Standard documentation of OTC derivatives

In the over-the-counter (OTC) market, each deal is negotiated between two parties depending on their particular circumstances. Asking both parties to use some form of generic documentation to record the deal can be unworkable especially if the details of their deal are unusual.

The International Swaps and Derivatives Association (ISDA) and the British Bankers’ Association (BBA) are two regulatory bodies that developed standard documentation for OTC derivatives.

There are now master agreement forms for many financial products that create a common legal framework that can be understood by all market participants. These master agreements cover most, if not all, of the major legal points that should be agreed as part of documenting the transactions to which they relate.

Master agreements cover how the parties will conduct themselves in the event of the early termination of the contractual agreements because of credit default or other unforeseen events. In particular, the agreements specify how the exposures for more than one transaction under the master agreement will be netted against each other if one or more transactions have positive exposure and other transactions have negative exposure.

In addition to the master agreements, individual transactions are tied to the master agreements with confirmation documents containing the specific terms of each transaction. The master agreements should ideally be negotiated prior to any individual transaction being agreed but, in many cases, they are only negotiated as a consequence of the first transaction.