ISDA Master Agreement: Definition, What It Does, and Requirements

Published by the International Swaps and Derivatives Association (ISDA), an ISDA master agreement is a standardized contract for over-the-counter (OTC) derivative transactions. It's the lingua franca of the derivatives world, used extensively by financial institutions, corporations, and other market participants.

The agreement provides prearranged terms, conditions, and forms of documentation, including payment arrangements and schedule, what happens if there's a default, what counts as termination events, and credit dealings. The ISDA master agreement is standardized but has customized schedules and sometimes a credit support annex that can be adjusted by the parties.

How an ISDA Master Agreement Works

While futures and most options are fully standardized and traded on exchanges like the Chicago Mercantile Exchange, OTC derivatives are just between two parties, not through an exchange or intermediary. Risk managers must carefully oversee traders and ensure approved transactions are correctly managed. When two parties enter a transaction, they each receive a confirmation setting out details and references to the signed agreement. The terms of the ISDA master agreement then cover the transaction.

The original ISDA master agreement was created to standardize these trades in 1985. It was revised in 1992 and again in 2002. Here are the types of derivatives for which they are used:

• Interest rate derivatives (e.g. interest rate swaps, caps, floors, swaptions)
• Credit derivatives (e.g. credit default swaps)
• Equity derivatives (e.g. equity swaps, options, forwards)
• Foreign exchange derivatives (e.g. currency swaps, forwards, options)
• Commodity derivatives (e.g. commodity swaps, options, forwards)

The ISDA master agreement makes transaction closeout and netting easier since it bridges the gap between various standards used in different jurisdictions. Below is the data on global derivatives trading since 2019. The chart is telling about what kinds of derivatives are traded OTC, since equities, commodities, and credit derivatives, popular exchange-traded contracts, are subsumed under "other" in the chart, and forex and interest rate derivatives are far more at issue in these contracts.

Most multinational banks have ISDA master agreements in place with one another. These agreements usually cover all branches that are active in foreign exchange, interest rate, or options trading. Banks require corporate counterparties to sign an agreement to enter into swaps. Some also require agreements for foreign exchange transactions.

While the ISDA master agreement is standard, its terms and conditions are amended and defined in its schedules. The latter are negotiated to cover either the requirements of a specific hedging transaction or an ongoing trading relationship.

A credit support annex (CSA) sometimes accompanies the master agreement. The CSA allows the two parties involved to mitigate their credit risk by stipulating the terms and conditions under which they're required to post collateral for each other.

Benefits of an ISDA Master Agreement

The most significant advantages of an ISDA master agreement are that it improves transparency and provides higher liquidity, that is, an easier ability to trade in derivatives worldwide, knowing there are standardized terms available. In addition, clarifying the terms in the agreement saves time and legal fees for everyone involved.

Requirements of an ISDA Master Agreement

The master agreement and schedule set out the grounds under which a party can force the closeout of covered transactions because of a termination event by the other party. Standard termination events include failure to pay or bankruptcy. Other termination events, including credit downgrades, can be added to the schedule.

The ISDA master agreement also specifies whether the laws of the U.K. New York state, or some other jurisdiction apply. It also sets out the terms for valuing, closing out, and netting all covered transactions in case of a termination event.

Netting in the ISDA Master Agreement

Netting is a key feature of the ISDA master agreement. It's a way to offset or consolidate different payment obligations between two parties into a single net payment. Instead of each party making separate payments for each individual transaction, the amounts due are calculated and combined, resulting in a single payment from one party to the other.

For example, if Party A owes Party B $1,000,000 for one derivative transaction, and Party B owes Party A $800,000 for another transaction, these obligations can be netted against each other. The result would be a single payment of $200,000 from Party A to Party B.

The ISDA master agreement allowance of netting is particularly important if there's a default. By netting the transactions, the overall credit exposure is reduced since the parties only need to settle the net amount rather than each individual transaction separately. Thus, netting helps to mitigate counterparty risk and simplify cash flows.

ISDA Master Agreement Example

Imagine that two companies, ABC Inc. and XYZ Corp. are in international finance. Each is located in a different country and wishes to trade OTC derivatives with each other.

ABC Inc. and XYZ Corp. could sign an ISDA master agreement based on the standard document. This agreement would set down provisions for how the two companies will handle these transactions, including what laws will apply and how the companies will close out the trades they make.

If there is a disagreement between the two companies about one or more trades, they will settle the disagreement using the laws specified in the agreement and based on the terms included in the ISDA master agreement.

The Bottom Line

The ISDA master agreement is a standardized document created by the ISDA for OTC derivatives transactions. It provides a framework for the terms and conditions for trading OTC derivatives, helping to cut legal and credit risks by establishing consistent documentation across different jurisdictions and many trades.

The major parts of the ISDA master agreement include the schedule, which allows parties to customize certain terms, and the CSA, which details the collateral arrangements. The master agreement also addresses issues like dispute resolution, the governing law, and tax considerations. In addition, it helps to manage counterparty risk since it ensures that both parties understand their rights and obligations.