ISDA: A User’s Manual (2) – Structure of the ISDA Documentation

The (1992 or 2002) ISDA master agreement is the central document to the ISDA suite of documents. A fundamental principle of the documentation’s structure is the single agreement principle. Another feature of the documentation is the hierarchy it establishes between its different elements, which may recall … the Matrioshkas, the Russian egg-shaped dolls that fit inside one another. Who said that ISDA can’t be fun ?!

This is best understood through considering the different elements in the documentation:

Master & Schedule. The 1992 ISDA comprises a pre-printed standard form document for the first eighteen pages. It attaches to it a schedule (the “Schedule”), which contains credit and other transaction-specific provisions and elections, which are individually tailored for the particular circumstances of each case. The Schedule allows the parties to amend the ISDA standard form: the provisions of the Schedule will therefore be negotiated by the parties. The Schedule specifies which provisions of the standard form shall be activated, disactivated or amended (in this case the amendments will be fully displayed in the Schedule). The parties may also choose to include some new clauses such as those extracted from the 2002 ISDA : if the ISDA standard may be compared to a rough stone block, the Schedule may be seen as the sculptor’s chisel.

Confirmations. The ISDA Master and Schedule comprise an agreement pursuant to which individual trades are entered into. These trades or Transactions are recorded in Confirmations. There shall be one Confirmation for each Transaction, being noted that a Master Confirmation may be used by the parties in order to define the generic terms applicable to an homogenous category of Transactions entered into in the framework of one specific ISDA. For instance, the Master Confirmations are used for the most standardised OTCs such as some equity derivatives and credit default swaps. Where a Master Confirmation is used, a Transaction Supplement, which is a fairly succinct document, is drawn up for each specific Transaction covered by the said Master Confirmation.

Furthermore, there are two types of Confirmations: the Long Form and the Short Form. A Long Form Confirmation is purported to be entered into by the counterparties that did not yet enter into an ISDA for example because the volume of OTC transaction between themselves does not justify it, or because they did not have the time to do so. A Long Form Confirmation contains some provisions reproducing an ISDA, which makes it … longer than a conventional Confirmation, i.e. a Short Form.

Single Agreement. The set of documents described above (Standard ISDA + Schedule + Confirmations/Transaction Supplements) form part of a single agreement, as stipulated in Article 1 (c) of the ISDA Master:

Single Agreement. All Transactions are entered into in reliance on the fact that this Master Agreement and all Confirmations form a single agreement between the parties (collectively referred to as this “Agreement”), and the parties would not otherwise enter into any Transactions.

It shall be noted that the Credit Support Annex (“CSA”) is also part of the said single agreement. This is however not the case for a Credit Support Deed, which consists of a separate guarantee.

Before moving on to consider some of the other elements of the documentation, it is useful to consider the benefit of this single agreement principle in the context of systemic risk and the risk reducing nature of netting. A number of Transactions may be entered into between the parties to an ISDA Master. As the exposures of the parties under each of these Transactions in effect comprise a single agreement with the relevant ISDA Master, this enables the parties on the occurrence of default to net exposures under all of these Transactions in accordance with the provisions of the ISDA Master. This reduces the risk of cherry picking and minimises systemic risk.

Close-Out Netting. The essence of this netting, which is referred to as “close-out netting” in the jargon, is that, on the occurrence of certain defaults, which entitle the parties to terminate some or all of the trades, the trades are terminated and valued, with the result that a net amount is due by one party to the other. This netting operates as described in the Bank A/B example, taking into account trades in the money and out of the money, such that the previous individual obligations of the parties under the different trades are, on termination, replaced by one single net amount due by one party to the other.

The netting provisions are contained in Section 6(e) of the 1992 ISDA and will considered in more detail in further posts, together with an additional broader contractual right of set-off, which is often incorporated into the Schedule to the 1992 ISDA and which now forms part of the preprinted part of the 2002 ISDA.

Governing Law. The governing law of the 1992 ISDA is generally UK or US. However, where two counterparties from the same country are involved, it is not unusual to apply this country’s law and to submit to the jurisdiction of the local courts by express provision in Part 5 of the Schedule. The French counterparties use a French documentation, the FBF documentation, instead of the ISDA. Similar “national” documentations can be found in Germany and in the People’s Republic of China.

Legal Opinions. As mentioned above, the 1992 ISDA has the benefit of opinion letters commissioned by ISDA from law firms in different jurisdictions. They principally cover the validity of:

• closeout netting;
• the ability to terminate Transactions on insolvency;
• enforceability of the automatic termination provision;
• the impact of entering into Transactions through branches in different jurisdictions; and
• collateral.

Definitions. Section 14 of the 1992 ISDA contains definitions of the terms that are used in the ISDA. Separately, ISDA has prepared a number of definitional booklets, which are relevant to particular types of products, which the parties to the ISDA propose entering into. There are:

The “2000 ISDA Definitions and Annex”, which are commonly incorporated into the ISDA between the parties by electing to do so in the Schedule or in the relevant Confirmation, if the proposed Transactions are basis swaps, currency or cross-currency swaps or forward rate transactions or interest rate caps, collars or floors or other similar transactions.

The “2006 Definitions” update the “2000 Definitions” and apply to same categories of Transactions. Some counterparties may found handy to incorporate the 2006 Definitions into Confirmations relating to some types of transactions covered by some more specialised definitions such as the 2002 Equity Derivatives Definitions or the 2005 Commodity Derivatives Definitions, in order to better frame the modalities of variable or fixed payments.

The “1998 FX and currency option Definitions” are usually incorporated for foreign exchange transactions or currency option Transactions. Forms of confirmations for the Transactions are included in these booklets, together with specific definitions and provisions regarding the manner in which the relevant Transactions operate, the making of payments and calculations thereunder, the exercise, termination and settlement of the Transactions.

It should be noted that the definitions contained in Section 14 have been revised in the 2002 ISDA Master Agreement to take account of some of the more substantive changes to the events of default and valuation mechanisms.

Some further posts will be specifically dedicated to the study of the Equity Derivatives Definitions and Funds Definitions.