People in legal, compliance, settlement and collateral roles find the differences between ISDA Master Agreement versions easier to read when they know this history.

What happened

In 1981, the World Bank entered into a formal currency swap with IBM. The World Bank describes it as the first formal currency swap in the world1. In 1985, the International Swaps and Derivatives Association (ISDA) was established as an industry body made up of the main swap participants2.

The organization's name today is the International Swaps and Derivatives Association. A 1987 Bank of England article uses International Swap Dealers Association, which appears to be its former name3.

1981The World Bank and IBM enter into acurrency swap1985ISDA is established, and standardtrade terms and documentation arepublished1987The 1987 master agreement is thefirst to include a close-outnetting clauseAug2008Major dealers agree to change howtheir contracts calculate thepayment on early terminationFeb 27,2009ISDA publishes a protocol formaking that changeSep 25,2009G20 leaders agree to clearstandardized OTC derivatives viacentral counterparties, and more
Figure 1Main milestones of the swap market and ISDA
Figure description

Six milestones appear in order: the first currency swap, the founding of ISDA, the master agreement clause, the revision of how contracts are settled, and the G20 agreement. The filled circles mark the start, the founding, and the G20 agreement. The first three are known only by year and the last three to the month or day, and the intervals are not proportional to time.

In the 1980s the swap market grew, and ISDA worked to standardize trade terms and contracts. In over-the-counter derivative transactions such as interest rate swaps and currency swaps, it is common to use the ISDA Master Agreement2.

Background

According to the Bank of England's 1987 article, the earliest swaps on record were currency swaps. They grew out of the parallel loans and back-to-back loans that spread in the United Kingdom from the late 1960s to the early 1970s. In the United Kingdom, these loans were used as a way to finance overseas investment within the exchange control rules4.

The Bank of England explains that swaps were devised to overcome two problems with these loans: rights of set-off and complex documentation. Isolated examples exist from the mid-1970s, but a swap "market" is said to exist only from 19814.

The 1981 World Bank and IBM transaction

According to World Bank material, interest rates in Swiss francs and Deutsche marks at the time were roughly half those in US dollars. World Bank borrowers wanted these currencies. However, the Swiss and German governments limited how much the World Bank could borrow, and by August 1981 it had reached the limit. IBM had borrowed large amounts of these currencies and wanted to increase its US dollars1.

Through Salomon Brothers, IBM exchanged the Swiss francs and Deutsche marks it had borrowed for the World Bank's US dollars1. The Bank of England says this transaction brought a measure of recognition and popularity to the swap technique4.

The World Bank had also carried out interest rate swaps by the end of 1985. The total notional amount of swap transactions (including currency swaps) it had carried out by the end of 1985 was USD 5.15 billion. The first interest rate swap was a transaction in which the World Bank received fixed-rate US dollars and paid floating-rate US dollars based on the interest rate on its three-month Treasury bills5.

Market growth and moves toward standardization

By the Bank of England's estimate, the swap market grew from about USD 5 billion in 1982 to about USD 400 billion at the end of 19866. One of the main legal concerns, the Bank of England says, was that no serious default had yet occurred and that contracts had not been tested in court. It was not unusual for a gap to open between agreeing the terms of a trade and signing the full contract. The move toward standardized documentation may have eased this delay7.

The move toward standardization had already begun. In mid-1985, ISDA and the British Bankers' Association published standard dealing terms and documentation for interest rate swaps. As of February 1987, a revision of ISDA's rulebook, the ISDA code, was under way3.

Versions of the master agreement

According to a Bank of Japan Institute for Monetary and Economic Studies paper, the 1987 version of the master agreement was the first to include a provision on close-out netting. This is a method of offsetting the parties' claims and obligations into a single amount when transactions are terminated early. Its effectiveness was debated around the world. The United States made it certain by amending its federal bankruptcy law.

In 1994, the Basel Committee on Banking Supervision allowed the reduction of credit risk on transactions under a valid close-out netting agreement to be recognized in the calculation of capital ratios. In response, countries enacted legislation8.

The body of the contract was revised afterward. According to a law firm's 2009 commentary, concerns after the market turmoil of 1998 and 1999 led to the 2002 version. They also led to the Close-out Amount it contains, a method of calculating the payment when a contract is terminated early. Even after the 2002 version became widespread, the 1992 version remained widely used9. The contents of the master agreement are covered in The ISDA Master Agreement and Schedule.

What changed afterward

In the law firm's 2009 commentary, the failure of several Lehman Brothers dealing entities in September 2008 and the market turmoil that followed highlighted the difficulty of using Market Quotation when markets are disrupted. Many 1992 versions require this method, in which quotations are collected to calculate the payment. In August 2008, nearly all the major over-the-counter derivatives dealers had entered into a multilateral agreement. Under it, they amended their 1992 agreements with one another to use the 2002 version's Close-out Amount method. On February 27, 2009, ISDA published the Close-out Amount Protocol, which lets all market participants use the same amendment9.

The leaders' statement of the September 2009 G20 Pittsburgh Summit said that standardized over-the-counter derivatives should be traded on exchanges or electronic trading platforms where appropriate. It also said they should be cleared through central counterparties by the end of 2012 at the latest. Trade information was to be reported to trade repositories10. This reform is covered in The G20 OTC Derivatives Reforms.

Timeline of developments

When What happened
Late 1960s to early 1970s Parallel loans and back-to-back loans spread in the United Kingdom
1981 The World Bank and IBM entered into a currency swap
By the end of 1985 The total notional amount of swap transactions (including currency swaps) carried out by the World Bank reached USD 5.15 billion
1985 ISDA was established. ISDA and the British Bankers' Association published standard dealing terms and documentation for interest rate swaps
1987 The 1987 ISDA Master Agreement was the first to include a close-out netting provision
1992 and 2002 versions The 1992 version and, later, the 2002 version of the ISDA Master Agreement came into use
August 2008 Major dealers agreed to amend the 1992 version's close-out calculation method to that of the 2002 version
February 27, 2009 ISDA published the Close-out Amount Protocol, which all participants can use for the same amendment
September 24–25, 2009 G20 leaders agreed on central clearing and other measures for standardized OTC derivatives

Notes

  1. World Bank, "The World Bank Treasury | IBRD • IDA: 70 Years Connecting Capital Markets to Development," page 66 (the Swaps section). "The world's first formal currency swap" is the wording of the World Bank material. ↩ ↩2 ↩3

  2. Bank of Japan Institute for Monetary and Economic Studies, "Recent Discussions on Close-Out Netting of Derivative Transactions" (in Japanese; title translated), page 2 (PDF page 6), footnote 1. It describes ISDA as "an industry body established in 1985 and made up of the main participants in the over-the-counter derivatives market" (translated) and gives the name as International Swaps and Derivatives Association, Inc. ↩ ↩2

  3. Bank of England Quarterly Bulletin, February 1987, the paragraph on liquidity in the interest rate swap market (PDF page 3). The same article gives the organization's name as "International Swap Dealers Association." ↩ ↩2

  4. Bank of England Quarterly Bulletin, February 1987, "Recent developments in the swap market," page 66 (Origins and evolution of the swap market). ↩ ↩2 ↩3

  5. World Bank, "The World Bank Treasury | IBRD • IDA: 70 Years Connecting Capital Markets to Development," page 66. The interest rate swaps carried out by the end of 1985 and the total notional amount of swap transactions (including currency swaps), USD 5.15 billion, are stated on the same page. ↩

  6. Bank of England Quarterly Bulletin, February 1987, the summary at the start of page 66. The estimates are about USD 5 billion for 1982 and about USD 400 billion for the end of 1986. ↩

  7. Bank of England Quarterly Bulletin, February 1987, pages 69–70 (the paragraph on legal concerns). The possibility that standardized documentation eased the delay is stated in parentheses. ↩

  8. Bank of Japan Institute for Monetary and Economic Studies, "Recent Discussions on Close-Out Netting of Derivative Transactions" (in Japanese; title translated), page 3 (PDF page 7), opening of the main text. ↩

  9. Paul, Weiss, Rifkind, Wharton & Garrison LLP, "ISDA Publishes Close-Out Amount Protocol" (March 5, 2009), the first two paragraphs on page 1 and the paragraph that follows, on the August 2008 agreement. ↩ ↩2 ↩3

  10. G20, "Leaders Statement: The Pittsburgh Summit" (the summit was held September 24–25, 2009), the paragraph on OTC derivative contracts. ↩