Counterparty or credit risk exists whenever a market participant has entered into a transaction with a counterparty where the latter has an obligation to make payments or deliveries at some point in the future. Except for some regulated entities such as banks, securities dealers, investment funds or other collective investment schemes and pension funds, which are required by law to monitor and limit their counterparty exposure generally or at least for certain types of transactions, market participants are in general free to assume unlimited counterparty risk at their discretion, whether under over-the-counter (OTC) derivative transactions or otherwise. Thus, unless market participants are subject to specific laws or regulations or are bound by contractual arrangements, they are free to choose whether, how and to what extent they wish to limit or mitigate their counterparty risks.
However, as a result of the recent credit crisis, most sophisticated parties which are aware of the extent that their trading volume is sufficient to warrant the respective costs – mainly legal expenses associated with the negotiation and maintenance of the necessary documentation, operational and technology costs, custody fees and financing costs associated with transferring, receiving and monitoring collateral – as a first step opt to enter into master agreements with their counterparties in order to reduce their exposure to a net amount. In a second step, in order to reduce the risk that such net amount is lost due to an unexpected insolvency of the counterparty, market participants can obtain credit support in the form of a financial guarantee provided by a financially robust affiliate or – usually more reliable – sufficient collateral posted by the counterparty itself.
Risk reduction by entering into master agreements with all relevant counterparties
A first measure to reduce counterparty risk is to consolidate the exposure under the various transactions entered into with a particular counterparty through the use of a close-out netting mechanism. This can be achieved by entering into a master agreement with each counterparty, providing for appropriate netting arrangements such as the International Swaps and Derivatives Association (ISDA) master agreement, the Swiss master agreement for OTC Derivatives or similar international (eg, the European master agreement (EMA) sponsored by the European Banking Federation (EBF)) or national master agreements. As a result of such netting provisions, if certain events occur which are highly likely to undermine the counterparties' financial health and thus their ability to fulfil their obligations, these agreements provide for the consolidation and conversion of multiple obligations between two parties into a single net obligation.
Structure of contractual framework
Each of the master agreements referred to above consists of a pre-printed body with standard provisions and one or more schedules or annexes. While the body of the master agreement is neither party specific nor transaction specific, and therefore the parties are not supposed to change it, they can make certain elections and, if needed, amendments or alterations to any of the provisions contained in the body of the schedule(s). The pre-printed body of the master agreement, together with any amendments and further terms, elections and arrangements provided for in the schedule pertaining to the master agreement, provide the (abstract) legal framework governing the relationship between the parties (eg, payment mechanics, a basic set of representations, warranties and covenants, events of default and other events or circumstances that give one or both parties the right to terminate all or certain transactions, applicable procedures to terminate transactions and to calculate, convert and offset termination values). They also specify certain credit aspects, but refer to no concrete transactions or economic terms for specific trades.
The commercial and any transaction-specific contractual terms for each transaction must be set forth in a confirmation which refers to, and forms part of, the respective master agreement. While the parties need to prepare and exchange a confirmation relating to each transaction that they enter into setting forth the agreed commercial terms of that specific trade, confirmations are generally quite short as they will normally incorporate, and make use of, certain standard definitions either provided for – as in the Swiss master agreement – in the body or annexes of the master agreement or – as in the ISDA framework – in one or more of the definition booklets published by ISDA, which each relate to a specific type of derivatives transaction and contain both definitions and mechanical provisions that alleviate the need for the parties to reproduce such standard terms in each confirmation.
An important aspect of most master agreements is that the master agreement and all the confirmations relating to transactions entered into thereunder together form a single agreement which allows the consolidation of the amounts owed under all such transactions in one net amount owed by one party.
1992 and 2002 ISDA master agreements
In an international context, OTC derivative transactions are most frequently documented pursuant to a form of master agreement provided by ISDA – either a 1992 ISDA master agreement or a 2002 ISDA master agreement. The 2002 ISDA master agreement was developed from the 1992 ISDA master agreement in the aftermath of the crises that affected the global financial markets in the late 1990s (among them the Russian bank crisis and the Asian currency crisis), and is considered to be more creditor friendly, as opposed to the 1992 version which was considered to be too debtor friendly in view of various grace periods which were considerably shortened in the 2002 version. Apart from a large number of smaller changes, the 2002 version introduced an additional termination event for force majeure and changed the process used in...