On June 27, 2024, the International Swaps and Derivates Association (ISDA) published a new interactive digital framework (the "ISDA Close-Out Framework") that market participants can use to help prepare for potential terminations of collateralized derivatives contracts documented under the 2002 ISDA Master Agreement.
The ISDA Close-Out Framework walks counterparties through two different Events of Default under the ISDA Master Agreement: Failure to Pay and Bankruptcy. It provides information about the non-defaulting party's rights under the 2002 ISDA Master Agreement, the impact of a resolution stay under US, EU and UK law, and procedures for calculating and paying an early termination amount. The ISDA Close-Out Framework also includes a decision tree guidance describing how a counterparty can enforce its rights to collateral and how – and when – to return collateral. The Framework includes high-level analysis of the default mechanics and collateral enforcement provisions in ISDA documentation, along with additional commentary on bank resolution legislation in the US and Europe.
The ISDA Close-Out Framework generally assumes that parties will exercise their rights at the earliest possible opportunity. It also assumes the following:
- The parties have entered into a 2002 ISDA Master Agreement.
- One party is the Defaulting Party.
- "Automatic Early Termination" has not been specified in the relevant ISDA schedule.
- The occurrence of any event giving rise to a contractual right will occur during business hours on the day attributed to that event, and with sufficient time for the relevant party to exercise such rights.
- There are no limitations on the parties' ability to exercise any such rights; for example, difficulties effectively delivering required notices.
- Exercise of any rights relating to termination, and the delivery of any related notices, are in relation to all transactions.
- "Custodian Event" is not applicable for the initial margin Credit Support Annex (IM CSA) and the occurrence of any contractual rights do not arise as a result of a custodian failing to follow valid instructions of either party, or any other analogous failure by the custodian.
- The contractual rights and obligations of both parties under the Control Agreement will be analogous with the equivalent contractual rights and obligations under the IM CSA.
- Parties will post only cash and government securities as collateral, in accordance with the applicable eligibility requirements.
- Local law security enforcement issues under the applicable governing law have not been considered.
- For the purposes of the bank resolution analysis, it is assumed that all parties have adhered to the appropriate ISDA protocols, or otherwise amended contracts that are in scope for a particular resolution regime, to opt-in to the application of the resolution stay on the exercise of termination rights and remedies and the enforcement of security interests.
- It is possible that a resolution action may involve cross-border elements. For simplicity, the Close-out Framework assumes that any applicable resolution action will be undertaken in, and will relate to a bank located in, one jurisdiction.
- The Close-out Framework distinguishes between statutory and contractual stays; however, this distinction is intended to address the application of the US Stay Protocol. The application of stays that are contractually recognized in third country law-governed agreements are considered to be statutory stays.
Derivatives market participants will need to be prepared for potential defaults – both their own and their counterparties – in order to effect remedies quickly and enforce their rights. Remedies will also need to be considered across a portfolio of transactions and broad collateral relationships, not only taking into account the rights under ISDA, but also under existing regulations in each relevant jurisdiction. These regulations add additional procedures to effect most terminations. As publicly announced by ISDA, the ISDA Close-Out Framework was developed in response to recent prominent bank failures, which illustrated the inherent complexity in terminating multiple derivatives trades or a trading portfolio. The Framework can be used both by banks and by other market participants, including corporate end-users, to prepare for any potential economic events or counterparty events. If you have a portfolio of over the counter derivatives trades, or make a market in over the counter derivatives, this tool can assist in preparing for potential terminations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.