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Explain what an ISDA master agreement is meant to achieve.

FRM® Part II · Credit Risk Measurement and Management · Netting, Close-out and Related Aspects · FRM2.CR.16.a

The idea

An ISDA Master Agreement is a standard contract published by the International Swaps and Derivatives Association. Two counterparties sign it once and then use it for every over-the-counter derivative they trade with each other. Its purpose is to replace a fresh negotiation for each deal with a common legal framework. That framework has a pre-printed Master with general terms, a Schedule for the parties' own elections and additions, a Credit Support Annex for collateral, definitions booklets for product terms, and a short Confirmation for each trade. Section 1(c) makes all of these one single agreement, which is what allows close-out netting. On default every trade is valued and combined into one net claim, so a liquidator cannot keep the profitable trades and disclaim the losing ones (cherry picking). The agreement cuts legal and operational risk and, with legal opinions on enforceability, lets a firm count netted rather than gross exposure. It does not remove credit risk, set prices or require collateral by itself.

A practice question

From the question bank, with the reason each wrong option is wrong.

What is the primary purpose of an ISDA Master Agreement between two derivative counterparties?

  1. To set a standard legal framework in which all their OTC trades form one agreement that can be netted - correct
  2. To fix the price and economic terms of every trade at inception so that no individual confirmations are neededWhy not: Confuses the master with the trade Confirmation, which records notional, rate and maturity for each deal.
  3. To guarantee that each counterparty's obligations are fully collateralised whatever its credit qualityWhy not: Collateral exists only if the parties add a Credit Support Annex; the master itself does not remove credit risk.
  4. To transfer the credit risk of their trades to a clearing house through novationWhy not: Describes central clearing, not a bilateral master agreement between two parties.

The master agreement standardises the legal terms once, makes every Confirmation part of a single agreement, and so enables close-out netting. It does not set prices, force collateral or clear trades.

A harder one

A bank has signed an ISDA Master Agreement with a counterparty in a jurisdiction for which it has no legal opinion on the enforceability of close-out netting. For regulatory capital, how should the bank normally measure its exposure to that counterparty?

  1. On a net basis, because the signed agreement is sufficient evidence that netting is enforceableWhy not: A signature does not decide enforceability; local insolvency law does, which is why reasoned legal opinions are needed.
  2. On a net basis with half of the netting benefit disallowed as a haircutWhy not: Invents a partial credit; recognition depends on legal certainty, it is not scaled by a haircut.
  3. As zero, because the agreement eliminates the exposureWhy not: The agreement does not eliminate exposure; if netting is not recognised the full gross exposure remains.
  4. On a gross basis, because netting is not recognised without a supporting legal opinion - correct

Netting is recognised only where the bank has a well-founded opinion that close-out netting would be enforced in the counterparty's jurisdiction; the agreement alone is not enough.

The hardest tier

A bank has four trades with a counterparty under one ISDA Master Agreement, valued to the bank at +30, +20, -25 and -15 (USD million). The counterparty defaults and unsecured claims recover 40 percent. With enforceable close-out netting the bank claims the net amount; without it the bank must pay the negative-value trades in full and claims the positive ones in the estate. Measured against the portfolio's pre-default value, closest to how much larger is the bank's loss when netting is NOT enforceable?

  1. USD 6.0 millionWhy not: This is the loss when netting is enforceable (net claim 10, less 40 percent recovery), not the extra loss.
  2. USD 30.0 millionWhy not: This is the total loss without netting; the question asks for the increase over the netted loss.
  3. USD 24 million - correct
  4. USD 20.0 millionWhy not: This is the recovery on the gross claims of 50, reported as if it were a loss.

Pre-default value is +10. Without netting the bank pays 40 and recovers 0.4 x 50 = 20, ending at -20, a loss of 30. With netting it recovers 0.4 x 10 = 4, a loss of 6. The difference is 24.

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