International Swaps and Derivatives Association

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The International Swaps and Derivatives Association (ISDA) is a trade organization of participants in the market for over-the-counter derivatives. It is headquartered in New York, and has created a standardized contract (the ISDA Master Agreement), that two parties sign before they enter into derivatives transactions with each other. There are currently two versions of the ISDA Master Agreement in widespread use - the 1992 edition and the 2002 edition. In practical terms there is very little to choose between the two since most of the amendments included in the 2002 edition are incorporated into 1992 edition as a matter of course by use of the Schedule (see below). References herein to section of the ISDA Master Agreement are references to the 1992 edition unless otherwise stated. The ISDA Master Agreement is a bilateral framework agreement. This means it contains general terms and conditions (such as provisions relating to payment netting, tax gross-up, tax representations, basic corporate representations, basic covenants, events of default and termination) but does not, by itself, include details of any specific derivatives transactions the parties may enter into. The ISDA Master Agreement is a pre-printed form which will not be amended itself (save for writing in the names of the parties on the front and signature pages). However, it also has a manually produced schedule in which the parties are required to select certain options and may modify sections of the Master Agreement if desired.

Details of individual derivatives transactions are included in Confirmations entered into by the parties to the ISDA Master Agreement. Each Confirmation relates to a specific Transaction and sets out the agreed commercial terms of that trade. Confirmations are generally quite short as they will normally incorporate one or more of the definition booklets published by ISDA. Each of these definition booklets relates to a specific type of derivatives transaction and, as well as defining terms, they include mechanical provisions (e.g. Articles 5 and 6 of the 2000 ISDA Definitions set out how to calculate the the Fixed and Floating Amounts payable under an interest rate swap) which do not then have to be laboriously reproduced in the Confirmation.

Possibly the most important aspect of the ISDA Master Agreement is that the Master Agreement and all the Confirmations entered into under it form a Single Agreement. This is very important (especially for regulated financial companies) as it allows the parties to an ISDA Master Agreement to aggregate the amounts owing by each of them under all of the Transactions outstanding under that ISDA Master Agreement and replace this with a single net amount payable by one party to the other. Transactional netting is dealt with under section 2(c) of the ISDA Master Agreement and allows the parties to net off amounts payable on the same day and in the same currency. The more important use of netting is close out netting under Section 6(e) of the ISDA Master Agreement. Pursuant to this section when an ISDA Master Agreement (or, more accurately the outstanding Transactions under it) is terminated (normally following a credit event of some kind) the value of each of the Terminated Transactions is assessed (there are several ways this can be done, but the most usual measure is to determine how much it would cost for a party to enter into a Transaction having identical commerical terms to the Terminated Transaction with an independent third party - this is called the Settlement Amount) and converted into the Termination Currency (which should have been specified in the schedule to the ISDA Master Agreement) and any outstanding Unpaid Amounts are taken into account. The Settlement Amounts (which may be positive or negative depending which party is 'in-the-money' with respect to a particular Terminated Transaction) and unpaid amounts (again positive or negative, depending on who owes them) are added up and a single figure in the Termination Currency is determined payable by one party or the other. The enforcability of the close out netting provisions are absolutely vital to financial institutions active in the derivatives market since they allow them to allocate capital only against the net figure they would have to pay on close out of an ISDA Master Agreement rather than the gross amount. ISDA have obtained legal opinions from all important jurisdictions confirming the effectiveness of the close out neting provisions in that jurisdiction. Members of ISDA ar entitled to rely on these opinions. ISDA also produces a model "Netting Act" which can be adopted by jurisdictions where close out netting does not work effectively at present.

ISDA also produce a credit support annex which further permits parties to an ISDA Master Agreement to mitigate their credit risk by requiring the party which is 'out-of-the-money' to post collateral (usually cash, government securities or highly rated bonds) having a market value being some percentage (usually slightly higher than 100%) of the (net) amount which would be payable by that party were all the outstanding Transactions under the relevant ISDA Master Agreement terminated.

The ISDA also creates industry standards for derivatives, and provides legal definitions of terms used in contracts. That this standard setting can have wide consequences, could be seen in a recent controversy over the definition in the 1999 ISDA Credit Derivative Definitions of a "restructuring event". It called into question the idea of such a reference being independent. A restructuring event was triggered in August 2000 when an insurance company restructured about USD 2.8 billion of debt by extending its maturity.

This prompted complaints from protection sellers, who had to compensate (under the 1999 ISDA Credit Derivatives Definitions) for an event that was seen as normal in the credit business. There was also a fear of a conflict of interest, since protection buyers had nothing to lose by agreeing to restructuring. (Protection buyers included some of the insurance company's lenders.)

In addition to legal and policy activities, the ISDA manages FpML (Financial products Markup Language), an XML message standard for the OTC Derivatives industry.