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How an ISDA Master Agreement Works

Over-the-counter (OTC) derivatives are traded directly between two parties, not on a stock exchange or through an intermediary. It is the risk managers responsibility to carefully oversee traders and make sure approved transactions are managed correctly. When two parties take part in a derivatives transaction, they each receive a confirmation that sets out its details and references the signed agreement. The terms of the ISDA Master Agreement then cover the transaction. When both parties are executing transactions later, they only need to exchange a confirmation. Each transaction is represented in one confirmation.

A confirmation lists what is being exchanged, the price, the currency, the date, and, if any, other information relevant for that specific transaction. A confirmation is automatically incorporated as a small part of the master agreement. Hence, the terms set out in the master agreement will manage all the future transactions represented by these confirmations.

ISDA Negotiations - The Purpose of the Agreement

The ISDA Master Agreement came about due to the foreign exchange and interest rate swap markets experiencing strong growth over the last several decades. The original ISDA Master Agreement was created to standardize these trades in 1985. It was revised in 1992 and again in 2002, both of which are currently available for use. Banks and other organisations around the world use ISDA Master Agreements. The ISDA Master Agreement also makes closeouts and netting easier, as it bridges the gap between various standards used in different jurisdictions.

The master agreement and supporting documentation also specify the terms under which one of the parties can order the closeout of covered transactions if any of the termination requirements are met. Cause for termination includes failure to pay or bankruptcy. Other termination events that can be added to the schedule include a credit downgrade below a specified level.

The Derivatives Market

The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two; one is for exchange-traded derivative and that for over-the-counter derivatives. A commodity market is a market that trades in the primary economic sector rather than manufactured products. Soft commodities are agricultural products such as coffee, sugar, and cocoa. Hard commodities are mined products such as gold and oil. Futures contracts are the oldest way of investing in commodities. Futures are secured by physical assets. The commodity market can include physical trading in derivatives using spot prices, forwards, futures, and options on futures. Collectively all these are called Derivatives.

Derivatives can seem like totally foreign concepts to those outside the world of finance. However, derivatives are part of our everyday life even if we are unaware. Below is a real-world example of derivatives in action.

Derivatives Example

There is a Beyonce concert next week that Ms X wishes to attend. Unfortunately, when she got to the ticket counter, she saw all the tickets have been sold out. With only seven days left until the concert, she is trying to quickly find a ticket including on the black market where prices are now twice the actual cost. Luckily her friend works closely with the venue owner, and her friend has given a letter from that owner to organisers recommending one ticket to Ms X at the actual price. She is now delighted she can attend the concert. However, in the black market, tickets are still available at a higher price than the actual price.

Here, the letter is the underlying asset and the value of the letter is the difference between the actual price of the ticket and the black market price.

Risk Mitigation

Risk managers who oversee the drafting of an ISDA Master Agreement may consider requesting “standard terms” when it comes to drawing up the agreement to expedite the process. However, in the world of ISDA negotiation, there is no such thing as "standard terms". The process may be simplified by focusing on the counterparty type so the risk manager can gauge the bargaining power of both sides and determine which terms are “must-haves” and which are “nice to have”.

If, for example, the counterparty’s creditworthiness is dependant on the continued support of a powerful parent company, would be prudent to consider how best to reflect this in the documentation and incorporate possible exit provisions in case of adverse change in control or ownership occur. If a third party guarantee is provided, the guarantor can be recognised as a Credit Support Provider in the ISDA Master Agreement Schedule. They will then be automatically added to the Events of Default and Termination Events.

Once the risk manager’s requirements have been set out in the first draft Schedule they will be reviewed by the counterparty’s negotiator, who will then respond with other changes to the proposed terms. At this stage, the risk manager is likely to be approached again for guidance on the proposed modifications and because of this, it is useful for risk managers to be familiar with commonly negotiated amendments. It may well be the case that many such changes are provided for in an institution’s documentation or credit policy but it of course makes sense for risk managers to understand what a given counterproposal is intended to achieve and any disadvantages that agreeing to it would entail.

The Structure of an ISDA Agreement and the Importance of Negotiation

The ISDA Agreement is made up of two parts: the master terms (legal provisions) and the schedule (elections and optional provisions, credit and jurisdictional provisions). It is only the schedule that needs to be negotiated. The ISDA can therefore be tailored to suit the counterparty and the particular credit risks or jurisdictional requirements of the counterparty by negotiating terms into the schedule.

Below is a list of credit provisions that may be negotiated:

Specified Entities

You may have requested all affiliates but your counterparty may only want to include certain named entities, or perhaps none at all.

Additional Termination Events

For example, if the parent ownership percentage drops below 51% this can be cause for termination.

Grace periods for certain Events of Default 

Grace periods can be extended or shortened beyond the ISDA standard.

Cross Default vs. Cross Acceleration 

Whether defaults under other agreements between the parties can lead to a default under your ISDA and the timing of when this Event of Default can be triggered. This can be a major sticking point in some negotiations if the parties want differing terms.

Threshold Amount 

This is the trigger at or above which a Non-defaulting Party can terminate all Transactions under the ISDA Master Agreement’s Cross Default clause. The level of this is often negotiated and whether it should be measured as a fixed monetary sum or a percentage of shareholders’ equity.

Without an expert, however, negotiating ISDA Master Agreements can often be lengthy, expensive and tedious. Negotiations can take months as parties go back and forth over legal, business and credit terms. Although much has been done to standardize the documentation process as far as possible, there are still numerous issues that parties must negotiate before executing the ISDA Master Agreement. Because of continuing legal uncertainty and credit risk in the OTC market, ISDA Master Agreement will probably always prove difficult to negotiate. Avoiding unnecessary delays in completing these agreements, however, will pay dividends. Negotiating ISDA Master Agreement faster can open up the possibility for even more profitable trading to be done between the parties.

An ISDA negotiator provides an essential service in the creation of an OTC derivative trading relationship. A good negotiator can ensure a trade agreement that suits a party’s goals and risk tolerance, and create a firm foundation for profitable trading.

ISDA Negotiation as a Career

ISDA negotiators are not required to be qualified lawyers, although legal training is certainly an advantage. Generally, an ISDA negotiator’s background includes specialised training and extensive knowledge of the financial products involved in the trade. The negotiator needs to be skilled at getting the stipulations of his party into the contract, and at swiftly reaching an agreement with the other party so that key trades can take place. There are incredible career opportunities for skilled ISDA negotiators, from working in-house for asset management companies or global banks like Goldman Sachs to negotiating for corporates like Google and Coca Cola (who use ISDAs for currency hedging purposes). ISDA negotiation is a highly specialised role and lucrative, it is well worth considering for those with a financial or legal background.

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I’m Edyta Knizewska

I’m an award winning derivatives lawyer that wants to share her secrets with you. Welcome to my office! Why don’t you take a seat?

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I’m Edyta Knizewska

I’m an award winning derivatives lawyer that wants to share her secrets with you. Welcome to my office! Why don’t you take a seat?
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