On Nov. 27, 2001 the International Swaps and Derivatives Association circulated the first draft of a new version of the ISDA Master Agreement (the 2002 Agreement) to its members. This went through several mass meetings in London and New York and five further drafts before being published on Jan. 8 last year. About 100 of its 600 members were involved.
At the time ISDA considered that the 2002 Agreement would be quickly taken up by institutions in North America for new counterparties, but that progress would be slower in Europe and Asia. In the event it has been pretty slow everywhere.
Why is this given the time and effort that went into producing the 2002 Agreement?
First let us look back. When the 1992 ISDA Master Agreement (the 1992 Agreement) was published in January 1993 with its User's Guide it took about two years for most of the market to make it their ISDA Agreement of choice for use with new counterparties. Renegotiation and upgrading from the 1987 Interest Rate and Currency Exchange Agreement to the 1992 Agreement took until about 1998 in some cases. Either Appendix B of the User's Guide was used or a suitable short provision was included in the amended and restated 1992 Agreement.
This time ISDA has indicated that there is no compulsion to change to the 2002 Agreement. The market is familiar with the 1992 Agreement and, in this case, familiarity breeds comfort rather than contempt.
During the past 18 months ISDA has sought to promote usage of the 2002 Agreement in the following ways:
* By obtaining 41 legal opinions for its members on the enforceability of the close-out netting arrangements and other matters under the 2002 Agreement. This is to enable the 2002 Agreement to be used in order for financial institutions to be able to obtain regulatory capital savings on their trading books, which they can already do with the 1992 Agreement;
* By publishing a Form of Amendment in March 2003, which would incorporate the new Section 6 Close-out Amount early termination arrangements into a 1992 Agreement;
* By publishing Forms of Amendment in May 2003 to take into account the arrival of Close-out Amount in the terms of the ISDA Credit Support Annexes under English and New York law;
* By publishing the 2002 Master Agreement Protocol and
* By holding seminars globally on the 2002 Agreement.
Despite all this, usage has been slight and sporadic perhaps little better at present than the 2001 ISDA Margin Provisions for documenting collateral arrangements.
One surprising thing is that the structure of the 2002 Schedule is very similar to that of the 1992 Agreement except for Part 4(k) (n) and even the matters treated there are not 'rocket science.'
Reasons For The Slow Take Up
Demand for the 2002 Agreement is low. Major banks have, in general, prepared their 2002 Schedules, but are only entering into them upon counterparty request. Institutions, which vigorously promoted the 1992 Agreement in 1993/94 and then had to wait many months for completions, are being more reactive this time. Many are waiting for large banks to get policy committee approvals for introducing the 2002 Agreement before sending them their 2002 Schedules or considering theirs.
There is growing usage of the 2002 Agreement with structured transactions, but only when the corporate counterparty or its external counsel requires this.
A few major North American and European banks have introduced the 2002 Agreement as their agreement of choice with new counterparties. If a counterparty insists on negotiating a 1992 Agreement, however, they will usually agree.
The European derivatives market is currently extremely busy and naturally tends to give a higher priority to processing the familiar 1992 Agreement than trying to negotiate the less familiar 2002 Agreement. In some quarters it is believed that the 1992 Agreement already provides adequate protection and there is no need to change.
Except in the largest banks, derivatives documentation and legal departments tend to be sparsely populated and often the same experienced people deal with all new documentation.
In 2003, for instance, the market needed to introduce both the 2002 ISDA Equity Derivatives Definitions and the 2003 ISDA Credit Derivatives Definitions, which together consumed large amounts of management time in the first half of that year.
Since then pressure of daily work has, in many cases, delayed implementation of the 2002 Agreement.
Dislike/Suspicion Of Provisions In The 2002 Agreement
Of the components of the 2002 Agreement, most comment from market participants focuses upon three items:-
* Shorter Grace Periods
While banks prefer the shorter grace period of one Local Business Day or one Local Delivery Day in the Failure to Pay or Deliver Event of Default and the 15 calendar day grace periods in two Bankruptcy Events of Default, they are understandably not popular with smaller corporate, emerging market and hedge fund counterparties. Banks have often reduced grace periods for hedge funds in 1992 ISDA Master Agreement Schedules and so hedge funds should have less cause to object.
* Close-Out Amount
Market players are used to the mechanics for the payment measures of Market Quotation and Loss in the 1992 Agreement. They are less sure about Close-out Amount and especially about the potential use of internal valuation and data despite the obligations on the Determining Party to act consistently and in good faith using commercially reasonable procedures to produce a commercially reasonable result. Consequently ISDA's March 2003 Amendment Agreement facilitating the importation of Close-out Amount into the 1992 Agreement has not been much used by the banks recently surveyed.
* Force Majeure
There has been more acceptance of the wide-ranging Force Majeure Event Termination Event. This wording has been incorporated in some 1992 Agreements via Amendment Agreements. Some houses, however, consider that the Impossibility wording on page 65 of the 1992 User's Guide is adequate enough.
Three other provisions that have attracted support and opposition are the revised definition of Specified Transaction to include non-derivative products such as repos and securities lending; the inclusion of repudiation in the Breach of Agreement Event of Default; and the aggregation language in the Cross Default provision (Section 5(a)(vi)) for Threshold Amount purposes.
Some counterparties have avoided using the 2002 Agreement so as not to disturb their existing ISDA Credit Support Annexes although help is at hand here via the Forms of Amendment to the ISDA Credit Support Annexes under English and New York Law.
The 2002 Master Agreement Protocol
On July 15, 2003 ISDA published its 2002 Master Agreement Protocol.
The Protocol offered market players an efficient multilateral method to amend 13 ISDA Definitions booklets and five credit support documents to reflect the new terminology and provisions of the 2002 Agreement. Essentially it updated these pre 2002 documents, which were not written with the 2002 Agreement in mind and which contain non 2002 Agreement concepts, such as Market Quotation and Loss.
The Protocol was open to ISDA members and non-members who did not need to enter into a 2002 Agreement to adhere to the Protocol. Annex choices made in the adherence letter take effect whenever the parties execute a 2002 Agreement in the future even if this was after the Protocol closed for adherence on June 1 (having been extended by ISDA for three months). 287 market players adhered to the Protocol.
It is fair to say that this response was a fraction of the 1132 market players who adhered to ISDA's landmark European Monetary Union Protocol in 1998. Indeed many of those who signed up to the 2002 Protocol only did so at the last minute, probably realising the considerable administrative work that would eventually become necessary to ensure harmonious cross-referencing between 2002 and non-2002 concepts in ISDA's general and product Definitions and credit support documents.
* Usage for the 2002 Agreement is patchy everywhere,
* There is a general 'wait and see' or 'after you' attitude in the market. In my opinion more big banks need to introduce the 2002 Agreement more vigorously if it is to catch on. There is a tendency to retreat to the 1992 Agreement at the slightest counterparty objection and
* There are supporters and opponents of the 2002 Agreement's shorter grace periods, Close-out Amount payment measure and Force Majeure Event provision. These important issues will, of course, be resolved though eventual negotiation of the 2002 Agreement.
Finally, it must be the case that many documentation people need to be re-educated in the 2002 Agreement. Some received training or attended seminars 18 months or more ago in the expectation of a swifter implementation of the 2002 Agreement in the market.
Will the ugly duckling turn into a beautiful swan? I think it will in time. I am very positive about the 2002 Agreement and consider it a big improvement on the 1992 Agreement and more in tune with the present state of the over-the-counter derivatives market.
Barring catastrophes, I would expect the 2002 Agreement to be the pre-eminent ISDA Master Agreement in use within the next two years.
Paul Hardingis managing director ofDerivatives Documentation Limited, a consultancy providing negotiation, training and recruitment services in derivatives documentation. He is also the author of Mastering the ISDA Master Agreement (1992 and 2002)