International Swaps and Derivatives Association
Encyclopedia
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
New York
New York is a state in the Northeastern region of the United States. It is the nation's third most populous state. New York is bordered by New Jersey and Pennsylvania to the south, and by Connecticut, Massachusetts and Vermont to the east...
, and has created a standardized contract (the ISDA Master Agreement) to enter into derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
transactions. In addition to legal and policy activities, ISDA manages FpML
FpML
FpML is an XML message standard for the OTC Derivatives industry.All categories of privately negotiated derivatives will eventually be included within the standard...
(Financial products Markup Language), an XML
XML
Extensible Markup Language is a set of rules for encoding documents in machine-readable form. It is defined in the XML 1.0 Specification produced by the W3C, and several other related specifications, all gratis open standards....
message standard
Standardization
Standardization is the process of developing and implementing technical standards.The goals of standardization can be to help with independence of single suppliers , compatibility, interoperability, safety, repeatability, or quality....
for the OTC Derivatives industry. ISDA has more than 820 members in 57 countries; its membership consists of derivatives dealers, service providers and end users.
History
ISDA was initially created in 1985 as the International Swap Derivatives Association and subsequently changed its name switching swap dealers to Swaps and Derivatives. This change was made to focus more attention on their efforts to improve the more broad derivatives markets and away from strictly interest rate swapInterest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
contracts.
Mark C. Brickell
Mark C. Brickell
Mark C. Brickell is an influential leader in the derivatives industry. He served as the president of the International Swaps and Derivatives Association from 1988 to 1992....
was the President of the International Swaps and Derivatives Association from 1988-1992. He helped defeat US Congressional efforts to regulate derivatives in 1994 and again in 1998.
In 2009 a New York Times article mentioned that in 2005 the ISDA allowed rule changes to CDO payouts (Pay as You Go) that would benefit those who bet against (shorted) mortgage-backed securities, like Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
, Deutsche Bank
Deutsche Bank
Deutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...
, and others.
ISDA Master Agreement
The ISDA Master Agreement is typically used between a derivatives dealer and their counterparty when discussions begin surrounding a derivatives trade. There are two basic forms of Master Agreement: single jurisdiction/currency and multiple jurisdiction/currency. One of these documents is generally combined with a Schedule to set out the basic trading terms between the parties; each subsequent trade is then recorded in a Confirmation which references the Master Agreement and Schedule. The terms of the Schedule are often negotiated, and many firms have preferred versions of the Schedule.According to Financial Times
Financial Times
The Financial Times is an international business newspaper. It is a morning daily newspaper published in London and printed in 24 cities around the world. Its primary rival is the Wall Street Journal, published in New York City....
reporter Stacy-Marie Ishmael, the Master Agreement is "fundamental to, and provides a template for, the derivatives market."
ISDA has also drafted a Tahawwut Master Agreement in cooperation with the International Islamic Financial Market, with the aim of standardizing derivatives transactions under Islamic law
Sharia
Sharia law, is the moral code and religious law of Islam. Sharia is derived from two primary sources of Islamic law: the precepts set forth in the Quran, and the example set by the Islamic prophet Muhammad in the Sunnah. Fiqh jurisprudence interprets and extends the application of sharia to...
.
Versions
The ISDA Master Agreement was first published in 1992, and a second edition was published in 2002. The second edition was drafted in response to market difficulties in the late 1990s, and could be adopted either in a unified form or as standard form amendments to the first edition. Key changes in the second edition include:- Shortening the grace periodGrace periodA grace period is a time past the deadline for an obligation during which a late penalty that would have been imposed is waived. Grace periods, which can range from a number of minutes to a number of days or longer, depending on the context, can apply in various situations, including arrival at a...
for payment defaults from three business days to one business day [Refer Section 5 (a)(i) of 2002 version] - Introduction of a force majeureForce majeureForce majeure or vis major "superior force", also known as cas fortuit or casus fortuitus "chance occurrence, unavoidable accident", is a common clause in contracts that essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of...
provision as a termination event - Introduction of a set-offSet-off (law)In law, a set-off is a statutory defense to the whole or to a portion of a plaintiff's claim. It had no existence under the English common law, being created by 2 Geo. II c. 22 for the relief of insolvent debtors, although set-off was recognized in equity...
provision [Included in the 2002 version in Section 6(f)] - Conformation of jurisdictionJurisdictionJurisdiction is the practical authority granted to a formally constituted legal body or to a political leader to deal with and make pronouncements on legal matters and, by implication, to administer justice within a defined area of responsibility...
clause to the Brussels RegimeBrussels RegimeThe Brussels Regime is a set of rules regulating which courts have jurisdiction in legal disputes of a civil or commercial nature between individuals resident in different member states of the European Union and the European Free Trade Association... - Introduction of Close-out Amount
On April 8, 2009, ISDA introduced further compulsory modifications known as the "Big Bang Protocol." The key changes introduced by this protocol include:
- Introduction of "auction settlement" to eliminate the need for credit event protocols to settle CDS transactions
- Automatic incorporation of Determinations Committee resolutions into the terms of standard CDS contracts
- "Look back" provisions, also known as "backstop dates," which institute a common standard effective date for CDS transactions
The Protocol also introduced more standardized terms in order to limit the scope of negotiation in individual CDS transactions, thus making individual contracts more fungible in trading.
Netting
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 them with a single net amount payable by one party to the other. NettingNetting
In general, netting means to allow a positive value and a negative value to set-off and partially or entirely cancel each other out.In the context of credit risk, there are at least three specific types of netting:...
, dealt with under section 2(c) of the ISDA Master Agreement, allows the parties to net out 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 commercial terms identical 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 is absolutely vital to financial institutions active in the derivatives market
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....
since the ability to net allows 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 has obtained legal opinions from all important jurisdictions confirming the effectiveness of the close-out netting provisions in those jurisdictions. Members of ISDA are 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.
Credit events and determinations committees
ISDA has five Determinations Committees, each having jurisdiction over a specific region of the world (the AmericasAmericas
The Americas, or America , are lands in the Western hemisphere, also known as the New World. In English, the plural form the Americas is often used to refer to the landmasses of North America and South America with their associated islands and regions, while the singular form America is primarily...
, Asia
Asia
Asia is the world's largest and most populous continent, located primarily in the eastern and northern hemispheres. It covers 8.7% of the Earth's total surface area and with approximately 3.879 billion people, it hosts 60% of the world's current human population...
excluding Japan, Australia
Australia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...
/New Zealand
New Zealand
New Zealand is an island country in the south-western Pacific Ocean comprising two main landmasses and numerous smaller islands. The country is situated some east of Australia across the Tasman Sea, and roughly south of the Pacific island nations of New Caledonia, Fiji, and Tonga...
, EMEA
EMEA
EMEA may stand for:* the previous acronym of the European Medicines Agency, an EU regulatory agency for the evaluation of medicinal products* Europe, the Middle East and Africa...
and Japan
Japan
Japan is an island nation in East Asia. Located in the Pacific Ocean, it lies to the east of the Sea of Japan, China, North Korea, South Korea and Russia, stretching from the Sea of Okhotsk in the north to the East China Sea and Taiwan in the south...
). Each committee consists of ten voting dealers and five voting non-dealer asset managers. The committees make official, binding determinations regarding the existence of "credit event
Credit event
A credit event is the financial term used to describe either:* A general default event related to a legal entity's previously agreed financial obligation. In this case, a legal entity fails to meet its obligation on any significant financial transaction...
s" and "succession events" (such as mergers), which may trigger obligations under a credit default swap
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
contract.
Since July 2009, the primary means of resolving a credit event is auction settlement, where holders of applicable instruments (as decided by the relevant determinations committee) auction their instruments to potential buyers at a set price.
Credit support annex (CSA)
ISDA also produces a credit support annexCredit Support Annex
A Credit Support Annex, or CSA, is a legal document which regulates credit support for derivative transactions. It is one of the four parts that make up an ISDA Master Agreement but is not mandatory...
which further permits parties to an ISDA Master Agreement to mitigate their credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
by requiring the party which is 'out-of-the-money' to post collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
(usually cash, government securities or highly rated bonds) corresponding to the amount which would be payable by that party were all the outstanding Transactions under the relevant ISDA Master Agreement terminated. Collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
other than cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
is usually discounted for risk, that is, the pledgor would have to post collateral in excess of the potential settlement amount.
Definitions
ISDA also creates industry standards for derivativesDerivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
and provides legal definitions of terms used in contracts. An example is the 1999 ISDA Credit Derivatives Definitions, which provide basic definitions for credit default swap
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
s, total return swap
Total return swap
Total return swap, or TRS , or total rate of return swap, or TRORS, is a financial contract that transfers both the credit risk and market risk of an underlying asset.- Contract definition :...
s, credit linked notes and other credit derivative transactions.
A controversy resulted over the definition of a "restructuring event
Credit event
A credit event is the financial term used to describe either:* A general default event related to a legal entity's previously agreed financial obligation. In this case, a legal entity fails to meet its obligation on any significant financial transaction...
" in connection with the August 2000 restructuring of USD 2.8 billion of debt by an insurance company. This prompted complaints from protection sellers in credit default swap
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
s, who had to compensate for an event that was seen as normal in the credit business. There was also a fear of a conflict of interest
Conflict of interest
A conflict of interest occurs when an individual or organization is involved in multiple interests, one of which could possibly corrupt the motivation for an act in the other....
, since protection buyers had nothing to lose by agreeing to restructuring. (Protection buyers included some of the insurance company's lenders.)