ISDA Master Agreement Overview
ISDA Master Agreement Overview
The ISDA Master Agreement is the foundational legal document for over-the-counter derivatives transactions. Published by the International Swaps and Derivatives Association, it standardizes terms across counterparties, reducing legal costs and enabling efficient trading. Understanding its structure is essential for anyone involved in OTC derivatives.
Definition and Key Concepts
Document Hierarchy
The ISDA framework consists of three interconnected documents:
| Document | Purpose |
|---|---|
| Master Agreement | Standard terms governing the relationship |
| Schedule | Customizations to the Master Agreement |
| Confirmation | Trade-specific terms for each transaction |
Principle: The Master Agreement and Schedule are negotiated once. Each trade then requires only a Confirmation referencing the master terms.
Version History
| Version | Year | Key Features |
|---|---|---|
| 1987 ISDA | 1987 | First standardized master |
| 1992 ISDA | 1992 | Added Market Quotation/Loss methods |
| 2002 ISDA | 2002 | Streamlined close-out; single agreement concept |
The 2002 ISDA Master is the current standard for new relationships.
Core Provisions
| Section | Content |
|---|---|
| Section 1 | Interpretation |
| Section 2 | Obligations (payments and deliveries) |
| Section 3 | Representations |
| Section 4 | Agreements (ongoing covenants) |
| Section 5 | Events of Default and Termination Events |
| Section 6 | Early Termination |
| Section 7 | Transfer (assignment rules) |
| Section 8 | Contractual Currency |
| Section 9 | Miscellaneous |
| Section 10 | Offices; Multibranch Parties |
| Section 11 | Expenses |
| Section 12 | Notices |
| Section 13 | Governing Law and Jurisdiction |
| Section 14 | Definitions |
How It Works in Practice
Schedule Customization
The Schedule modifies the Master Agreement for the specific relationship:
Common Schedule elections:
| Item | Standard Options |
|---|---|
| Governing law | English or New York |
| Termination Currency | USD, EUR, or other |
| Cross-default threshold | Amount (e.g., $25 million) |
| Additional Termination Events | Fund NAV decline, ratings downgrade |
| Netting | Multiple Transaction Payment Netting |
Key Schedule Provisions
Part 1: Termination Provisions
- Specify which Events of Default apply
- Set thresholds for cross-default
- Define Additional Termination Events
Part 2: Tax Representations
- Payer representations
- Payee representations
- FATCA compliance
Part 3: Agreement to Deliver Documents
- Legal opinions
- Board resolutions
- Annual financial statements
Part 4: Miscellaneous
- Address for notices
- Process agent appointments
- Calculation Agent designation
Part 5: Other Provisions
- Relationship between parties
- Recording of conversations
- Confidentiality
Confirmation Structure
Each trade has a Confirmation specifying:
| Element | Example |
|---|---|
| Trade date | 2025-01-15 |
| Effective date | 2025-01-17 |
| Termination date | 2030-01-17 |
| Notional amount | $100,000,000 |
| Fixed rate | 4.25% |
| Floating rate | SOFR |
| Payment frequency | Quarterly |
| Day count | Actual/360 |
| Business days | New York |
Confirmations reference ISDA Definitions (e.g., 2021 ISDA Interest Rate Derivatives Definitions) for standard terms.
Worked Example
Scenario: Investment bank (Party A) and hedge fund (Party B) establish ISDA relationship.
Schedule elections:
| Election | Choice |
|---|---|
| Governing law | New York |
| Threshold (Party A) | Infinity (no cross-default) |
| Threshold (Party B) | $10,000,000 |
| Additional Termination Event | Party B NAV declines >30% |
| Credit Support Annex | NY Law CSA with daily margining |
Trade example: 5-year interest rate swap, $50 million notional
Confirmation terms:
- Party A pays: Fixed 4.50%
- Party B pays: SOFR + 0 bps
- Payment dates: IMM dates (Mar/Jun/Sep/Dec 20)
- Calculation Agent: Party A
Payment calculation (first quarter, 91 days):
Party A fixed payment: = $50,000,000 × 4.50% × (91/360) = $568,750
Party B floating payment (SOFR average = 4.25%): = $50,000,000 × 4.25% × (91/360) = $537,153
Net: Party A pays Party B $31,597
Risks, Limitations, and Tradeoffs
Events of Default
Standard Events of Default include:
| Event | Description |
|---|---|
| Failure to Pay | Missed payment after grace period (typically 3 business days) |
| Breach of Agreement | Violation of Schedule covenants |
| Credit Support Default | Failure to post or return collateral |
| Misrepresentation | Material misstatement proven false |
| Default Under Specified Transaction | Cross-default to other derivatives |
| Cross-Default | Default on other debt above threshold |
| Bankruptcy | Insolvency or bankruptcy filing |
| Merger Without Assumption | Successor fails to assume obligations |
Early Termination Mechanics
Upon Event of Default or Termination Event:
- Designation: Non-defaulting party designates Early Termination Date
- Calculation: Close-out amount determined for all transactions
- Netting: Single net amount owed between parties
- Payment: Net amount due within specified period
Close-out methodology (2002 ISDA): Close-out Amount based on actual or hypothetical replacement cost, including bid-offer costs and other losses.
Single Agreement Concept
All transactions under an ISDA are treated as a single agreement:
| Benefit | Description |
|---|---|
| Netting | Offsets positive and negative values |
| Close-out | Terminates all trades together |
| Collateral | Margin covers net exposure |
This prevents "cherry-picking" where a defaulting party honors profitable trades but walks away from losing ones.
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Expired legal opinions | Opinions dated before current trades | Refresh opinions periodically |
| Threshold miscalculation | Cross-default triggered unexpectedly | Monitor debt levels vs. thresholds |
| Missing representations | Required documents not delivered | Track delivery requirements |
| NAV trigger breach | Fund decline triggers termination | Monitor AUM and NAV |
Checklist and Next Steps
ISDA negotiation checklist:
- Confirm version (1992 or 2002 Master)
- Select governing law and jurisdiction
- Set cross-default thresholds appropriately
- Define Additional Termination Events (if any)
- Specify termination currency
- Address tax representations for both parties
- List required documents for delivery
- Review netting provisions
- Attach Credit Support Annex (CSA)
Ongoing compliance checklist:
- Deliver annual financial statements timely
- Monitor cross-default trigger levels
- Update legal opinions as needed
- Review for regulatory changes
- Confirm counterparty representations remain accurate
Related articles:
- For equity swap applications, see Equity Swap Use Cases for Hedge Funds
- For collateral details, see Credit Support Annex and Collateral Terms