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Understanding ISDA Master Agreement Early Termination: A Guide for Market Participants
The International Swaps and Derivatives Association (ISDA) Master Agreement is a widely used document that governs over-the-counter (OTC) derivatives transactions between counterparties. One important aspect of the Master Agreement is the provision for early termination, which allows either party to terminate all outstanding transactions if certain events occur. In this article, we will explain what ISDA Master Agreement early termination means, what triggers it, and how it works in practice.
What is ISDA Master Agreement early termination?
ISDA Master Agreement early termination is a contractual mechanism that allows one party to terminate all or some of the outstanding derivative transactions with the other party before their scheduled maturity, usually due to a default or an event of default. This option is intended to reduce the risk of loss or exposure to further losses if one party fails to fulfill its obligations under the Master Agreement or becomes insolvent. It also aims to provide a simple and standardized way of determining the net amount payable by one party to the other upon early termination, based on a formula that applies to all transactions covered by the Master Agreement.
What triggers ISDA Master Agreement early termination?
ISDA Master Agreement early termination can be triggered by various events or conditions that indicate a party`s inability or unwillingness to perform its obligations or that affect the value or enforceability of the transactions. These events or conditions are defined in the Master Agreement as « events of default » or « termination events » and include, but are not limited to, the following:
– Failure to pay or deliver: If a party fails to pay or deliver an amount or asset due under a transaction, such as a margin call, a settlement payment, or a delivery obligation, and does not remedy such failure within a specified grace period, the other party may terminate the transaction or all transactions.
– Bankruptcy or insolvency: If a party becomes bankrupt, insolvent, or subject to similar proceedings, the other party may terminate all transactions immediately or after a specified waiting period.
– Default under other agreements: If a party defaults under another agreement with the other party or with a third party, and such default constitutes an event of default under the Master Agreement, the other party may terminate all transactions or those related to the defaulted agreement.
– Illegality or force majeure: If a transaction becomes illegal or impossible to perform due to changes in laws, regulations, or market conditions beyond the parties` control, or due to a force majeure event, the parties may terminate the transaction or all transactions.
How does ISDA Master Agreement early termination work?
ISDA Master Agreement early termination involves a calculation of the net amount payable by one party to the other, based on the « close-out amount » of each transaction that is terminated. The close-out amount is determined by a formula that takes into account the market value of the terminated transaction, the costs of replacing or hedging the transaction, and the interest rates applicable to the transaction. The Master Agreement provides for various methods of determining the close-out amount, depending on the type of transaction, the currency, and the valuation date. The parties may also agree on a different method or source of valuation.
Once the close-out amounts are determined, they are netted together to produce a single close-out amount owed by one party to the other. If the close-out amount is positive, meaning that the terminating party has lost money, the other party must pay the positive amount to the terminating party. If the close-out amount is negative, meaning that the terminating party has gained money, the terminating party must pay the negative amount to the other party. The payment must be made within a specified period, usually two business days, after the termination event or a notice of termination.
Conclusion
ISDA Master Agreement early termination is a crucial feature of OTC derivatives trading that helps to mitigate counterparty risk and ensure the orderly termination of transactions in case of default or other events. Market participants should be aware of the events of default and termination events that may trigger early termination, as well as the methods of calculating and netting the close-out amounts. They should also consider the legal and operational aspects of implementing early termination, such as the timing, the communication, and the documentation required. By understanding and applying the ISDA Master Agreement early termination provision correctly, market participants can avoid or minimize losses and maintain the integrity of the OTC derivatives market.