's Guide in 1995.
The Master Agreement was updated again in 2002 (known as the 2002 ISDA Master Agreement). The move to update the 1992 Agreement had its origins in the succession of crises that affected the global financial markets in the late 1990s. These events, including the liquidation of Hong Kong broker-dealer Peregrine Investments Holdings
and the 1998 Russian financial crisis, tested the ISDA documentation to a previously unseen degree. Although the ISDA documentation withstood that test, ISDA decided to establish a strategic review of its documentation to see what lessons could be learnt from these events. This review led, in time, to the full-scale update of 1992 Agreement, which culminated in the 2002 Agreement.
Together with the schedule, the master agreement sets forth all of the general terms and conditions necessary to properly allocate the risks of the transactions between the parties but does not contain any commercial terms specific to a particular transaction. Once the master agreement is executed, the parties can enter into numerous transactions by agreeing to the material commercial terms over the telephone as evidenced by a written confirmation without any need to revisit the underlying terms contained in the master agreement.
There are two versions of the Master Agreement, the local version for transactions between parties located in the same jurisdiction
who are transacting in only one currency
, and the multicurrency version for use when parties are located in different jurisdictions transacting in different currencies. The provisions included in the multicurrency version but not in the local currency version concern issues such as tax
es, currency
of payment, the use of multiple office
s to enter into transactions, and the designation of an agent
for service of process
.
This single agreement concept is integral to the structure and forms part of the netting based protection offered by the master agreement. The fact that all transactions are the one contract reinforces the ability to close out those transactions and come up with a single net amount payable if a default occurs.
.
The Events of Default can be described in summary as events for which a party is at fault
, such as a failure to perform under a transaction, breach of a representation or undertaking, and insolvency
.
The Termination Events are other events which, although no-one is at fault, warrant the early termination of the transactions, such as a change in tax law resulting in taxes being imposed on transactions, illegality, and a merger of a party resulting in a deterioration in its credit quality.
There are two elections that the parties make in the Schedule which affect the operation of these provisions:
The above only applies in relation to the 1992 Master Agreement. The 2002 Master Agreement did away with First and Second method. In practice First Method was very rarely opted for because its use required the relevant financial institutions to report their gross, rather than net, exposure under the Master Agreement. The 2002 Master Agreement also replaced the distinction between Market Quotation and Loss with a single concept, "Close-out Amount". This is determined in respect of each Terminated Transaction and is, broadly, the profit or loss which would be made in incurred on entering into an equivalent Transaction as of the Early Termination Date. The aggregate of the Close-out Amounts and Unpaid Amounts is referred to as the "Early Termination Amount". This is the net amount payable by one party to the other in respect of the Terminated Transactions.
The range of taxation matters which can be relevant to particular derivative transactions include interest withholding tax, quasi-withholding tax, goods and services tax
and stamp duty
.
The printed form of the Master Agreement is never amended on the face of the document. In negotiations it is not even exchanged, on the presumption that the standard terms will always be used.
is to be provided by a party if the exposure of the other to it exceeds an agreed amount. The Annex contains provisions concerning the posting and return of collateral, the types of collateral that may be used, and the treatment of collateral by the secured party.
Each type of derivative transaction, such as credit derivative, currency derivatives, and equity derivatives have their own definitional booklet.
These calculations are made on a mark-to-market basis to reflect the current position of each transaction.
The Master Agreement permits the netting of payments due under the same transaction so that only a single amount is exchanged between the parties, rather than numerous payments involving the same transactions. Most counterparties also agree to net all amounts due on a single day regardless of whether amounts are due under a single or multiple transactions.
on any amounts paid after the due date.
In support of this practice, the United States Bankruptcy Code
exempts participants in OTC derivative transactions from the automatic stay provisions of the Bankruptcy Code and permits them to set-off obligations owed between the creditor
and the bankrupt party even during the pendency of a bankruptcy stay order.
Parties try to limit this responsibility by including "non-reliance" representations in their agreements, to the effect that each is not relying on the other and they are making their own independent decisions. Whilst these representations are useful, they would not prevent an action under trade practices legislation nor other actions if the conduct of a party was inconsistent with this representation.
The Master Agreement provides the parties two means by which the Master Agreement and all transactions thereunder may be terminated upon the occurrence of specified events. The first is the occurrence of an event of default
, which permits a party to terminate the Master Agreement and liquidate all transactions if the other party is affected by an Event of Default. In contrast, Termination Events may affect both parties, are usually the result of the actions of third-parties, and may provide the affected party a grace period
to cure the Termination Event before the other party may terminate and liquidate the Master Agreement.
Master contract
A master contract is a contract reached between parties, in which the parties agree to most of the terms that will govern future transactions or future agreements...
for OTC
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
derivative
Derivative
In calculus, a branch of mathematics, the derivative is a measure of how a function changes as its input changes. Loosely speaking, a derivative can be thought of as how much one quantity is changing in response to changes in some other quantity; for example, the derivative of the position of a...
transaction
Financial transaction
A financial transaction is an event or condition under the contract between a buyer and a seller to exchange an asset for payment. It involves a change in the status of the finances of two or more businesses or individuals.-History:...
s internationally. It is part of a framework of documents, designed to enable OTC derivatives to be documented fully and flexibly. The framework consists of a master agreement, a schedule, confirmations, definition booklets, and a credit support annex. The ISDA master agreement is published by the International Swaps and Derivatives Association
International Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
.
The master agreement is a document
Legal instrument
Legal instrument is a legal term of art that is used for any formally executed written document that can be formally attributed to its author, records and formally expresses a legally enforceable act, process, or contractual duty, obligation, or right, and therefore evidences that act, process, or...
agreed between two parties that sets out standard terms that apply to all the transactions entered into between those parties. Each time that a transaction is entered into, the terms of the master agreement do not need to be re-negotiated and apply automatically.
Although it is often viewed as a tool for bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s and financial institution
Financial institution
In financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries...
s, the Master Agreement is widely used by a wide variety of counterparties
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
.
Advantages
The master agreement is quite lengthy, and the negotiationNegotiation
Negotiation is a dialogue between two or more people or parties, intended to reach an understanding, resolve point of difference, or gain advantage in outcome of dialogue, to produce an agreement upon courses of action, to bargain for individual or collective advantage, to craft outcomes to satisfy...
process can be burdensome, but once a master agreement is signed, the documentation of future transactions between parties is reduced to a brief confirmation of the material terms of the transaction.
The master agreement also aids in reducing disputes by providing extensive resources defining its terms
Contractual term
A contractual term is "Any provision forming part of a contract" Each term gives rise to a contractual obligation, breach of which can give rise to litigation. Not all terms are stated expressly and some terms carry less legal gravity as they are peripheral to the objectives of the...
and explaining the intent of the contract, thereby preventing disputes from beginning as well as providing a neutral resource to interpret standard contractual terms. Finally, the master agreement greatly aids in risk and credit management for the parties.
History
The ISDA Master Agreement is a development of the Swaps Code, introduced by ISDA in 1985 and updated in 1986. In its earliest form, it consisted of standard definitions, representations and warranties, events of default, and remedies.In 1987, ISDA produced three documents: (i) a standard form master agreement for U.S. dollar interest-rate swaps; (ii) a standard form master agreement for multi-currency interest-rate and currency swaps (collectively known as the "1987 ISDA Master Agreement"); and (iii) the interest rate and currency definitions.
The 1990s resulted in major document production by ISDA, including (i) a revised version of the Swaps Code, known as the 1991 ISDA Definitions, drafted and replaced later by the 2000 ISDA Definitions; (ii) a revision to the 1987 Master Agreement resulting in the 1992 Master Agreement; (iii) the User’s Guide to the 1992 Master Agreement, drafted in 1993, explaining in detail each section of the 1992 Master Agreement; (iv) the Commodities Derivatives Definitions, drafted in 1993 and supplemented in 2000; and (v) the Annex, providing for collateral documentation, finalised in 1994, followed by its User's Guide in 1995.
The Master Agreement was updated again in 2002 (known as the 2002 ISDA Master Agreement). The move to update the 1992 Agreement had its origins in the succession of crises that affected the global financial markets in the late 1990s. These events, including the liquidation of Hong Kong broker-dealer Peregrine Investments Holdings
Peregrine Investments Holdings
Peregrine was an investment company based in Hong Kong...
and the 1998 Russian financial crisis, tested the ISDA documentation to a previously unseen degree. Although the ISDA documentation withstood that test, ISDA decided to establish a strategic review of its documentation to see what lessons could be learnt from these events. This review led, in time, to the full-scale update of 1992 Agreement, which culminated in the 2002 Agreement.
Document architecture
The master agreement is the central document around which the rest of the ISDA documentation structure is built. The preprinted master agreement is never altered except to insert the names of the parties, but is customised through use of the schedule to the master agreement, a document containing elections, additions and amendments to the master agreement.Together with the schedule, the master agreement sets forth all of the general terms and conditions necessary to properly allocate the risks of the transactions between the parties but does not contain any commercial terms specific to a particular transaction. Once the master agreement is executed, the parties can enter into numerous transactions by agreeing to the material commercial terms over the telephone as evidenced by a written confirmation without any need to revisit the underlying terms contained in the master agreement.
There are two versions of the Master Agreement, the local version for transactions between parties located in the same jurisdiction
Jurisdiction
Jurisdiction is the practical authority granted to a formally constituted legal body or to a political leader to deal with and make pronouncements on legal matters and, by implication, to administer justice within a defined area of responsibility...
who are transacting in only one currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
, and the multicurrency version for use when parties are located in different jurisdictions transacting in different currencies. The provisions included in the multicurrency version but not in the local currency version concern issues such as tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
es, currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
of payment, the use of multiple office
Office
An office is generally a room or other area in which people work, but may also denote a position within an organization with specific duties attached to it ; the latter is in fact an earlier usage, office as place originally referring to the location of one's duty. When used as an adjective, the...
s to enter into transactions, and the designation of an agent
Law of agency
The law of agency is an area of commercial law dealing with a contractual or quasi-contractual, or non-contractual set of relationships when a person, called the agent, is authorized to act on behalf of another to create a legal relationship with a third party...
for service of process
Service of process
Service of process is the procedure employed to give legal notice to a person of a court or administrative body's exercise of its jurisdiction over that person so as to enable that person to respond to the proceeding before the court, body or other tribunal...
.
Single agreement
Section 1(c) of the 2002 ISDA Master Agreement states that:"All transactions are entered into in reliance on the fact that this Master Agreement and all Confirmations form a single agreement between the parties ... and the parties would not otherwise enter into any Transactions."
This single agreement concept is integral to the structure and forms part of the netting based protection offered by the master agreement. The fact that all transactions are the one contract reinforces the ability to close out those transactions and come up with a single net amount payable if a default occurs.
Events of default and termination events
Section 5 of the ISDA Master Agreement contains the "Events of Default" and the "Termination Events". These are events which can lead to termination of transactions before their intended maturityMaturity (finance)
In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
.
The Events of Default can be described in summary as events for which a party is at fault
Fault (legal)
Fault, as a legal term, refers to legal blameworthiness and responsibility in each area of law. It refers to both the actus reus and the mental state of the defendant. The basic principle is that a defendant should be able to contemplate the harm that his actions may cause, and therefore should...
, such as a failure to perform under a transaction, breach of a representation or undertaking, and insolvency
Insolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
.
The Termination Events are other events which, although no-one is at fault, warrant the early termination of the transactions, such as a change in tax law resulting in taxes being imposed on transactions, illegality, and a merger of a party resulting in a deterioration in its credit quality.
Close out and netting
Section 6 of the ISDA Master Agreement contains the provisions which enable a party to terminate transactions early if an Event of Default or Termination Event occurs in respect of the other party and set out the procedure to calculate and net the termination values of those transactions to produce a single amount payable between the parties.There are two elections that the parties make in the Schedule which affect the operation of these provisions:
- whether the party not at fault is required to pay if the net termination amount is worked out to be payable to the party at fault. This is a choice of payment method between "First Method" (under which the party not at fault does not need to pay) and "Second Method" (under which the party not at fault is required to pay);
- whether the termination values for the transaction will be determined by obtaining quotes from dealers in the market for replacement transactions or by the party not at fault working out how much it has lost or gained as a result of early termination. This is a choice of payment measure between "Market Quotation" and "Loss".
The above only applies in relation to the 1992 Master Agreement. The 2002 Master Agreement did away with First and Second method. In practice First Method was very rarely opted for because its use required the relevant financial institutions to report their gross, rather than net, exposure under the Master Agreement. The 2002 Master Agreement also replaced the distinction between Market Quotation and Loss with a single concept, "Close-out Amount". This is determined in respect of each Terminated Transaction and is, broadly, the profit or loss which would be made in incurred on entering into an equivalent Transaction as of the Early Termination Date. The aggregate of the Close-out Amounts and Unpaid Amounts is referred to as the "Early Termination Amount". This is the net amount payable by one party to the other in respect of the Terminated Transactions.
Taxation
Section 2(d) of the ISDA Master Agreement contains provisions setting out the consequences if a tax is imposed on a payment required to be made by a party under a transaction. Included is a gross-up obligation for certain "Indemnifiable Taxes". This interlocks with other provisions in the ISDA Master Agreement, such as the taxation representations contained in ss 3(e) and 3(f), undertakings in ss 4(a) and 4(d), and termination events in ss 5(b)(ii) and 5(b)(iii). These provisions are extremely complex and great care is usually taken by negotiators to ensure that the result is not the opposite of what was intended.The range of taxation matters which can be relevant to particular derivative transactions include interest withholding tax, quasi-withholding tax, goods and services tax
Goods and Services Tax
A goods and services tax or value added tax is a tax on exchanges.By country:*Goods and Services Tax *Goods and Services Tax *Goods and Services Tax *Goods and Services Tax...
and stamp duty
Stamp duty
Stamp duty is a tax that is levied on documents. Historically, this included the majority of legal documents such as cheques, receipts, military commissions, marriage licences and land transactions. A physical stamp had to be attached to or impressed upon the document to denote that stamp duty...
.
Multi-branch issues
Section 10 of the ISDA Master Agreement addresses issues that arise in connection with counterparties that enter into transactions through more than one office or branch and more than one jurisdiction.Schedule
The Schedule and Paragraph 13 are used to make all amendments to and customisations of the Master Agreement and Annex, including the elections of the various options presented to the parties in the Master Agreement and Annex and the addition of provisions not contained in the Master Agreement. It contains:- the elections referred to in the Master Agreement, such as the payment measures and methods, the thresholds relating to certain events of default,and the offices through which parties can act;
- any amendments that the parties agree to make to the terms of the Master Agreement; and
- any additional terms that the parties want to include, such as a set-off clause between close-out amounts and amounts owing under other contracts.
The printed form of the Master Agreement is never amended on the face of the document. In negotiations it is not even exchanged, on the presumption that the standard terms will always be used.
Credit Support Annex
The Annex is optional but is widely used in most Master Agreements for OTC derivative transactions. The Annex is added if the parties agree that collateralCollateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
is to be provided by a party if the exposure of the other to it exceeds an agreed amount. The Annex contains provisions concerning the posting and return of collateral, the types of collateral that may be used, and the treatment of collateral by the secured party.
Confirmations
Derivatives transactions are usually entered into orally or electronically and the contract between the parties is formed at this time. The evidence of the terms of the transaction is contained in a confirmation (also known as a trading advice or contract note), usually a short letter, fax or email. The form of the confirmation is set out in the Master Agreement and a limited period of time is usually allowed for objections or amendments to the confirmation after its receipt. Confirmations are usually very short (except for complex transactions) and contain little more than dates, amounts, and rates. Confirmations are exchanged to minimise the possibility of a dispute as to the terms of a transaction occurring.Definitions
ISDA has produced a wide array of supporting materials for the Master Agreement, including definitions and user's guides. This documentation is designed to prevent disputes and to facilitate the consistent use and interpretation of the Master Agreement. These materials are produced by ISDA and are regularly updated to reflect the most recent regulatory or market changes.Each type of derivative transaction, such as credit derivative, currency derivatives, and equity derivatives have their own definitional booklet.
Netting
The Master Agreement allows parties to calculate their financial exposure under OTC transactions on a net basis, i.e. a party calculates the difference between what it owes to a counterparty under a Master Agreement and what the counterparty owes it under the same agreement.These calculations are made on a mark-to-market basis to reflect the current position of each transaction.
The Master Agreement permits the netting of payments due under the same transaction so that only a single amount is exchanged between the parties, rather than numerous payments involving the same transactions. Most counterparties also agree to net all amounts due on a single day regardless of whether amounts are due under a single or multiple transactions.
Set-off
Set-off is used as a final settlement of accounts that extinguishes the mutual debts owed between the parties in exchange for a new, net amount due. The parties are incentivized to pay in a timely manner by the imposition of interestInterest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
on any amounts paid after the due date.
In support of this practice, the United States Bankruptcy Code
Title 11 of the United States Code
Title 11 of the United States Code is the primary source of bankruptcy law in the United States Code.-Contents:Title 11 is subdivided into nine chapters. It used to include more chapters, but some of them have since been repealed in their entirety...
exempts participants in OTC derivative transactions from the automatic stay provisions of the Bankruptcy Code and permits them to set-off obligations owed between the creditor
Creditor
A creditor is a party that has a claim to the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption that the second party will return an equivalent property or...
and the bankrupt party even during the pendency of a bankruptcy stay order.
Authority and capacity
The principles for resolving the issue as to whether an individual has the authority to bind the company are not special to derivatives, they are derived from traditional agency law. In essence it is necessary to examine the relevant circumstances to determine whether the individual had the actual or apparent authority to bind the company to the transaction. It is common for parties to exchange authorised signatory lists of persons who have authority to execute confirmations and refer to this in the Schedule to the ISDA Master Agreement. However, this does not mean that this is determinative of the authority issue, and a person not on one of these lists may have the authority to sign a confirmation. As a matter of market practice, this issue is dealt with on the understanding that institutions are responsible for their own internal authorisation matters and that any person who is held out as being able to enter into OTC derivative transactions has the apparent authority to do so.Reliance and suitability
One area in which a party to an OTC transaction can be attacked by its counterparty, if the transactions "goes south", is if the counterparty was relying on the party in relation to the transaction and the party owes either some kind of fidcuciary relationship to the counterparty or has engaged in misleading conduct in inducing the counterparty to enter into the trade. In this regard the principles of equity, contract, and trade practices law apply to OTC derivatives in the same way as they apply to other contracts.Parties try to limit this responsibility by including "non-reliance" representations in their agreements, to the effect that each is not relying on the other and they are making their own independent decisions. Whilst these representations are useful, they would not prevent an action under trade practices legislation nor other actions if the conduct of a party was inconsistent with this representation.
Termination
While set-off provisions provides a creditor some relief from a counterparty’s bankruptcy by permitting the set-off of obligations due and owing, it does not provide relief from the exposure to future positions that have not yet become due and owing. In recognition of this problem, the Master Agreement contains provisions permitting a creditor party to terminate and liquidate transactions upon a counterparty’s bankruptcy or other default under the Master Agreement.The Master Agreement provides the parties two means by which the Master Agreement and all transactions thereunder may be terminated upon the occurrence of specified events. The first is the occurrence of an event of default
Event of default
Event of default is a term used in commercial loan documentation. It refers to the occurrence of an event which allows the lender to demand repayment of the loan in advance of its normal due date...
, which permits a party to terminate the Master Agreement and liquidate all transactions if the other party is affected by an Event of Default. In contrast, Termination Events may affect both parties, are usually the result of the actions of third-parties, and may provide the affected party a grace period
Grace period
A grace period is a time past the deadline for an obligation during which a late penalty that would have been imposed is waived. Grace periods, which can range from a number of minutes to a number of days or longer, depending on the context, can apply in various situations, including arrival at a...
to cure the Termination Event before the other party may terminate and liquidate the Master Agreement.
See also
- GISB Base Contract for Short-Term Sale and Purchase of Natural Gas
- EEI Master Power Purchase & Sale Agreement