[This article was first published by Rand Merchant Bank in 2011.]
Over the years companies have used derivatives transactions increasingly as a means to hedge and manage their business and financial risk. However, following the financial crisis in 2008, and in particular the collapse of Lehman Brothers, more scrutiny has been placed on the derivatives business, and how it can potentially wreak havoc in an unregulated environment. The financial crisis highlighted the need to ensure that when entering into derivatives transactions, they are properly documented and that both parties to the transaction are duly protected in terms of the governing contract.
The International Swaps and Derivatives Association, Inc. (ISDA®) is the international organization, founded in 1985, which represents the participants in the privately negotiated over-the-counter (OTC) derivatives industry. ISDA® is responsible for drafting the ISDA® Master Agreement, which is the globally used standard legal agreement which counterparties use to document their OTC derivatives transactions. Over the years various different versions of the ISDA® Master Agreement have been published, with each new version addressing the ever changing nature of the derivatives industry, as well as court decisions, which have resulted from litigation on the ISDA® Master Agreement, and legislative changes. The latest version of the agreement, which is currently in use, is the 2002 version.
The ISDA® Master Agreement is drafted to operate as a cross border, multi-product, multi-currency, agreement. In other words, it can be used between parties located in different jurisdictions, who are entering into a range of different derivatives products, where each transaction could be denominated in different currencies.
The Structure of the ISDA® Master Agreement
The ISDA® Master Agreement is comprised of various different components. The master terms of the agreement form the standard, non-negotiable section of the agreement, which outlines the basic legal rights and obligations of the parties to a derivatives transaction. The schedule to the master agreement is the portion of the agreement which can be amended and ‘tailor made’ to address any particular credit concerns you may have about a counterparty. The confirmation for each derivatives transaction, which is done under the ISDA® Master Agreement, contains the economic terms of the transaction. There may be thousands of confirmations concluded under the umbrella of an ISDA® Master Agreement, but from a legal point of view, each confirmation is seen to form part of the single legal agreement which is the ISDA® Master Agreement. The Credit Support Annex (CSA) is an optional agreement, which can be bolted onto the ISDA® Master Agreement, should the counterparties wish to include a collateral arrangement, which provides for parties to post collateral.
Since the master terms, schedule and confirmations all form part of a single legal agreement, this provides parties with the legal right to perform netting. Netting is the ability to reduce off setting claims down to a single net claim. There are various different types of netting which the ISDA® provides for:
Payment Netting: This type of netting provides the parties with an ability to settle their derivatives transactions on a net basis. The benefit one gets from settlement netting is that it provides operational efficiency.
Close Out Netting: This type of netting can be invoked when one party to the ISDA® Master Agreement calls for an early termination of transactions due to the occurrence of a termination or default event. Once the value of all the terminated transactions is calculated, the parties then have the ability to net off all the terminated transactions against each other, in order to come up with one net figure as to who owes whom what. This is the process which is known as close out netting. This type of netting provides parties with a tool to mitigate their credit risk.
Set Off: This type of netting allows you to take the close out net amount under the ISDA® Master Agreement and set it off against sums owed under any other agreements with the counterparty which are being terminated. This offers yet another way in which the parties can mitigate their credit risk. When a counterparty defaults, it is unlikely that it will only default in terms of its derivatives positions. It is likely that the default will affect all their financial positions (repo, securities lending and so forth). So whilst a non-defaulting party may owe sums to the defaulting party under a Global Master Securities Lending Agreement (GMSLA), they may be owed money from a defaulting party under the ISDA®, and the ISDA® provides for these amounts to be set off against each other. It should be noted that a party’s ability to perform set off is subject to its local insolvency laws. In terms of South African law, Section 35B of the Insolvency Act only permits set off between Master Agreements, as defined in the Act.
What Benefits does the ISDA® provide?
The main benefit which one gets from signing an ISDA® is the netting benefit, outlined above.
The ISDA® Master Agreement also provides parties with a reliable structure of legal rights and obligations, which governs their derivatives transactions. However, the ISDA® Master Agreement is also flexible in that parties are free to amend and draft additional provisions in the Schedule, which can assist in addressing certain concerns or credit policies, which a party may have in relation to its counterparty.
As the ISDA® Master Agreement covers any OTC derivative products, the parties have a huge range of products which they are able to enter into under the protective umbrella of the ISDA® Master Agreement, without the need to re-negotiate or amend the terms.
What does ISDA® mean to me?
The ISDA® Master Agreement is an absolute necessity when trading OTC derivatives transactions, as it provides you with a standard, robust framework to govern your rights and obligations in terms of the derivatives which you are trading. It provides parties with tools to mitigate their credit risk, settlement risk, operational risk and to some extent market risk. Since the 2008 financial crisis, counterparties are focussed on managing and reducing risk, and the ISDA® certainly provides a good starting point to achieve this goal.
The master terms of the ISDA® are standard and fairly straightforward. Whilst the initial process of negotiating and signing the ISDA® Master Agreement may be a little daunting, and may require outsourcing to a specialist, once the ISDA® Master Agreement is in place, the only maintenance required is the confirmations which simply include the economic terms for each transaction.
Is the ISDA® Master Agreement effective?
The Enron crisis in 2000 and the Lehman Brothers collapse in 2008 put ISDA® Master Agreements to the test. These two events led to several major court cases where the ISDA® Master Agreement was successfully interpreted and applied. After both these crises, the market saw the importance of having an ISDA® Master Agreement in place, to protect the parties in a default situation.
Furthermore, the use of a Credit Support Annex (CSA) as a bolt on to the ISDA® was seen to offer the best possible protection to the parties. This is because in terms of the CSA, collateral that is posted to cover exposure on a derivatives portfolio can be applied in a default situation to offset any losses suffered, as a result of the default.
In the current market, credit risk is a main focus, and those who trade OTC derivatives are realizing the crucial role that the ISDA® Master Agreement has in protecting them in a default situation.
 The Global Master Securities Lending Agreement or GMSLA is the global standard master agreement which is used to govern securities lending transactions.