A master compensation agreement is an agreement between two parties — known as counterparties — that governs the processing of certain compensations or contracts. Two transactions reward each other if a profit in one transaction results in a loss in the other. In other words, transactions protect each other. A master compensation agreement requires a practice called “net settlement” when one of the counterparties acidizes or terminates late a contract included in the master compensation agreement. An ISDA master contract is the standard document that is regularly used to regulate over-the-counter derivatives transactions. The agreement, published by the International Swaps and Derivatives Association (ISDA), outlines the conditions to be applied to a derivatives transaction between two parties, usually to a derivatives trader and counterparty. The master contract of the ISDA itself is the norm, but it is accompanied by a bespoke timetable and sometimes an annex to support the credit, both signed by both parties in a given transaction. As part of the net tally, counterparties add up the net amount owed under all contracts under the master compensation contract. The counterparty that owes money is required to settle its debts by a one-time payment in one currency to the other counterparty. Contracts normally include derivative financial instruments, including futures, options, swaps, convertible bonds and other contracts whose derivative value comes from the value of a related underlying security, as part of a master netting agreement. In addition, reverse pension contracts and securities lending contracts are often included in master netting agreements. Two manufacturers can enter into a compensation master contract if they act as suppliers and customers for each other. Over-the-counter derivatives are traded between two parties, not through an exchange or intermediary.
The size of the over-the-counter market means that risk managers must carefully review traders and ensure that authorized transactions are properly managed. When two parties complete a transaction, they will each receive confirmation explaining their details and referring to the signed agreement. The terms of the ISDA master contract then cover the transaction. The main advantages of an ISDA management contract are improved transparency and liquidity. As the agreement is standardized, all parties can study the ISDA master agreement to find out how it works.