Monday 23 January 2023
The ISDA Master Agreement is an internationally agreed document published by the International Swaps and Derivatives Association, Inc. (“ISDA”) which is used to provide certain legal and credit protection for parties who enter into over-the-counter or “OTC” derivatives transactions.
OTC derivatives are mainly used for hedging purposes. For example, a corporate may wish to protect itself against adverse movements in medium or long term interest rates by entering into an interest rate swap to “lock in” a fixed interest rate for a fixed period of time. OTC derivatives can also be used for speculation.
The ISDA Master Agreement is an umbrella agreement which sets out the overarching terms between the parties who want to trade OTC derivatives. There are two main versions which are still commonly used in the market: the 1992 ISDA Master Agreement (Multicurrency – Cross Border) and 2002 ISDA Master Agreement.
In both cases the Agreement is split into 14 Sections which outline the contractual relationship between the parties. It includes standard terms which detail what happens if a default occurs to one of the parties e.g. bankruptcy and how OTC derivative transactions are terminated or “closed out” following a default. There are 8 standard Events of Default and 5 standard Termination Events under the 2002 ISDA Master Agreement covering various default situations which could apply to one or both parties. However, in close out situations, the Bankruptcy Event of Default will be the one most commonly triggered.
In addition to the standard Master Agreement text, there is a Schedule which allows parties to add to or amend the standard terms. The Schedule is what negotiators negotiate. It typically takes at least 3 months to negotiate the Schedule but this can be shorter or longer depending on the complexity of the provisions concerned and the responsiveness of the parties.
When parties enter into individual Transactions a Confirmation will be prepared (either on paper or electronically) detailing the terms of that specific trade. Each Confirmation will reference the ISDA Master Agreement. All the trades are then covered by the terms of the Agreement.
The key thing to remember is that the ISDA Master Agreement is a netting agreement and all Transactions depend upon each other. Therefore a default under one Transaction counts as a default under all Transactions. In Section 1(c) of the Agreement the single agreement concept is outlined and is vital because it is the basis of close-out netting. The intention is that if an Event of Default occurs, all Transactions are terminated without exception. The close-out netting concept stops a liquidator from “cherrypicking” i.e. choosing to make payments on Transactions which are profitable to his bankrupt client and refusing to do so on unprofitable ones.
It is possible to enter into OTC derivative trades without a signed ISDA Master Agreement and often when this happens the Confirmation will include an undertaking between the parties that an ISDA Master Agreement will be negotiated and signed within a 30, 60 or 90 day period. This is a credit department decision. In the meantime a “vanilla” ISDA (the ISDA Form) is deemed to apply. This is an ISDA Master Agreement without a Schedule. However without the Schedule and assuming that the Confirmation does not outline extensive choices relating to the ISDA Master Agreement, the parties are not entirely protected.
While, upon first glance, the ISDA Master Agreement can appear daunting with its long text (28 pages in the 2002 version) and multiple defined terms and cross references, it is an important document which sets out the general contractual relationship between the parties and time should be taken to ensure that the points most important to you have been addressed.
DDL offers online training on OTC derivatives and securities legal documentation which can help you familiarise yourself with the provisions and commonly negotiated terms.
ISDA® is a registered trademark. Please be advised that ISDA® documentation training provided by Derivatives Documentation Limited are not sponsored by or affiliated with the International Swaps and Derivatives Association, Inc. ("ISDA®").
Posted by Paul Harding