About that ISDA: Pt 1: Three aims of an ISDA

The first in a series of backgrounders on the ISDA Master Agreement

The original Church of ISDA, deep in the Forest of Bretton, founded on the spot where the First Men encountered the Children of the Woods

In 2024, the JC will be launching a few more specialist newsletters about the lore and law of derivatives contracts, aimed at the legal/negotiation market. As are all the JC’s substack newsletters, this one is also on the JC. The general public can find the short version here and premium subscribers the long version here.

The three aims of an ISDA

In which the JC looks into the point of an ISDA Master Agreement. What it does, why you need one, and why you can’t just crack on and trade swaps without one.

This might seem like pocket-calculator stuff to seasoned veterans, but it never hurts to stop and ponder the ostensibly bleeding obvious. Going back to basics is bracing for the spirit.

The JC encountered his first Aïessdiyé a good thirty years ago now and is still discovering new things about it every week.

The beginning of history and the First Men

Let us start with some basics: the conventional and only socially acceptable way for Muggles to refer to the sacred word, therefore is “izder”.

From the programme notes to Otto Büchstein’s unfinished operetta, Ser Jaramey Slizzard (Fruty knyghte of the Isdere):

The First Men were the survivors of an advanced garrison of mercenary Lanchmani soldiers loosely aligned to the ancient, lost city of Salomoné who, on a routine patrol of the wild Bretton Woods came across a ruined settlement which they believed to be evidence of the Synthæse (lit., “Children of the Woods”).

The Synthæse were a mythical civilisation of child-like faeries. They eschewed all earthly rancour, regarded physical settlement of disputes as sinful and, instead, voluntarily exchanged their differences in a standardised, non-physical, “synthetic” terms¹ across a centralised marketplace. Such a resolution they called a “contract for differences”.

Now the Lanchmani were a cunning, but socially awkward and physically pathetic, tribe. They relied for their survival on their powers of wit, deception, and an unusal facility for managing convexity risk.

After a heated argument, followed by dyspraxic hand-to-hand combat, most of the garrison lay dead or dying in the forest clearing. But the warlord Reg Margin and his equerry, Romanian nobleman Vlad Paripasu — since remembered as the “First Men” — stood alone and in the starlight, and had visited upon them the mystical verities of the Synthæse. It was the mushrooms or something. Without ado they took these yearning, artful aspirations and thoroughly bastardised them.

Instead of comparing idealised values plucked from a hypothetical realm of platonic perfection and cash-settling any differences, the First Men used rudimentary iron tools to offset actual loan contracts in different currencies. After a time they had built an unwieldy machine-age contrivance they called a “swap” (now pronounced “sw-ŏp”, to rhyme with “plop”, but originally pronounced “swæp”, to rhyme with “pap”).

But in doing so, inadvertently, they created the conditions for financial weapons of mass destruction and, eventually, the annihilation of the capitalist system as we know it.

This has not yet happened, yet, but it is oft foretold. Yea, even amongst the legions of modern rational, technocrats who manage financial risk with computers and models there are some who yet silently pray for some furry little warm-blooded futures brokers to arrive with a range of standardised, centrally-cleared derivatives products which will vanquish these masters of the universe. Should this happen — unlikely, but let’s say — their schadenfreude will be total.

On becoming a shibboleth

Through bad habits and inattention, humans tend to work around the easances² they make to their “built environment”.

So it is with the ISDA Master Agreement. What started as the shortest route to market became, through acquiescent disregard, a shibboleth: a sacred cow: a hindrance on the road to transaction.

Once precisely an easance — a means to quickly dispense with formalities it would be laborious to repeat for every trade — the ISDA became a mountain of its own. Sure, you only need to climb it, from the bottom, once — but that has become a three-month operation. Nor do you scale an ISDA master agreement the way Alex Honnold scales El Capitan, brave and alone, an aeronaut of the spirit. You must take the entire modernist machinery of your institution with you. KYC. AML. Compliance. Credit. The docs team. And, of course, dear old legal.

Once, the aggravation of a “long-form confirmation” was the mischief the ISDA sought to solve. Some miss the good old days. Where legal departments have not legislated outright against them — most have, long since — the temptation now is to ask, “Must we have an ISDA? Would not a long-form confirmation do?

There are other good reasons for an ISDA, as we will see, but none necessitates all the bureaucratic machinery that has grown around it. This is how the military-industrial complex of agency operates: it shapeshifts to create work to occupy the available rent.³

The ISDA Master Agreement is a framework under which two “counterparties” can transact over-the-counter derivatives — mainly, but not only, swaps.

Besides its original appeal as an easance, the ISDA has three main aims: it is a relationship contract; a credit risk management tool, and — for those who need it — a capital optimisation tool.