Survey of the OTC Derivatives Market in Australia – May 2009 Box 1: Legal documentation supporting OTC derivatives transactions

Globally, OTC derivatives contracts are increasingly supported by comprehensive, standardised documentation which clearly sets out the rights and obligations of contracting parties over the course of a derivatives contract, and particularly in case of counterparty default. Much of this documentation is produced and disseminated by large industry bodies, such as ISDA, and is recognised and recommended by regulators internationally.

ISDA, in particular, has developed Master Agreements that counterparties sign before, or soon after, a trading relationship is established. Importantly, these agreements and associated protocols include provisions for the netting and valuation of contracts in the event of counterparty default. Some agreements also set out early-termination options, for instance in the event that a party's credit rating falls below a specified threshold. Without reliable legal interpretations, the efficacy of Master Agreements is limited, especially where remaining creditors seek to close out and net their obligations to a defaulting party. ISDA has encouraged protective legislation to ensure the reliability of Master Agreements in those jurisdictions (such as the United States and continental Europe) in which courts have traditionally placed greater weight on the rights of insolvent debtors. ISDA routinely keeps members updated on relevant legal developments in major jurisdictions.

Master Agreements often include an annex detailing the contracting parties’ margining and collateral-posting obligations. According to ISDA's latest Margin Survey, 65 per cent of OTC derivative transactions were covered by collateral agreements at the end of 2008.[1] More than three-quarters of these were two-way agreements (ie, both parties are subject to mark-to-market margin calls), and by far the majority of collateral (84 per cent) was posted in the form of cash. In many cases these agreements also permit cross-product netting and portfolio margining, which enable more efficient use of capital.

The rapid growth of the market for credit derivatives has been accompanied by the development of specific protocols to streamline procedures in the event of a credit default. Most recently, ISDA's Auction Hardwiring protocol (known as the ‘big bang’ protocol) came into effect in April 2009, with over 2,000 signatories. This incorporates auction-based cash settlement arrangements into standard Master Agreements, and provides an independent umpire for determination of credit ‘events’.[2]


See ISDA Margin Survey, 2009: <> [1]

Since the outstanding notional value of credit default swaps referencing a particular entity often substantially exceeds the outstanding value of debt instruments issued by that entity, the industry has developed auction arrangements for cash settlement of obligations arising should a credit event occur. To date, counterparties have had to sign up to such auctions on an ad hoc basis: the recently agreed ISDA protocol ‘hardwires’ such auction arrangements into the Master Agreement and also establishes industry-wide arrangements for determining when a credit event has occurred. [2]