ISDA Documentation Architecture 3: Happy Lehman Day!

As I mentioned in the last post in this series, in 2002 ISDA revised its Master Agreement to create a better way of determining who owes what to whom when an agreement goes into default. The 1992 Master Agreement provided two methods (with the creative monikers "First Method" and "Second Method") both of which proved unsatisfactory during bad market conditions. The 2002 Master Agreement replaced these mechanisms with a much more flexible method called "close-out amount."

Unfortunately, the 2002 Master Agreement was adopted only gradually. In a March memo, Manuel Frey and Jordan Yarett of Paul Weiss observed that, "since its introduction, the 2002 ISDA Master Agreement has become increasingly common in the market place, although the 1992 ISDA Agreement continues to be widely used." In a January article in Butterworths Journal of International Banking and Finance Law, Edmund Parker and Aaron McGarry second that: "Many Master Agreements still in use are based on the 1992 version, which contains the greatest weaknesses."

In addition to an understandable unwillingness to spend money amending thousands of contracts, reluctance to adopt the new Master Agreement also stems from the need to very closely match a hedge to the transaction being hedged. The fear is that hedging a transaction written on 1992 Master Agreement with a transaction written on the 2002 Master Agreement might cancel the value of the hedge.

The collapse of Lehman Brothers, with its 8,000 Master Agreements and 67,000 outstanding transactions, pointed out the folly of being so conservative (or lazy) and since then, there as been a concerted effort to ditch the 1992 settlement procedures. In August of 2008, most of the large OTC derivatives dealers signed the Close-out Multiparty Agreement which bulk-updated their existing 1992 Agreements to conform with the 2002 Agreement's close-out protocol. In February of 2009, ISDA published the Close-Out Amount Protocol, a standard-form version of the Multiparty Agreement. ISDA maintains a list of adherents to the Protocol.