2002 ISDA Master Agreement: Explanation and Overview
The 2002 ISDA Master Agreement is a widely used standard form agreement between parties trading in over-the-counter derivatives. The International Swaps and Derivatives Association (ISDA) published the 2002 ISDA Master Agreement in 2002 following the 1992 ISDA Master Agreement which was published by ISDA in 1992. Since the 2002 ISDA Master Agreement is a global standard form agreement, it applies to an international audience and not only to the US market. The 2002 ISDA Master Agreement serves as the general trading agreement between counterparties in over-the-counter derivatives, and within that general standardization, allows a blanket trade confirmation framework to be used between those counterparties . It also allows both parties to incorporate new trades upon execution of a confirmation of the individual trade into the master framework. The trade confirmations, being the individual agreements, fit into the master framework. This results in greater efficiency for market participants and allows businesses to minimize the amount of documentation required to commence trading. In addition, an ISDA Offering Letter is given by one party to the other party which sets out the arrangements pertaining to the individual transactions of derivatives. ISDA has published a most recent version of the ISDA Master Agreement in 2011.
2002 ISDA Master Agreement: Key Contract Terms
Several key provisions of the 2002 ISDA Master Agreement govern the transactions between parties. In this section we will discuss these provisions with a focus on payment netting, events of default, and termination events. Each of these provisions is significant to the parties at the time of entering into an agreement under the 2002 ISDA Master Agreement.
The 2002 ISDA Master Agreement contains two valuable netting provisions: set-off and payment netting. Under the set-off provision, a party is permitted to set off amounts owed by it to the other party against amounts owed to it by such other party. This form of set-off is permitted, (1) at the election of the party receiving a payment ("Payee"), (2) prior to the calculation of the termination amount, (3) only to the extent that such payment is a "set-off payment," and (4) as long as such payment is not a settlement payment in connection with the close-out of transactions under the 2002 ISDA Master Agreement.
There is also a contractual right of netting for payments under the 2002 ISDA Master Agreement. The payment netting provision allows parties to the 2002 ISDA Master Agreement to unilaterally make payments to and from each other with respect to the relevant netting provisions. This scheme of netting permits payments to and from both parties to the 2002 ISDA Master Agreement to be netted against one another and facilitates the settlement of only the balance owed to the other party.
The 2002 ISDA Master Agreement sets forth several events of default. Generally speaking, an event of default occurs if one party fails to fulfill certain obligations, such as payments due under the 2002 ISDA Master Agreement, or if one of the parties becomes unable to pay the amounts owed under the 2002 ISDA Master Agreement.
There are two categories of events of default under the 2002 ISDA Master Agreement: (1) non-default and (2) default. An event of default described in the first category includes conditions such as non-payment of amounts due under the 2002 ISDA Master Agreement, failure to deliver, or failure to comply with a judgment, all of which give the non-defaulting party the right to terminate the transactions and the 2002 ISDA Master Agreement by notice to the other party. The second category of events of default described in the 2002 ISDA Master Agreement relates to bankruptcy whereby a non-defaulting party may terminate the transactions and the 2002 ISDA Master Agreement regardless of whether there has been a monetary default.
The timing of payment of the amounts due to the non-defaulting party under the terms of the 2002 ISDA Master Agreement is critical. In the event of an event of default, the defaulting party is required to make payments as soon as practicable upon receipt of a demand from the non-defaulting party. Such payments are due within the number of days as specified in the 2002 ISDA Master Agreement and it is important to note that in the event of a bankruptcy of a party, the payments under the 2002 ISDA Master Agreement must be made by the defaulting party no later than two days prior to the date on which such payment is due.
Termination events are defined under the 2002 ISDA Master Agreement as circumstances that might prevent transactions from being performed after they have been initiated. In the 2002 ISDA Master Agreement, two termination events are provided for which permit parties to terminate transactions. The first termination event is due to illegality. A party may terminate all or any series of transactions under the 2002 ISDA Master Agreement if the performance of the transaction by either party under the applicable law has become illegal. The second termination event is tax event where a party may terminate the 2002 ISDA Master Agreement in the event it determines that it has become subject to an adverse tax consequence from a taxation authority. A tax event permits a party to terminate the relevant transactions under the 2002 ISDA Master Agreement at any time after the occurrence of such event.
Key Differences Between The 1992 and 2002 ISDA Master Agreements
When comparing the 1992 ISDA Master Agreement with the 2002 ISDA Master Agreement, the primary differences can be found in the "which way" clauses, the indemnification clauses, and the cross-default provisions.
The ‘which way’ clauses in the 1992 ISDA require that the non-defaulting party give notice of its intention to the defaulting party prior to exercising its right to terminate the contract. In contrast, the 2002 changes removed this requirement for an active cancellation process and now allows either party to propose what is essentially an ‘autocancellation’ without notice to the other party. This substantial change can significantly influence the drafting of hedge finance agreements and the timing of cross-border transactions. Prior consultation between the parties can be used to tailor the cancellation term, and this is particularly important in ensuring that solid agreements are made regarding which types of defaults will trigger which type of cancellation.
The indemnification clauses in the 1992 ISDA Master Agreement give the non-defaulting party the option of forcing the defaulting party to pay the indemnification amount in front of creditors in the case of insolvency. This clause has been removed in the 2002 ISDA Master Agreement, as it was thought that the ability to force a breach of creditor priority would prevent the previous overarching purpose of the insolvency regime: providing the insolvent party with an opportunity to save itself. The 2002 ISDA Master Agreement states that the non-defaulting party will ‘Italianise’ payments to creditors in the case of insolvency. This means that the non-defaulting party will make payment in accordance with the order of priorities set out in applicable legislation.
The default provision is updated in the 2002 ISDA Master Agreement provided by the ISDA. The 1992 ISDA Master Agreement provided for a: ‘cross default of 12.5 million or more giving the other the right to terminate.’ The 2002 ISDA Master Agreement offers a choice of a cure period of ten days or 30 days, and the default amount was raised to $100 million or the greater amount of the net equity of the creditor party. The 2002 ISDA Master Agreement also has a separate non-payment default provision, where a failure to pay the required amount within three payment dates cancels the agreement.
It is important when carrying out a cross-border transaction to know which ISDA Master Agreement is going to be used for a particular agreement. While normally, the 1992 ISDA Master Agreement is used for transactions in Europe, and the 2002 ISDA Master Agreement is used in New York, it is not a strict practice. The 2002 ISDA Master Agreement has been amended over time by various parties to cover specific practices, and an experienced legal consultant will offer many changes to the 1992 ISDA Master Agreement.
2002 ISDA Master Agreement: Use For Risk Management
The 2002 ISDA Master Agreement is not merely a legal agreement. In the realm of derivative trading, it plays an integral role in managing and mitigating risks associated with these complex financial instruments. It does this in several ways.
A clear illustration of this is in the netting of exposures that occurs upon an event of default and termination of transactions. The ISDA Master Agreement allows for "jumbo netting" where close out amounts as at any termination date will be determined by calculating a loss amount and an available gain amount for the various types of transactions under the two ISDA Master Agreements and be set off against each other on a "single entity single obligation" basis.
The ISDA Master Agreement also provides for transfer of credits among transactions, by means of issuing a payment order to be applied against exposures of the parties.
The ISDA Master Agreement further creates a security interest over all collateral provided by the parties to each other under the trade confirmations that are governed by ISDA Master Agreements. The "security interests" create a priority over other creditors of the collateral provider.
In summary, the ISDA Master Agreement, through its clauses and incorporated definitions, facilitates the imposition of significant economic and credit risk control practices within the broader scope of risk management.
2002 ISDA Master Agreement Legal Issues
When entering into an agreement under the ISDA 2002 Master Agreement framework, or ISDA 2002 framework, there are a number of legal considerations and implications that both parties should be aware of.
The legal considerations and implications for parties wishing to enter into a 2002 ISDA framework will be determined based on their unique requirements and circumstances and it is therefore, not be appropriate to provide a single recommendation that will apply globally to all. However, we will consider below some such legal implications and considerations, including, jurisdiction and enforceability.
Jurisdiction
In each case, the parties must decide what jurisdiction’s courts will have exclusive jurisdiction to settle any disputes. In addition to the above, it is important to consider:
Enforceability
Contracts will generally need to be governed by the law of the jurisdiction in which the party is located at the time of signing the master agreement. This conclusion has been made by discretion through certain principles handed down in case law. With respect to enforceability in a specific jurisdiction , in addition to the considerations listed above, the most significant consideration must be as to whether the laws of the jurisdiction have specific legislation governing or prohibiting that type of transaction in place or whether the regulations discourage the transaction in principle (for example, the transaction may contravene "sharia law", "anti-money laundering" or other culturally or financially important laws or policies). Furthermore, the enforceability of the actual contract will depend on the characteristics of the contract itself (for example an agreement may be unenforceable if it contravenes a specific piece of legislation, involves illegal activities or fraud or if it is against public policy). Practitioners must be aware that the jurisdiction and validity and enforceability of the contractual provisions covered by the ISDA 2002 framework are separate issues that can be made independently of each other. As such, the potential ramifications in the local jurisdiction(s) will need to be weighed against the need/flexibility for and/or importance of being able to enforce the contract and its provisions in the local jurisdiction(s).
ISDA Agreements: Usage and Seeking Global Adoption
The 2002 ISDA Master Agreement has achieved wide-ranging acceptance around the world, being in use in most jurisdictions by a broad spectrum of financial institutions and corporations. The broad acceptance has resulted in the 2002 ISDA Master Agreement being made available in multiple foreign languages and having become the industry standard worldwide. These documents represent over 90 per cent. of currently outstanding OTC derivative transactions. Overall, there are over 1.2 billion inter-dealer and client trades that make up a notional value of approximately US$700 trillion, and these transactions are documented by the ISDA Master Agreement.
It has become the accepted market standard form agreement for cross-border OTC derivatives transactions. It is widely recognised as the appropriate document for transactions governed by UK law. It is equally widely recognised (although less so than those governed by UK law) as an appropriate agreement for transactions governed by Swiss, New York and German law. Other countries that have adopted the 2002 ISDA Master Agreement or are adopting it include: the Netherlands, Italy, Japan, Hong Kong, France, Spain, the Cayman Islands etc.
The general concept of a standard form agreement is now common among OTC derivative dealers and their customers. Documentation based on the 2002 ISDA Master Agreement has become the industry norm worldwide.
ISDA Agreements: Future and Evolution
As the financial markets continue to evolve and become more complex, ISDA agreements will need to adapt in order to cover new products and trading arrangements. One key development in this context is the impending introduction of the margin requirements for non-centrally cleared OTC derivatives. Currently, ISDA agreements provide for a netting of payments following the termination of a trade, but the scope of those netting rights is generally limited to netting that would occur as between a clearing house and an end user. Increased regulatory oversight of the OTC derivatives markets has therefore led to calls for a more comprehensive approach to netting rights. ISDA is currently working on a new protocol which will allow the parties to transactions governed by ISDA agreements who would be entitled to payment under the relevant margin rules to include those payments in the netting calculation to be performed under the terms of their ISDA agreement . This protocol is likely to be introduced in parallel with the relevant margin requirements. A key area for development in relation to ISDA agreements will be the treatment of digital currencies and other new cryptocurrency products. As yet, ISDA agreements do not include reference to these products. Given the rise in popularity of digital currencies, it seems likely that ISDA agreements may be amended to deal with them, perhaps in the context of consideration of margining requirements in relation to digital currencies. Another key development area is the increased ability of financial institutions to use virtual currencies. The use of virtual currencies for cross-border transactions brings with it a particular regulatory burden which may be dealt with as part of the next ISDA [] Risk Mitigation Standards which are due to be published by ISDA in July of this year.