The ISDA master agreement is the most commonly used master service agreement for OTC derivative
transactions 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
banks and financial institutions, the Master Agreement is widely used by a wide variety
of counterparties.
Advantages The master agreement is quite lengthy, and
the negotiation 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.
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: a standard form master agreement for U.S. dollar
interest-rate swaps; a standard form master agreement for multi-currency interest-rate
and currency swaps; and the interest rate and currency definitions.
The 1990s resulted in major document production by ISDA, including a revised version of the
Swaps Code, known as the 1991 ISDA Definitions, drafted and replaced later by the 2000 ISDA
Definitions; a revision to the 1987 Master Agreement resulting in the 1992 Master Agreement;
the User’s Guide to the 1992 Master Agreement, drafted in 1993, explaining in detail each
section of the 1992 Master Agreement; the Commodities Derivatives Definitions, drafted
in 1993 and supplemented in 2000; and 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. 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.
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 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 taxes, currency of payment, the use of multiple offices to enter into transactions,
and the designation of an agent for service of process.
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
maturity. 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. 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" and "Second Method";
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 and 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.
Related documents 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 collateral 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, 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 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.
Legal issues 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 interest 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. 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 fiduciary 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,
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. See also
GISB Base Contract for Short-Term Sale and Purchase of Natural Gas
EEI Master Power Purchase & Sale Agreement Notes
^ a: Despite this distinction, the multicurrency version is often used even when transactions
are in the same jurisdiction and payment will be in the same currency in order to include
the more comprehensive provisions contained in the multicurrency version.
References
See: Zepeda, R. The ISDA Master Agreement 2012: A Missed Opportunity? 28(8) Journal
of International Banking Law and Regulation, pp.12-28.
External links International Swaps and Derivatives Association