ISDA stands for International Swaps and Derivatives Association, which is a OTC derivatives market trade group. The ISDA has worked to standardize documentation, definitions and terms for the industry, which is especially useful as there is no central clearinghouse for these OTC contracts. The ISDA has played a central, albeit quiet, role in the Eurozone Credit Crisis.
Q. What’s ISDA?
A. The International Swaps and Derivatives Association. It’s the trade group of participants in most of the over-the-counter derivatives markets. When I first was involved with swaps back in the 80s as a lawyer, there was no standard documentation for them; all the contracts were different. ISDA’s done a lot to fix that, standardize the documentation, the definitions, the collateral provisions, and the general procedures for the industry. Essentially all the financial institutions in the world belong to it.
Q. So they’re involved with all these derivatives that we hear so much about, like sovereign credit default swaps? What exactly do they do?
A. Well, first, here’s what they don’t do: they aren’t a traditional clearinghouse as we have in publicly traded derivatives, like futures. They don’t guarantee execution of the transaction. But they do several other really critical things. First, they provide all the standard documents, which is a lot more important than you would think, because, for example, they set the rules for how to measure net exposure when an institutions have many positions.
Q. And that’s a huge deal, right, because netting dictates how much collateral counterparties have to put up … and its also a big regulatory question, as the regulators try to understand the exposure of financial institutions.
A. Exactly. But even more importantly, since 2009, ISDA is actually the organization that decides whether a credit default swap is triggered. ISDA is actually a central player in the EZ crisis, because it’s the group that decides whether a Greek (or Portuguese, Italian, or Irish) “haircut” trigger will trigger trillions of dollars of CDSs.
Q. So ISDA decides that? Who at ISDA?
A. Committees of industry participants who are writing and selling these same CDSs, called Determination Committees. This has led to lots of complaints about possible conflicts of interest: institutions with the biggest exposures may well be deciding whether or not the CDSs have to pay out. Some people even claim this determination mechanism threatens the legitimacy of the whole CDS market (by the way, as to naked credit default swaps, not necessarily a bad thing!).
Q. And so no government or regulatory agency oversees ISDA?
A. Not on matters like this. Its quite ironic, really: the EZ governments and central banks essentially have to appease the ISDA Determinations Committee in their workout, since this group of bankers holds the pin on the grenade of the CDS marketplace. Some people ask who’s in charge: the governments and central banks, or ISDA and its members?