ISDA Anatomy™

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Index: Click to expand:Navigation
See ISDA Comparison for a comparison between the 1992 ISDA and the 2002 ISDA.
The Varieties of ISDA Experience
Subject 2002 (wikitext) 1992 (wikitext) 1987 (wikitext)
Preamble Pre Pre Pre
Interpretation 1 1 1
Obligns/Payment 2 2 2
Representations 3 3 3
Agreements 4 4 4
EODs & Term Events 5 Events of Default: FTPDBreachCSDMisrepDUSTCross DefaultBankruptcyMWA Termination Events: IllegalityFMTax EventTEUMCEUMATE 5 Events of Default: FTPDBreachCSDMisrepDUSTCross DefaultBankruptcyMWA Termination Events: IllegalityTax EventTEUMCEUMATE 5 Events of Default: FTPDBreachCSDMisrepDUSSCross DefaultBankruptcyMWA Termination Events: IllegalityTax EventTEUMCEUM
Early Termination 6 Early Termination: ET right on EODET right on TEEffect of DesignationCalculations; Payment DatePayments on ETSet-off 6 Early Termination: ET right on EODET right on TEEffect of DesignationCalculationsPayments on ETSet-off 6 Early Termination: ET right on EODET right on TEEffect of DesignationCalculationsPayments on ET
Transfer 7 7 7
Contractual Currency 8 8 8
Miscellaneous 9 9 9
Offices; Multibranch Parties 10 10 10
Expenses 11 11 11
Notices 12 12 12
Governing Law 13 13 13
Definitions 14 14 14
Schedule Schedule Schedule Schedule
Termination Provisions Part 1 Part 1 Part 1
Tax Representations Part 2 Part 2 Part 2
Documents for Delivery Part 3 Part 3 Part 3
Miscellaneous Part 4 Part 4 Part 4
Other Provisions Part 5 Part 5 Part 5
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So, you were wondering “what are the main differences between the 1992 ISDA and the 2002 ISDA?” Well, funny you should ask. I had the same question once upon a time, so I found out. They are below.<ref>What is that you say? You weren’t wondering about the differences between the 1992 ISDA and the 2002 ISDA? Well, in that case you might like Otto Büchstein’s uncelebrated opera, La Vittoria della Forma sulla Sostanza.

Close-out method

The 2002 ISDA, with its Close-Out Amount, is way simpler than the 1992 ISDA which gets bogged down with all this Loss, Market Quotation, First Method, Second Method malarkey.

Two way payments only

The 1992 ISDA offered parties the choice between one-way payment (the “First Method”) and two-way payment (the “Second Method”) of a settlement amount following the early termination and liquidation of the 1992 ISDA. The 2002 ISDA provides for only two-way payment.

Valuation Method

Likewise, the election of the Loss or Market Quotation method in the 1992 ISDA has been replaced with a hybrid valuation method called Close-Out Amount. Close-Out Amount was established in response to the following concerns:

  • Reliability: the Market Quotation valuation method is unreliable and potentially inaccurate in markets lacking adequate liquidity or in situations of market distress, and
  • Objectivity: the inherent subjectivity of the Loss valuation method. Close-Out Amount is a calculation of the gains, losses, and costs incurred in replacing or realizing the economic equivalent of the Terminated Transactions including (i) the cost of terminating, liquidating or re-establishing hedges so long as this value does not duplicate any other amount already included in the Close-Out Amount calculation; and (ii) the value of the option rights of the parties.
  • Valuation Process: The Determining Party enjoys flexibility in its choice of price sources, including the option to use internal valuations so long as the internal information used is of the same type used in valuing similar Transactions in the ordinary course of its business. However, regardless of the valuation method used, the Determining Party must use third party quotations or market data in its valuations unless it believes the information is not available or would not provide commercially reasonable results. The Determining Party may consider its creditworthiness and any Credit Support Document ation existing between the Determining Party and the entity providing the quotation when obtaining Market Quotations.
  • Force Majeure: Special considerations exist when the Close-Out Amount is calculated following termination due to a Force Majeure or Illegality . When calculating the Close-Out Amount for an Illegality or a Force Majeure , mid-Market Quotations must be used to value the Termination Transaction , and the creditworthiness of the Determining Party may not be considered. The 2002 ISDA requires the Determining Party to use “commercially reasonably procedures to produce a commercially reasonable result” when calculating the Close-Out Amount . This calculation method may be less attractive to some parties than the old Loss method due to concerns that this requirement adds uncertainty and limits the Determining Party ’s discretion in calculating the Close-Out Amount .

Illegality and Force Majeure Termination Events

Although the 2002 ISDA preserves most of the 1992 ISDA’s provisions concerning Termination Events, it extensively changes Illegality and adds Force Majeure as a Termination Event.

  1. if an occurrence would constitute an Illegality and a Force Majeure , the occurrence will be treated as an Illegality ;
  2. if an occurrence would constitute an Illegality or Force Majeure and an Event of Default under Section 5(a)(i), Section 5(a)(ii)(1), or 5(a)(iii)(1), it will be treated as an Illegality or Force Majeure so long as the occurrence relates to a failure to make any payment or delivery, failure to comply with a material term of the Agreement, or a failure to comply with a material provision of the 2002 ISDA or any Credit Support Document ; and
  3. if an occurrence would constitute an Illegality or Force Majeure and an Event of Default (other than an Event of Default as described in clause (ii)) or Other Termination Event , then it will be treated as the applicable Event of Default or Other Termination Event and not as a Force Majeure or Illegality

Events of Default

The Events of Default in the 1992 ISDA have proven successful and were spared major modification in the 2002 ISDA. Many participants have observed that changing market conditions merit some changes to the Events of Default however, and some revisions have been made to reflect these changes. These changes include

  • Cure Periods: Some of the cure periods were reduced out of the concern that these cure periods create undue risk when market volatility increases in times of turmoil in the financial markets. This was addressed in the 2002 ISDA by:
  1. reducing the cure period for a failure to pay or deliver pursuant to Section 5(a)(i) from three Local Business Days to one Local Business Day following notice of such failure;
  2. reducing the cure period for a payment Default Under Specified Transaction pursuant to Section 5(a)(v)(2) from three Local Business Days to one Local Business Day; and
  3. reducing the cure period for an involuntary bankruptcy filing pursuant to Section 5(a)(vii)(1)(B) from thirty to fifteen days.
  1. Delivery and other general defaults require the liquidation or early termination of the Specified Transaction (for general defaults) or the liquidation or early termination of all outstanding Transactions under the documentation supporting the Specified Transaction (for a delivery default). This change was made with repos in mind because a failure under a repo is not uncommon and may not be indicative of the Defaulting Party’s creditworthiness, particularly when the default concerns delivery obligations.
  2. This Event of Default may now be triggered by a default under a credit support arrangement relating to a Specified Transaction . Specified Transaction credit support arrangements were not addressed in the 1992 ISDA.
  3. As discussed above, the cure period for the failure to make a final payment or early termination payment in respect of a Specified Transaction has been reduced from three days to one.
  4. The repudiation subsection was modified in two significant ways: (i) the phrase “or challenges the validity of” was added after “disaffirms, disclaims, repudiates or rejects” to reduce ambiguity as to whether a party’s action Page 5 constitutes a repudiation; and (ii) a Non-Defaulting Party is now required to possess evidence of such repudiation that is executed and delivered by the Defaulting Party, its Credit Support Provider, or a Specified Entity; (iii) The definition of Specified Transaction has been broadened to include additional types of Transactions market participants commonly add to Schedules to the Master Agreement, such as repos, and includes a catchall clause designed to include any future derivative products that are not specifically enumerated in this definition.
  • Cross Default: The formula for determining a Cross Default has been revised to permit the aggregation of amounts owed under multiple defaults. In determining whether the Cross Default threshold has been exceeded, the principal amount of the accelerated obligations in subparagraph (i) and the unpaid amount under subparagraph (ii) are added together to determine whether the Cross Default threshold has been exceeded. In the 1992 ISDA, subparagraphs (i) and (ii) could not be combined to evidence a Cross Default.
  • Merger Without Assumption: The types of events that constitute a “merger” have been broadened to include reorganization, reincorporation and reconstitution, and the methods by which a resulting, surviving or transferee entity can assume obligations have been deleted.
  • Credit Support Default: The failure of a security interest granted pursuant to a Credit Support Document now constitutes a Credit Support Default.
  • Set-Off: The absence of a Set-Off provision is seen by many as the biggest weakness of the 1992 ISDA. Although the User’s Guide to the 1992 ISDA included an optional Set-Off provision, the optional provision was not effective unless the parties added the provision to the Schedule to the 1992 ISDA. The 2002 ISDA remedies this concern by including a Set-Off provision that is similar to the provision included in the User’s Guide. This provision permits the Non- Defaulting Party to Set-Off any amounts owing between the parties against any early termination amount. While cross-product Set-Off is permitted, cross-affiliate Set-Off is not incorporated into this provision. The User’s Guide also suggested adding a representation to satisfy the requirement that mutuality must exist between the parties for a Set-Off to be effected. In response to this concern, the 2002 ISDA includes an additional representation in Section 3(g) that both parties are principals in respect of all Transactions.


References