CFM11050a - Understanding derivative contracts: what is a derivative?
The ISDA Master Agreement
The current version of the ISDA Master Agreement was published
in 1992. There are, in fact, two forms: a general multicurrency
agreement and a simpler version for use in transactions where there
is no international element. You can download either version (as
well as other ISDA standard documents) free of charge from the ISDA
website, www.isda.org/publications.
The documentation consists of the Master Agreement itself,
which sets out the basic terms and conditions, and a Schedule to
the agreement, which sets out any particular terms the parties
agree will apply to transactions between them. A company entering
into a master agreement with a particular counterparty will need to
negotiate the terms of the schedule, although many banks and other
derivatives professionals have their own standard forms of
schedule.
If you want to know the full contractual terms governing any
particular derivatives transaction, you will need to look at the
master agreement, the schedule and the confirmation of that
particular transaction.
It is generally accepted that, in law, all transactions which
two parties enter into under a master agreement constitute a single
contract. Each time a new transaction takes place, a new contract
is created which assumes all previous unsettled deals – a
process of novation (see CFM3352). This means that if one party
defaults on a transaction, it is essentially regarded as defaulting
on all transactions. Otherwise, if one party was owed money under
transaction A but was due to make a payment under transaction B, it
would be legally obliged to make the payment under transaction B
even if it never received the money under transaction A.
The ISDA Master Agreement allows payments between the parties
to be netted off, even where there is no default, provided the
payments are due on the same date and in the same currency. This
applies across transactions, as well as to payments in respect of
the same transaction.
Example
A company enters into two swaps (X and Y) with the same bank.
Under the terms of swap X, the company is due to pay the bank
£100,000 on 31 March. On the same day, the bank is due to pay
the company £150,000 under the terms of swap Y. The bank can
make a net payment of £50,000 to the company.
CFM11050 explains that a company which becomes party to an
OTC contract may have to provide collateral (which may be cash, or
some negotiable instrument such as bonds). ISDA publishes two
standard credit support documents, the Credit Support Deed and the
Credit Support Annex. Both allow one party to call for cash or
other collateral from the other if the mark to market value of the
transaction falls below a certain amount – an arrangement
rather like the payment of margin on exchange-traded contracts (see
CFM11031a).
Under the Credit Support Deed, the counterparty does not own
and cannot use the margin, but has a legal charge over it, which
can be enforced if there is a default. The Credit Support Annex, on
the other hand, provides that title to the margin passes to the
counterparty. So if there is a default, the counterparty can net
off the amount of collateral it holds against what it is owed under
the contract.
