ISDA: A User’s Manual (1) – Introduction

ISDA or the International Swaps and Derivatives Association is an industry body comprising full and associate members from the finance community and associated service providers such as law firms. ISDA has designed a suite of high-quality documents aimed at documenting the over-the-counter derivatives (“OTCs”), i.e. the financial derivatives that are not traded on a regulated market such as an exchange.

The ISDA’s objective is to facilitate and provide some legal comfort to these transactions: the ISDA’s website displays a number of legal opinions dealing with the key issues involved by the ISDA. These legal opinions are drafted by prominent law firms and cover a wide range of jurisdictions.

Before considering the structure and content of the ISDA documentation, it is useful to step back and take an overview. The daily volumes of transactions between participants in the capital markets are massive: transactions totalling billions of dollars are transacted every day. This means that the participants in these markets potentially have large exposures to each other. Regulators and the participant financial institutions themselves are concerned about the consequence of the failure of a participant in the market, as this can have a domino effect on other participants. The failure of one participant can trigger other participants being unable to meet obligations they have entered into with other parties. This risk of “domino effect” is known as systemic risk. Netting, which is considered below in more detail in the context of ISDA documentation, is considered as a method of reducing systemic risk.

This is best demonstrated through an example below:

Bank A owes Bank B 50 million. Bank B owes Bank A 30 million. Instead of Bank A being exposed to a 30 million exposure on Bank B and Bank B being exposed to a 50 million exposure on Bank A, if netting is used, the 50 million exposure of Bank A is reduced by the 30 million exposure owed to it by Bank B. This results in the exposures being replaced by one single net payment of 20 million due by Bank A to Bank B.

Within the framework of regulated markets, it is the clearing house’s job to daily calculate the net exposure of  each participant to a given market. As the clearing house operates as a central counterparty, there is no counterparty risk – to the extent that the clearing house is sufficiently funded.

The situation is different for OTC markets because there is no clearing house: it is therefore of the utmost importance to find legal means to limitate counterparty risk and “chery picking” risk as much as possible.

“Cherry picking” risk may occur in case of insolvency: the liquidator or other insolvency official appointed to either bank might decide to honour trades that are “in the money”, i.e. trades under which the other party owes money to the party in liquidation, thereby recovering payments due to it but not honouring trades that are “out of the money”, i.e. where it owes money to the other party, and leaving the other party to rank as an unsecured creditor in the liquidation. In our example, if a liquidator is appointed to Bank A, the liquidator might seek to disclaim the contract under which 50 million is owed by it to Bank B but seek to enforce the payment by Bank B of 30 million to Bank A. This clearly increases financial risk in Bank B whereby it could effectively not recover the 50 million due to it but be forced in addition to pay out 30 million as opposed to receiving a net 20 million back.

The scope of this post is not intended to cover the capital treatment of OTC transactions for capital adequacy purposes. However, it is important to remember that effective netting arrangements can enable participants in financial markets to avail of reduced risk weighting for regulatory capital purposes and consequently reduce the amount of capital allocated for these purposes.

It is important to understand the distinction between exchange traded derivatives and OTCs in this context as the ISDA documentation is focused with documenting OTC products. OTC products are generally tailored products that are poorly stantardised – there is however a standardisation trend that grows together with the size of the OTC markets, especially in the fields of equity derivatives and credit default swaps. OTC derivatives are the only products documented under the ISDA, while standardised derivatives such as the futures are negotiated on regulated markets, and benefit from the safety offered by a clearing house.

The ISDA is a good example of a consensual regulation devellopped by the participants to a market: it is a legal standard stemming from a ongoing negotiation and enhancement process.  It illustrates how the wise use of contractual freedom can contribute to the consistency of the economy and financial law. The ISDA documentation is however a sophisticated one, which I will try to clarify and explain in this series of posts.

The ISDA Documentation

These posts will focus on the 1992 ISDA Master Agreement (Multi-Currency/Cross- Border) (the “1992 ISDA”) which is aimed at documenting cross-border transactions involving a number of currencies.

While the 1992 ISDA has been updated with the publication of the 2002 ISDA Master Agreement (“2002 ISDA”), the 1992 ISDA is still currently used by many counterparties. I will therefore focus on the content of the 1992 ISDA but also highlight the key changes that are incorporated in the 2002 ISDA. The 2002 ISDA does not amend the 1992 ISDA: it is just the most recent form of Master Agreement available.

The market participants that keep using the 1992 ISDA often amend the existing 1992 ISDAs to incorporate some of the more important changes incorporated in the 2002 ISDA.

In addition, I will consider (i) the 1995 UK Credit Support Annex (English Law) which creates a title transfer financial collateral arrangement, under which cash collateral is deposited with and readily marketable securities are transferred to the collateral taker, (ii) the 2001 ISDA Margin Provisions dealing with the margin calls, i.e. the right for the collateral taker to adjust the amount of the collateral deposited with him depending on the variations of the value of the derivatives covered by the ISDA and, briefly, (iii) the provision of security in more traditional form in the form of guarantees, mortgages and debentures.