Current Legal Issues Affecting Central Banks, Volume IV.

22B. An Analysis of the International Foreign Exchange Master Agreement

Robert Effros
Published Date:
April 1997
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This chapter deals specifically with the provisions of the International Foreign Exchange Master Agreement (IFEMA),1 which was published in the United States in November 1993 and in the United Kingdom in December 1993.2 The major issue is the extent to which enforceable global master agreements should protect against systemic risk by allowing counterparty failure to be handled on the basis of a net, rather than a gross, valuation of the deals under the agreement.

There are currently three forms of master agreements accepted as industry-standard documentation governing bilateral trading in the inter-dealer spot and forward foreign exchange markets. First, the 1992 International Swap Dealers Association (ISDA) Master Agreement3 can be used as a cross product master agreement covering not only swaps (where it was traditionally the standard document) but also a variety of other products, including foreign exchange and currency options. Second, the FXNET Worldwide Netting and Close-Out Agreement,4 published in 1993, covers only foreign exchange trades and has not come into very wide use. IFEMA5 has been gaining wider acceptance globally as a product-specific foreign exchange master agreement. It was drafted to reflect the current market practices in the interdealer spot and forward foreign exchange markets. IFEMA incorporates into the master agreement, as do both of the other agreements, appropriate legal rights and obligations. It is slightly different from the ISDA Master Agreement, which contains primarily credit-based provisions (unlike the more product-specific and market-practice-sensitive IFEMA). In order to reflect market practices, one can add the product-specific terms to the schedule to the ISDA Master Agreement.

Each of these agreements functions in a similar way. Each includes market practice provisions to a greater or lesser extent, events of default, and a method of liquidating outstanding transactions after a default. These agreements are organized slightly differently, but they contain many of the same provisions. Moreover, perhaps most significant to those who are unfamiliar with these agreements, the ISDA Master Agreement and IFEMA both have reader-friendly guides that explore in detail the purpose of specific provisions and, sometimes more important, explain why specific provisions have been omitted. The guide to IFEMA is helpful in fleshing out details of that agreement.

Section 1: Definitions

The definition section comes first in IFEMA. These definitions have become accepted as industry standard and generally conform to those in the ISDA Master Agreement. This was a deliberate attempt to ensure that, when one institution deals with another institution in more than one master agreement, the same set of credit protections should apply across those master agreements.

Clearly, the most significant of the definitions is that of an “event of default.”6 Events of default apply either to failures under the terms of IFEMA, which would primarily involve payments, or to occurrences related to the creditworthiness of a party. Because these events of default are specific to the counterparties, some parties have desired to include in the definition affiliates of the counterparty, in order to assess more accurately the credit standing of an institution in its broadest sense. The practice of including affiliates is quite typical in the swap markets under the ISDA Master Agreement.

Examples of defaults related to creditworthiness that prove to be early warning triggers of the deterioration of a counterparty would be cross default to specified indebtedness and cross default to specified transactions. Cross default to specified indebtedness occurs if a party to the IFEMA defaults on debt for money borrowed to any third party in excess of a threshold amount (which should be a standard of materiality). If such default occurs, the other party to the IFEMA has the right to close out all of the transactions under the IFEMA.

A different, but equally good, standard of credit standing is cross default to specified transactions. In this provision, a default under another master agreement or under another agreement with a counterparty in another type of trading transaction, in any amount, would permit the party to close out all defaults under the IFEMA if, under the other agreement, action has been taken with respect to that default. These cross default provisions are becoming standard in virtually all of the master agreements. The provisions are aimed at protecting one counterparty against its counterparty and should be much more helpful in dealing with systemic risk issues because they capture whole entities.

In addition, the parties may agree to include on the schedule as an event of default the right of one party that has “reasonable grounds for insecurity” to require “adequate assurances”7 from the other party of its ability to perform its obligations under the IFEMA. Failure to deliver such adequate assurances after two business days constitutes a default. Because of the subjective nature of this provision, which could be triggered by an unfounded rumor, an article in a newspaper, or more substantiated reasons, many counterparties are increasingly reluctant to include this provision in agreements. The British Bankers’ Association, in fact, has stated publicly its lack of support for rights in the nature of adequate assurances. This position is indicative of the clear movement in the market toward using objective standards for events of default in these kinds of transactions.

Section 2: Structure of IFEMA


The agreement then describes the structure of transactions under it. The agreement governs all foreign exchange transactions entered into after the date of the IFEMA between each counterparty’s trading branches that have been so designated on the schedule to the agreement. Consequently, a foreign exchange transaction under the agreement is a transaction entered into by one party or its designated offices and the other party through its designated offices. It is the trading through these designated offices, which are branches located presumably anywhere in the world, that gives rise to some of the multibranch issues arising under IFEMA. The agreement also allows the parties to incorporate all transactions outstanding prior to signing the agreement.

Single Agreement

The IFEMA is a master agreement, incorporating the agreement itself, as well as all confirmations, schedules, and annexes. It is intended to be a single agreement and therefore immune to cherry-picking, a practice according to which a trustee in bankruptcy may pick and choose among transactions of the bankrupt estate, assigning validity to some and rejecting others.


Foreign exchange transactions are expected to be confirmed in writing immediately after being entered into by the participants. The product is a simple product and has remained virtually unchanged over time. The confirmations continue to contain only the economic terms of a transaction. Increasingly, confirmations are sent electronically. The Federal Reserve Bank in New York,8 as well as the London Code of Conduct,9 has stated that it is best market practice to confirm in writing all transactions.

In Section 8.15 of the miscellaneous section, IFEMA discusses confirmation procedures. It states that, in the event of an inconsistency between the terms of the IFEMA and any confirmation, the master agreement shall control. In other markets, including currency options and derivatives products, the confirmation prevails over any inconsistency with the master agreement. This difference in market practices between the foreign exchange market and the market for currency options and derivatives partly reflects the well-established practice in the foreign exchange market, but it probably has more to do with the simplicity of the trades and the lack of information contained in confirmations for foreign exchange transactions other than purely economic terms. It is best market practice to confirm in writing all transactions, including spot trades.

Section 3: Settlement and Netting

Section 3 of IFEMA deals specifically with settlement, that is, the delivery of currencies on a value date, and netting. Section 3 deals with netting to reduce settlement risk: payments netting and novation netting. Both these types of netting are employed in predefault situations. Payments netting simply serves to reduce the amount of payments that go from one party to another. Novation netting legally extinguishes a trade as of the trade date while reducing the obligation to be paid subsequently.

Both payments netting and novation netting require the development of systems and operations. However, most of the parties signing the agreement have chosen to opt out of settlement netting and novation netting provisions because of operational constraints. As a result, the IFEMA is used primarily as a close-out agreement. However, the massive reduction in settlement risk possible through netting should encourage participants to develop systems or rely on counterparties’ systems, so that these types of netting become more interesting to both counterparties.

Section 4: Representations, Warranties, and Covenants

Section 4 is the representation section. In it, IFEMA requires that each party represent that it is authorized to enter into and to perform the agreement. It also asks that each party represent that it is acting as a principal. Representations can provide comfort but they cannot assure authority or suitability. For example, a transaction that is later deemed to be ultra vires (that is, beyond the authority of a counterparty) is not an authorized trade and accordingly will not be enforceable. This is what occurred in the swap context in the Hazell v. Hammersmith and Fulham London Borough Council case.10 Representations are reconfirmed on each trade date. Frequently, an institution may look to a legal opinion to give greater comfort on these issues.

Section 5: Close-Out and Liquidation

The next section, dealing with close-out and liquidation, is the heart of IFEMA. The ability to close out all transactions and determine a single net payment owing from one party to the other clearly reflects the “single agreement” nature of IFEMA. It is the conclusion that the close-out provision is enforceable under applicable law that will support the recognition by qualifying institutions of the benefits of netting in reducing the amount of capital required and permit credit officers to view credit exposure on a net basis under IFEMA.


Foreign exchange transactions are closed out by determining the replacement cost of all outstanding transactions and calculating a single net payment to be made by one party to the other.

Loss Versus Market Quotation

Market practice among foreign exchange dealers is that the nondefaulting party determines the close-out amount. The non-defaulting party must demonstrate good faith and commercial reasonableness. IFEMA reflects the difference in market practice between foreign exchange, on the one hand, and derivatives, on the other hand. Prices are easy to obtain in the liquid cash market. In addition, in contrast to some derivatives, the tenure of trades is usually not very long. Derivatives, however, are highly complex and difficult to price because the markets are not as liquid and the transactions are highly structured. In most swap agreements, external sources are used for market quotations to determine the value. In the interdealer market in foreign exchange, however, each dealer has access to those values.

Enforceability in Insolvency

A major issue is the enforceability in insolvency of the netting of all outstanding transactions under the close-out agreement. There is little doubt, except in situations of insolvency, that most of these agreements are enforceable as contracts between two parties governed by the law agreed by the parties. In the event of an insolvency, enforceability of netting provisions is determined on a country-by-country basis. In order to comply with the Basle Committee on Banking Supervision’s guidelines,11 robust legal opinions are required as to the enforceability in insolvency of the close-out provisions of the IFEMA in each jurisdiction where a counterparty is incorporated, or where one of its branches is transacting under the IFEMA. Industry groups, including the ISDA and the group that has prepared the IFEMA, are in the process of obtaining agreement-specific legal opinions on insolvency in a variety of jurisdictions.

Other Transactions

IFEMA provides that on its close-out the non-defaulting party has the explicit right to include other foreign exchange transactions with its counterparty that were entered into through branches not included as designated offices. This provision is designed to achieve greater credit protection with respect to a single counterparty. In addition, as a savings clause, IFEMA specifically states that the non-defaulting party is permitted to exclude the closing-out of certain transactions when, in its good-faith judgment, close-out of such transactions may not be enforceable under the laws applicable to the jurisdictions covering those transactions. As in most other master agreements, if an event of default has occurred and no action has been taken to close out, or if an event of default is pending, the counterparty has die right to suspend performance, depending on the passage of time or the giving of notice. In addition, all other legal rights that would be available to a counterparty, such as common law or statutory rights of setoff, will be available in the event of a close-out.

Section 6: Force Majeure

A separate section, force majeure, has been included to deal with failures beyond the control of a counterparty. Examples include the counterparty’s inability to pay, or the prohibition of its making any payments under the IFEMA, owing to act of state, illegality, impossibility, or force majeure. This situation occurs with some frequency in foreign exchange markets, largely because of the volume of payments made daily in multiple jurisdictions around the world. When such an event occurs, only the affected transactions may be closed out; there is no right to close out all transactions.

Section 7: Expertise

Section 7 stipulates that the parties are to rely on their own expertise. They are dealing as principals and should not rely on each other’s advice in dealing with trades.

Section 8: Miscellaneous

The miscellaneous section has many “boilerplate” provisions. The two most important are probably the currency indemnity and tape recording provisions.

Currency Indemnity

The currency indemnity provision requires that payments made after default or force majeure, or because of a judgment of a court, should be made in the “base currency” of the receiving party. This base currency is typically the home currency, U.S. dollars, or pounds sterling.

Tape Recording

Tape recordings are an important part of the foreign exchange market. It has been deemed in the United States and the United Kingdom that it is best market practice to record conversations between dealers. The conversation (whether oral or electronic) between dealers is the binding contract; a written foreign exchange confirmation is supplementary evidence of that transaction. These recordings can be submitted to a court of law as evidence and should overrule a confirmation later produced by a back office.

Section 9: Law and Jurisdiction

IFEMA provides for New York or English governing law. Japanese law, Canadian law, Australian law, and Hong Kong law versions of IFEMA have also been published or are in the process of being published.

Section 10: Schedule

The schedule is the part of the agreement between the counterparties that can be tailored to include specific provisions. It is where the parties specify their designated offices and payment instructions, and where they elect to include certain provisions, such as adequate assurances. Usually, it is best to include as designated offices any branches through which the parties may intend to enter into transactions, although the inclusion of branches in countries that do not have clear legislation with respect to netting can leave the enforceability of the agreement open to interpretation or uncertainty.

Currency Options Master Agreement

Currency options have their own specific agreement as well, the International Currency Options Market (ICOM) Master Agreement,12 which was published in 1992. A restated ICOM Master Agreement was published in May 1993, revised to conform to the more recent IFEMA as to market practices and credit protections.13 Any of the product-specific master agreements can be combined with other product-specific master agreements by the use of a “master” master agreement, which comes in many forms under U.S. laws and would be enforceable under English and New York law. Each of these special agreements would, after a default, allow netting across the net amounts from each of the master agreements. Research has not yet been done to determine whether these master agreements are equally effective in other countries, but there may be a way to achieve cross product netting of foreign exchange trades with other trades. Additionally, a combined version of the ICOM Master Agreement and IFEMA, for use with both currency options and spot and forward transactions, called the Foreign Exchange and Options Master Agreement (FEOMA), was prepared for publication in 1996. Currency options are frequently documented under the ISDA Master Agreement, which was designed as a cross product master agreement. Frequently, an ISDA Master Agreement is modified to add certain of the currency options market practice provisions when it is used for currency options. In any event, however, an ISDA Master Agreement covering currency options should be equally as enforceable as the ICOM Master Agreement.



This comment is divided into three parts: review, analysis, and issue spotting. First, the salient features of the prior chapters on the new master foreign exchange trading agreements are briefly summarized. Second, the critical issue, cherry-picking, is analyzed. Third, a few difficult and unresolved problems concerning the International Foreign Exchange Master Agreement (IFEMA)1 are identified.

The Foreign Exchange Market and IFEMA

The foreign exchange market is vast. IFEMA is important because the market that it pertains to is so important. The average daily turnover in the market for spot and forward foreign exchange contracts is approximately $1 trillion—the largest financial market in the world. The market is global, and trading occurs virtually around the clock. It is a market that defies national borders and, therefore, local contract law. IFEMA is the world’s first standard-form contract designed expressly for this unique market.

Until IFEMA was introduced in 1993, there were few standard-form agreements available to govern the rights and obligations of parties to spot and forward transactions. The FXNET Worldwide Netting and Close-Out Agreement2 was not adopted on a widespread basis. Few market participants modified the International Swap Dealers Association (ISDA) Master Agreement3 to cover their spot and forward transactions. This contractual void created uncertainty among participants. To be sure, there were well-developed customs and practices. However, formal legal documentation with supporting legal opinions obviously provides greater comfort to commercial and investment banks that actively trade in the foreign exchange markets—and to the regulatory authorities that supervise these institutions and markets.

The importance of IFEMA is underscored by the enormous risks associated with foreign exchange trading. For example, there is credit risk, the risk that a counterparty will fail to settle its position (that is, fail to deliver the currency that it is obligated to deliver) because of liquidity problems or outright insolvency. There is also “Herstatt risk,” the risk that a party whose office is in one time zone may fulfill its obligation to deliver currency but not receive the currency that it is owed from a counterparty whose office is located in a different time zone. This risk also can result from liquidity problems or insolvency of the counterparty. Finally, systemic risk is the risk that a default or failure by one party may have knock-on effects, causing other parties to default or fail. The default may concern an obligation owed under a foreign exchange contract, and the knock-on effects may concern the foreign exchange market. The driving force behind IFEMA is the attempt to minimize at least some of the risks associated with foreign exchange trading by implementing contractual protections for the parties.

More specifically, IFEMA accomplishes (or attempts to accomplish) six goals. First, IFEMA establishes with certainty and precision the contractual rights and obligations of the parties to a spot or forward transaction. Second, it governs all foreign exchange spot and forward transactions between the designated offices (that is, the head office and branches) of the parties. Third, IFEMA minimizes the likelihood of cherry-picking should credit risk or Herstatt risk materialize and the counterparty fail to deliver foreign exchange. Fourth, because it is a written agreement, IFEMA should help resolve the problem of enforceability under the statute of frauds. Fifth, IFEMA is a single, integrated agreement and, therefore, should help avoid problems arising under the “parol evidence” rule regarding the inadmissibility of prior or contemporaneous inconsistent statements, whether oral or written. Sixth, IFEMA clarifies that it, and not any written confirmations of a foreign exchange transaction, establishes the terms of a transaction in the event of an inconsistency between the IFEMA and confirmations. At the same time, IFEMA also states that a tape recording of the transaction negotiated by foreign exchange traders is the best evidence of those terms.

Analysis of IFEMA

The heart of IFEMA is the provision on close-out and liquidation netting.4 It is designed to address the problem of cherry-picking. How it does so is worth examining. Suppose that two banks, Citibank and Bankers Trust, trade dollars and yen in the spot market on Wednesday, May 18 for value on Friday, May 20. Suppose that there are three such transactions (see Figure 1). In the first deal, Citibank owes Bankers Trust $100,000. In the second deal, Citibank owes Bankers Trust $50,000. In the third deal, Bankers Trust owes Citibank $60,000. Without netting, three separate payments must be made—two from Citibank to Bankers Trust of $100,000 and $50,000, respectively, and one from Bankers Trust to Citibank in the amount of $60,000.

Figure 1.

IFEMA expressly calls for payments netting in this situation. Therefore, only one payment of $90,000 from Citibank to Bankers Trust must be made, resulting from the sum that Citibank owes to Bankers Trust ($150,000) less the amount that Bankers Trust owes Citibank ($60,000). Payments netting, however, is conceptually and operationally distinct from close-out and liquidation netting. Payments netting is designed to occur as a routine matter and presupposes that neither party is unable to settle its payment obligations. When a party defaults on an obligation—or, more generally, when any event of default specified in IFEMA occurs—liquidation and close-out netting is triggered.

Suppose that Citibank defaults on either a specified indebtedness to a third party (such as the Bank of Tokyo) or on a specified transaction with Bankers Trust not governed by the IFEMA. Each of these occurrences is an event of default under IFEMA. Accordingly, Bankers Trust is entitled to close out all of its outstanding transactions with Citibank. Suppose further that the reason for Citibank’s default is that it has become insolvent.

Here is the scenario that Bankers Trust fears: the Federal Deposit Insurance Corporation (FDIC), having been appointed the receiver for Citibank by the Office of the Comptroller of the Currency, cherry-picks among the three spot deals. If it could lawfully do so, the FDIC would reject the $100,000 and $50,000 transactions because these involve payments out of the debtor’s (Citibank’s) estate. If these payments were to be made, the pool of funds available for depositors and other unsecured creditors that the FDIC must protect would be diminished. However, the FDIC would seek to assume the $60,000 deal because this involves a payment into the estate, thereby enhancing the asset pool.

If the FDIC were allowed to cherry-pick, Bankers Trust would have to pay $60,000 to Citibank’s receiver and stand in line as a creditor of Citibank. In this position, Bankers Trust would receive the proverbial “ten cents on the dollar,” or $10,000, Thus, Bankers Trust’s net loss would be $50,000 ($60,000 less $10,000). Yet, it had expected $90,000 from the three dollar-yen spot deals!

The liquidation and close-out netting provision of IFEMA would help Bankers Trust avoid this unsatisfactory scenario. Bankers Trust would be authorized to activate the close-out and liquidation procedure upon an event of default. As the non-defaulting party, Bankers Trust would, in good faith and subject to reasonable commercial standards, determine the close-out amounts corresponding to each of the three spot transactions. This calculation is based on a formula set forth in IFEMA. It yields a replacement cost for the transactions and a single, net lump-sum payment amount. This amount must be paid by whichever party is the payment obligor. In this example, Bankers Trust would close out all three spot dollar-yen transactions, convert them to a base currency (in this instance, U.S. dollars), mark the transaction to market, and net the resulting amounts to yield one payment obligation. If the values used above were the relevant costs calculated under the contractual formula, a single payment of $90,000 would be made by Citibank to Bankers Trust.

Could the FDIC, as receiver for Citibank, block the operation of IFEMA’s close-out and liquidation procedure, reinstate the gross obligations, and cherry-pick among the three dollar-yen spot deals? No, not under U.S. law. The Federal Deposit Insurance Corporation Improvement Act of 19915 and Federal Reserve Regulation EE6 assure the enforceability of the IFEMA netting provision. However, the hard case occurs when Bankers Trust’s defaulting counterparty is a bank’s designated office subject not to the laws of the United States but rather to those, for example, of Germany, Morocco, Malaysia, or Uruguay. To what extent is the IFEMA close-out and liquidation procedure legally enforceable under the insolvency laws of such other jurisdictions? Naturally, the answer depends on the law of the foreign jurisdiction. Based on legal opinions obtained by the Foreign Exchange Committee (the organization that sponsored the IFEMA drafting project), the procedure is likely to withstand cherry-picking efforts in the United Kingdom and Japan, just as in the United States. It is not surprising that the Basle Committee on Banking Supervision’s capital adequacy guidelines require legal opinions as to the enforceability of the IFEMA closeout and liquidation netting provision for each jurisdiction in which a designated office or a party to IFEMA is located.7 Without such opinions, favorable treatment under the risk-based capital guidelines is unavailable (namely, a capital charge is imposed on gross rather than net exposures arising from foreign exchange transactions).

Issues Regarding IFEMA

The extraterritorial enforceability of the liquidation and close-out netting provision is only one example of an unresolved issue arising under IFEMA. A number of others are readily apparent. First, why should market participants sign the IFEMA? In particular, what incentives do banks located outside the major trading centers of New York, London, and Tokyo have to enter into the agreement? This question also applies to the International Currency Options Market (ICOM) Master Agreement.8

Second, to what extent are different master agreements competing products? Is the market better served by a single standard-form contract?

Third, given that the heart of IFEMA is the close-out and liquidation netting provision, is it reasonable to conclude that IFEMA is an unbalanced agreement that is drafted largely from the position of the nondefaulting party? More specifically, is the close-out and liquidation netting provision of IFEMA a bankruptcy preference granted to the nondefaulting party in a foreign exchange contract at the expense of unsecured creditors of the defaulting counterparty? After all, by preventing a receiver like the FDIC from cherry-picking, the size of the asset pool available to other creditors to satisfy their claims is diminished.

Fourth, do the events of default specified in IFEMA actually increase systemic risk? These events are broadly drafted. Some of them are subjective standards. For instance, the demand for “adequate assurances,” which could be triggered by a rumor in the market or a newspaper, could cause an otherwise healthy counterparty to experience difficulties in settling its payment obligations. In turn, other parties with exposures to (that is, owed money by) the counterparty could be adversely affected.

Fifth, suppose that a bank has several different branches that are actively involved in foreign exchange trading. Can the obligations of the branches be netted? That is, is multibranch netting possible under IFEMA? If so, the Basle Committee on Banking Supervision would presumably require a legal opinion regarding the enforceability of the liquidation and close-out netting provision from each jurisdiction in which a branch is located. As a practical matter, what is the likelihood of obtaining such opinions, particularly in the case of a bank like Citibank, with branches in dozens of countries?

Sixth, a cross product master agreement is a single, integrated agreement that covers several different foreign exchange instruments (for example, spots, forwards, options, and swaps). While the ISDA Master Agreement can serve as a cross product contract, it has not been widely used as such. IFEMA does not purport to be a cross product master agreement. What are the prospects for devising such an agreement that would gain widespread use? Would that agreement, from the perspective of bank regulators and market participants, reduce systemic risk? Or would that agreement exacerbate the financial difficulties of counterparties—and thereby perhaps increase the possibility of systemic risk because it calls for universal close-out and termination upon an event of default?

Finally, what role, if any, should bank regulators and the Basle Committee on Banking Supervision play in developing future master agreements for specific financial transactions? Currently, the Foreign Exchange Committee is sponsoring work on an agreement that would govern gold bullion trading. The Committee acts under the auspices of the Federal Reserve Bank of New York. Should the Federal Reserve play a more active and visible role, or should it remain entirely on the sidelines?

Some of these questions may be debated for years to come. Nonetheless, it is clear that the advent of IFEMA represents a new, more legalistic phase in the growth and the development of the world’s largest financial market.

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