ISDA Documentation Architecture 1

1995 ISDA Credit Support Annex
1995 ISDA Credit Support Deed (Security Interest – English Law)
2008 ISDA Credit Support Annex (Loan/Japanese Pledge)
1994 ISDA Credit Support Annex (Security Interest - New York Law)

The first time I was asked to pull one of the components of the International Swaps and Derivatives Association's "documentation architecture" I was pretty intimidated. I spent a few minutes in that forest of teensy, similarly-named pamphlets, chose what I thought was the right one and then, shortly, found myself back at the shelf taking a closer look because I'd pulled the wrong document. Eventually, I became more adept at navigating the ISDA waters, but I always felt a little at sea.

To understand why the ISDA documentation architecture is confusing (aside from the irritatingly similar names), I think it is helpful to remember that derivatives were devised as a hedging tool. A hedge is a way of protecting an investment against a worst-case scenario. For instance, if you owned a store in a seaside town and anticipated a hot, sunny summer you might buy more sunglasses than usual. If you're wrong and it rains, you won't make any money from your investment in shades. So, to hedge against that possibility you might buy umbrellas. If the summer is as you expect, you'll make lots of money, but if it rains every day, you can limp along selling umbrellas.

To be useful as a hedge your umbrella purchase must be precisely related to your investment in sunglasses. Hedging transactions are always associated with a primary investment and must be narrowly tailored to protect against a disaster without negating the primary investment's value. Thus, hedging transactions are always customized to accommodate the needs of both counter-parties.

If you are reluctant to get into the umbrella business, there are other ways to hedge your risky sunglasses play - you could invest in an umbrella company, short a sunglasses manufacturer, or you might want to try something more exotic: like investing in the price of umbrellas. That's where derivatives come in - they were developed as a way to hedge by investing in intangibles, like the price of wheat.

The ISDA documentation architecture was developed to institutionalize and standardize the process of writing these highly customized contracts. So when, in 1980's, the ISDA started working on a set of standard forms for derivatives transactions, they were faced with a daunting task: how do you create a standard agreement for an industry where every agreement is different?

Part 2: THE ISDA MASTER AGREEMENT