The ISDA Master Agreement - The Rise and Fall of a Major Financial Instrument
56 Pages Posted: 20 Jan 2009 Last revised: 27 Apr 2009
Date Written: August 24, 2007
The rapid growth and complexity of the over-the-counter (OTC) derivatives market, particularly swaps, and the perceived risks to the financial system, continue to stimulate debate on regulatory controls. Too often minimized in these debates are the industry's own efforts and incentives to produce superior mechanisms for controlling risks- in terms of both effectiveness and efficiency than those imposed through regulation. While product innovation is certainly a hallmark of the derivatives industry, so too has been its ability to develop market-based solutions for addressing risk.
This dissertation examines one such successful solution - the swap master agreement - that has seen significant innovations as the swaps market has grown and matured. The use and design of master agreements has evolved in response to demands for better documentation that reduces negotiating costs, addresses counterparty credit risk, and help ensure contract enforceability. Indeed, the importance of sound documentation for reducing derivatives losses has been emphasized since the 1993 report prepared by the Group of Thirty Global Derivatives Study Group.
Derivatives have become an indispensable component of global financial markets, yet their ever increasing complexity, combined with the tremendous upsurge in the volume of derivatives transactions, made it essential that the risks associated with them are identified, managed and monitored. To a great extent, self-preservation and the fear of loss of reputation motivate dealers and end-users to manage derivatives risk. Moreover, dealers and end-users are in a position to appreciate the risks specific to their derivatives activities (Hu, 1993). Hence, the dealers and end-users who actually use derivatives are also best able to establish and implement a comprehensive framework of derivatives risk management and controls that are tailored to their situation. The hope is that these entities live up to that ideal, but reality often falls short of this goal.
Uncertainties and legal risks complicate both trading and the management of derivative financial products in the trading book and the portfolio. Legal ambiguities associated with new vehicles can be substantial, and, though they lessen over the product cycle, they do impede the control of risk. To overcome this situation, many banks assume that the adherence to well-established market conventions provides adequate legal protection. Yet, even in respect to business involving established financial products, many players learn the hard way that 'legal surprises' may occur.
Keywords: ISDA, derivatives, contract, master agreement
JEL Classification: F00
Suggested Citation: Suggested Citation