What is a Termination Clause

A termination clause is a section of a swap contract that describes the procedures and remedies for one of the counterparties if the other counterparty defaults or otherwise ends the contract. This includes, but is not necessarily limited to, the payment of damages to the injured counterparty. When a swap terminates early, both parties will cease making the contractually agreed upon payments.

BREAKING DOWN Termination Clause

Counterparties using the International Swaps and Derivatives Association's (ISDA) master swap agreement can take advantage of the termination clause that is already written into that agreement. Possible termination events include legal or regulatory changes that prevent one or both parties from fulfilling the contract terms ("illegality"), the placement of a withholding tax on the transaction ("tax event" or "tax event upon merger"), or a reduction in one counterparty's creditworthiness ("credit event"). The failure to pay or a declaration of bankruptcy by either party are examples of default events.

In other words, a termination clause contains language that could lead to an early end to the swap contract if either party experiences specific, pre-determined events or changes in its financial status, or if other specific events outside the party's control will change that party's ability to legally maintain the contract.

The agreement value method, formula method, or indemnification method can be used to calculate these damages, called "termination payments."

While a clear default of the swap contract immediately releases the non-defaulting, or injured, party from further obligations to make payments, it does not address potential relief from the risks and benefits of future payments not yet due, or the risks associated with replacing the injured party's contract at similar terms. Therefore, the termination clause contains provisions that can speed up the counterparty's obligations (acceleration) and other procedures to compensate the injured party for the loss of the swap contract.

Master Swap Agreement

The master swap agreement is a basic, standardized swap contract created by the International Swaps and Derivatives Association in the late 1980s. It identifies the two parties, i.e. the counterparties, entering the transaction and describes the terms of the arrangement, such as payment, and events of default and termination. It also lays out all other legalities of the deal, including early termination.

The agreement simplifies the process because it established the basic legal terms so that only the specific financial terms, such as rate and maturity, must be discussed. Signing a master swap agreement also makes it easier for the same parties to engage in additional transactions in the future because they can conform to the initial agreement.