Interpretation - ISDA Provision
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2002 ISDA Master Agreement
Section 1 in a Nutshell™ Use at your own risk, campers!
Full text of Section 1
Related agreements and comparisons
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Content and comparisons
Redlines
- 1987 ⇒ 1992: Redline of the ’92 vs. the ’87: comparison (and in reverse)
- 1992 ⇒ 2002: Redline of the ’02 vs. the ’92: comparison (and in reverse)
- 1987 ⇒ 2002: Redline of the ’92 vs. the ’87: comparison (and in reverse)
Discussion
The 2002 ISDA does the reader the service of acknowledging there might be terms defined in the schedule and not just Section 14 — as indeed there must — party-specific things like Party A, Party B, Credit Support Provider, Credit Support Document, and no doubt you can think of others — but beyond this, the text of Section 1 in the 2002 ISDA is the same as Section 1 in the 1992 ISDA.
The 1987 ISDA was broadly the same, though there was no “single agreement” subclause (c) — that is built instead into the Preamble. By 1992 ISDA’s crack drafting squad™ deemed this important enough to deserve its own place in Section 1(c), and there it stayed for the 2002 ISDA.
Summary
Section 1 is a gentle introduction indeed to the dappled world of the ISDA Master Agreement.
In a nutshell, unless you are doing repackagings — and even then, don’t get carried away — make sure you understand what Section 1 is there for and what it does, but don’t fiddle with it.
Section 1(a)
The large slew of definitions are set out in Section 14. JC considers each in its own write in Section 14, so not much more to say here.
Section 1(b)
It wouldn’t be ISDA if there weren’t a hierarchy clause; like all hierarchy clauses, this one states what ought to be obvious: the pre-printed ISDA Master Agreement itself sits at the bottom of the hierarchy, is modified by the Schedule; once that is negotiated and stuck into the netting database, the Schedule sits there, ungainly, unloved and unregarded until the Great King of Terror comes down from the sky[1] and may be (but generally isn’t) modified as needs be for each Transaction by the Confirmation.
In point of fact the Confirmations don’t tend to modify anything in the Master or Schedule, but rather builds on them, but if there is inconsistency — and with a document as pedantic and overwrought as the ISDA Master Agreement you never know — then the most specific, recently edited document will be the one that prevails.
All of this follows from general principles of contractual interpretation and common sense communication, of course.
A message to internal audit and quality control teams
One quick point that only needs saying when busy-bodies from internal audit come on their biannual trip hunting for worms and earwigs under rocks in your neighbourhood: you — and by that we mean one — never, never, never “inline” amends the form of ISDA Master Agreement. It is sacred. Never to be edited. If, er, one wants to amend its terms — of course one does, one is a legal eagle and one’s client is special — you do that remotely by setting out the amendment in Part 5 of the Schedule.
Why labour this obvious point? Because JC has had to explain to a disbelieving external audit consultancy, retained to ensure quality control over a portfolio of tens of thousands of master trading agreements, that there was no need for a control measuring the number of agreements that had been inline amended; no need for a core-sample test, a gap analysis or a nine-month all-points operational risk deep dive to be sure that this was the case — and it was an argument that ran for three weeks and which JC almost lost.
No-one, ever, inline amends the ISDA.
The ISDA Master Agreement is shot through with unimaginative design, unnecessary verbiage and conceptual convolution, but this is one design principle the ’squad got perfectly right: “offboarding” amendments to the Schedule does several smart things: it creates a neutral standard for all participants offering no scope for interrogation by sancimonious quality controllers, it makes very clear at a glance what has changed from the standard and most importantly it disincentivises formalistic fiddling: it is a rare — though by no means unknown — kind of pedant who insists on insertions like, “Section 2(a)(i) is amended by adding, “, as the case may be” before the full stop on the third line.”
Section 1(c)
Section 1(c) starts getting a bit tastier in that it comprises the Single Agreement. This is deep ISDA lore, from which all the close-out netting that gives the ISDA Master Agreement its capital efficiency flows.
The “single agreement” concept
Here several pieces of magic come together to create the capital foundation of the modern master trading agreement. The challenge, originally solved by the First Men, was to create an architecture that allowed discrete, unitary, complete Transactions, such that creating a new one or terminating an old one didn’t upset the economic or legal integrity of other Transactions that were currently on foot — no untoward tax consequences, that is to say — while at the same time creating an umbrella framework so that, should something regrettable happen to either party, all Transactions can be quickly rounded up, evaluated, stopped and then collapsed down — “netted” — to a single payment, payable by one party to the other.
This involved some canny financial engineering. The general rules of set-off require not just a mutuality of parties to the off-setting debts, but also amounts falling due on the same day and in the same currency — neither of which was necessarily true of the independent Transactions executed under a multi-currency, cross-border ISDA Master Agreement.
Their solution was this concept of the “Single Agreement”: the over-arching agreement that, however independent and self-contained Transactions are for any other purpose, when it comes to their early termination, they transmogrify into the single host agreement, in the process reduced to mere calculation inputs to the final amount which one party must pay the other. Thereby the process is not one of “set-off” at all, but of calculating a single net amount, the payment of which would sort out all matters outstanding under the relationship.
The JC once had the idea of doing a “boring talk” about the history of the ISDA Master, and actually pitched it to the BBC for their podcast series. It was rejected, on account of being too boring. True story.
General discussion
Section 1(c): the Single Agreement
Most of Section 1 may be theatrical throat-clearing, but section 1(c) is important — by some lights, the main reason one even has an ISDA Master Agreement: it vouchsafes your close-out netting analysis, purporting to inextricably bind together all Transactions under the ISDA Master Agreement as part of a single, concerted, nettable whole. Should (God forbid) your counterparty have imploded, an unthinking administrator might feel the three-year jet fuel swap you traded in July 2012 had nothing really to do with your six-month interest rate swap from February last year and when it comes to considering who owes who what, the two should be treated as separate, unitary transactions. It might think this quite enthusiastically if one of those transactions happens out-of-the-money to you, and the other one in-the-money. This, at any rate, has been the dominant fear of the Basel Committee on Bank Supervision since it hit upon the idea of capital relief for master netting agreements in 1986.
“Why, that’s dashed bad luck, old man! You have to pay me that out-of-the-money exposure[2] and while this dead parrot owes you on the other trade, the end of the creditors’ queue is that one you can see over there in the far distance, should you have a telescope on you.”
You might be inclined to say, “but wait: we should be able to set these off surely! This is all the same stuff, right! Swaps! They all go together! They’re not unitary transactions at all!”
Well, Section 1(c) — the one that says “it is all a single agreement, and we would never have done any of this if we had thought for a moment it might not be, and to prove it we are saying this out loud at the very inception of our derivatives relationship” is your friend in making that argument. There are similar provisions in other agreements, but none is so classic or elegant as the ISDA Master Agreement’s.
For details freaks
See also
References
- ↑ © Nostradamus
- ↑ Yes I know: Section 2(a)(iii). We’ll get to that. And in some jurisdictions mandatory insolvency set-off would also spike an administrator’s guns. But for now, let’s say.