In managing contract documents, you check whether master agreements that have not been signed are piling up. In managing counterparty credit risk, you check whether you can rely on the mechanism that adds up the values into one amount when the counterparty fails.

Why trades do not each get their own contract

A master agreement is a contract that sets, once and in advance, the terms common to all the trades the parties will enter into with each other.

Consider a hypothetical example in which Bank B enters into two interest rate swaps and one cross-currency swap with another financial institution. With one master agreement in place, the three trades sit under the same terms, and what is exchanged for each trade is a confirmation that states the terms of that trade.

Bank BOther institutionMaster agreement (usually one)Confirmations (per trade; 3)CSA (if secured)
Figure 1Documents exchanged between Bank B and the other party
Figure description

The figure shows the documents that Bank B and the other financial institution exchange. Between them, they usually sign one master agreement. For the two interest rate swaps and the one cross-currency swap, they exchange three confirmations, one per trade. When the trades are secured with collateral, they also sign a CSA, a separate contract signed alongside the master agreement that sets the terms for delivering collateral. The solid line is the master agreement, and the dashed lines are the documents added per trade or when collateral is posted. The direction of the arrows has no meaning, because both parties exchange the documents. The figure is limited to the three kinds of documents used in trades; the schedule and the definitions are covered in the table below.

In the OTC derivatives market around 2002, it was usual to sign a master agreement with each counterparty1. Swap contracts, too, were usually concluded under standards such as ISDA's in practice around 19982.

Signing a master agreement helps make clear that the later trades are conducted on the same terms1. The contract documents for a swap consist of a confirmation, a payment schedule, and a master agreement using standard wording2.

If a master agreement contains netting provisions, it can reduce the overall credit risk to the counterparty1. Netting provisions consist of payment netting, which offsets payments in the same currency on the same day into a single payment, and close-out netting, which applies when an event of default or similar event occurs with the counterparty. In close-out netting, the values of the trades under the master agreement (positive and negative) are added up into a single amount3. A numerical example of adding up the values is covered in the Close-Out Netting page.

The Act on Close-out Netting of Specified Financial Transactions Conducted by Financial Institutions, etc. (the Close-out Netting Act) defines a master agreement as a contract made so that two or more specified financial transactions can be entered into in succession, and one that sets basic matters such as how obligations are performed. It also defines close-out netting as adding up the values of all trades under a master agreement into a single claim or obligation4.

How the documents fit together

The ISDA Master Agreement is a form created by ISDA. It is used in combination with the following documents.

Document Unit Role
Master agreement Usually one per counterparty Sets the provisions common to the trades, in standard wording
Schedule Per master agreement (two cases that went to court) In those two cases, special terms attached to the master agreement. In one case a cross-affiliate set-off clause was written in it
Confirmation Per trade States the terms of that trade
Definitions - The documents that trades refer to5.
CSA Signed alongside the master agreement An agreement that allows trades to be secured with collateral

The master agreement is generally used for interest rate swaps, currency swaps, commodity swaps, credit derivatives, weather derivatives, and similar trades6. The master agreement deals with items such as the following2.

  • The events that end the contract
  • How damages are determined on default or early termination
  • Payment netting
  • Where payments are made
  • Collateral
  • Tax and legal treatment
  • Notice of changes of address and similar details

As examples of schedules, the two master agreements that went to court (concluded in 2001 and 2007) each consisted of a 1992 version of the master agreement and a schedule attached to it7.

A confirmation is the document that states the terms of each trade. How it is written and sent is covered in the Trade Confirmations page.

A CSA is an agreement concluded alongside the master agreement to reduce the credit risk to the counterparty arising from the trades8. CSAs are generally used for collateral agreements on OTC derivatives6.

Items set party by party

A master agreement is concluded using standard wording, specifying the products and the parties it covers. The following are examples of items that the parties agree on.

Item What is decided
Scope of the agreement The types of products covered, and the parties covered (legal entities and branches)1
Method for the settlement amount How the settlement amount is determined when trades are terminated early. In a case that used the 1992 version, a method called "Loss" had been chosen10
Cross-affiliate set-off A clause that, once an early termination date is designated, allows set-off that includes affiliates' obligations. There is a case in which it was written in the schedule11
Governing law English law is mainly chosen, and New York State law sometimes12

A cross-affiliate set-off clause operates when an early termination date has been designated for one party. The other party (the one for which no date was designated) can then set off two amounts against each other. One is what it and its affiliates owe to the first party. The other is what the first party owes to it and its affiliates.

In the master agreement in that case, the other party, when an early termination event occurred with respect to one party, used the amount of loss it had reasonably calculated as the settlement amount. It could also obtain valuations from leading dealers and use that amount10.

In another case, a set-off was made under a cross-affiliate set-off clause after the counterparty had entered civil rehabilitation proceedings, and its effect was disputed. The Supreme Court denied the effect of that set-off, made after the rehabilitation proceedings began, in that case13.

Versions and use in Japan

ISDA's master agreement forms exist in 1987, 1992, and 2002 versions15. The 1987 version was the first to adopt a close-out netting provision16.

How the agreement was used in Japan differed by counterparty. Around 2013 in Japan, the ISDA Master Agreement was used only for trades between financial institutions. For OTC derivatives between financial institutions and ordinary corporations, close-out netting was carried out through confirmations based on a bank transaction agreement6.

A standard form may also be amended by a protocol. A protocol applies all at once to trades between the parties that have adhered to it17. The fallback provisions that prepare for the end of publication of LIBOR and similar rates apply through the definitions that trades refer to, and through protocols that cover master agreements and CSAs5. The supplement to the 2006 definitions took effect on January 25, 202118.

Notes

  1. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2070.1 "Legal Risk" (September 2002), page 1, text under "Documentation." ↩ ↩2 ↩3 ↩4 ↩5

  2. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 4325.1 "Interest-Rate Swaps" (February 1998), page 2, "Swap Agreement." ↩ ↩2 ↩3 ↩4

  3. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2070.1 (September 2002), page 3, "Master Agreements." ↩

  4. "金融機関等が行う特定金融取引の一括清算に関する法律" (Act on Close-out Netting of Specified Financial Transactions Conducted by Financial Institutions, etc., in Japanese), Article 2, paragraph 5 (master agreement) and paragraph 6 (close-out netting). ↩

  5. Japanese Bankers Association, "ISDA マスター契約にもとづき取引されるデリバティブに関するQ&A" (October 8, 2021), Q3 (pages 2–3) (in Japanese). ↩ ↩2

  6. Keiko Yamamoto, "デリバティブ取引等の一括清算ネッティングを巡る最近の議論" (Recent discussions on close-out netting of derivatives transactions, in Japanese), Bank of Japan Institute for Monetary and Economic Studies, IMES Discussion Paper Series 2013-J-13 (July 2013), page 2, note 1. ↩ ↩2 ↩3

  7. 全国銀行協会 金融法務研究会 (financial law study group of the Japanese Bankers Association), "デリバティブ取引に係る諸問題と金融規制の在り方" (Issues in derivatives transactions and the approach to financial regulation) (March 2018), Chapter 1 (Hiroyasu Nakata), page 13, "b　事実経過" (b. Course of events) (in Japanese). ↩

  8. 全国銀行協会 金融法務研究会, "デリバティブ取引に係る諸問題と金融規制の在り方" (March 2018), Chapter 2 (Hideki Kanda), page 27, "５　店頭デリバティブ取引における国債の担保提供" (5. Provision of government bonds as collateral in OTC derivatives transactions), summary of the facts (in Japanese). ↩

  9. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2020.1 "Counterparty Credit Risk and Presettlement Risk" (September 1999), page 7. ↩

  10. 全国銀行協会 金融法務研究会, "デリバティブ取引に係る諸問題と金融規制の在り方" (March 2018), Chapter 2 (Hideki Kanda), page 36, "６　店頭デリバティブ取引におけるネッティング後の損害の額の算定" (6. Calculating the amount of loss after netting in OTC derivatives transactions), comment (in Japanese). ↩ ↩2

  11. 全国銀行協会 金融法務研究会, "デリバティブ取引に係る諸問題と金融規制の在り方" (March 2018), Chapter 1 (Hiroyasu Nakata), page 14, the explanation of the set-off clause in Schedule 乙 (Schedule B) and note (24) (in Japanese). ↩

  12. 全国銀行協会 金融法務研究会, "デリバティブ取引に係る諸問題と金融規制の在り方" (March 2018), Chapter 6 (Hiroyuki Kanzaku), page 90, note (38). The note, attached to the passage on OTC derivatives trades in Germany, explains the governing law of ISDA master agreements (in Japanese). ↩

  13. 全国銀行協会 金融法務研究会, "デリバティブ取引に係る諸問題と金融規制の在り方" (March 2018), Chapter 1 (Hiroyasu Nakata), page 15, "d　上告審判決" (d. Supreme Court judgment) (in Japanese). ↩

  14. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2070.1 (September 2002), pages 3–4, "Enforceability Issues" and "Reliance on Netting Agreements." ↩

  15. 全国銀行協会 金融法務研究会, "デリバティブ取引に係る諸問題と金融規制の在り方" (March 2018), Chapter 2 (Hideki Kanda), page 25, "３　ISDA のマスター契約書式" (3. ISDA's master agreement form) (in Japanese). ↩

  16. Keiko Yamamoto, "デリバティブ取引等の一括清算ネッティングを巡る最近の議論" (July 2013), page 3, "２．（１）店頭デリバティブ取引等における一括清算ネッティングの役割" (2.(1) The role of close-out netting in OTC derivatives trades) (in Japanese). ↩

  17. Japanese Bankers Association, "ISDA マスター契約にもとづき取引されるデリバティブに関するQ&A" (October 8, 2021), Q4 (page 3) (in Japanese). ↩

  18. Japanese Bankers Association, "ISDA マスター契約にもとづき取引されるデリバティブに関するQ&A" (Q&A on derivatives traded under the ISDA Master Agreement) (October 8, 2021), Q1 (page 1) (in Japanese). ↩