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| In this backgrounder the JC will look deeply at what the basic point is of an ISDA Master Agreement. Why can’t you just crack on and trade swaps without all this dusty paperwork? What is wrong with long-form confirmations?
| | {{drop|I|n which the}} 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. |
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| This might seem like pocket-calculator stuff to seasoned veterans, but it never hurts to stop and ponder what seems to be the bleeding obvious. The JC encountered his first {{aies}} fully thirty years ago now, and he still found himself discovering things he didn’t know, or hadn’t occurred to him, as he prepared this essay. | | This might seem like pocket-calculator stuff to you, my seasoned veterans, but it never hurts to stop and ponder the ostensibly bleeding obvious. Going back to basics is bracing for the spirit. |
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| The {{isdama}} is, as we know, a [[Relationship contract|framework agreement]] under which parties can transact [[swap]] contracts. The ISDA has three main goals: it is a [[relationship contract]]; it is a [[Credit risk mitigation|credit risk management tool]], and it is a [[capital optimisation]] tool. | | The JC encountered his first [[Aïessdiyé]] a good thirty years ago now — shout out to GFF, still at it, down in the southern wilds — and is still discovering new things about it every week. |
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| ===== Relationship contract ===== | | ===On becoming a shibboleth === |
| It is a relationship contract. A commitment signal, and an opportunity to simplify and streamline the process of transacting derivatives by getting as much “relationship stuff” out of the way before trading as possible.
| | Through bad habits and inattention, humans tend to work ''around'' the [[Easance|easances]]<ref>Yes, the JC made this word up. Think of it most nearly as the opposite of a nuisance.</ref> we once made to our “built environment”. |
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| ===== Credit risk management=====
| | So it is with the [[ISDA Master Agreement]]. What started as the shortest route to market can, through acquiescent disregard, become a shibboleth: a ''hindrance'' on the road to transaction. |
| It is a [[Credit risk management|credit management]] tool: it give each party the tools it needs to manage and reduce its [[credit exposure]] to ''the other party'' as a result of all this derivatives trading.
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| Here, there is a clear difference between the Master Agreement, which is all about reducing credit risk, and the {{isdaprov|Confirmation}}, which is designed to to precisely describe (but not ''reduce'', as such) ''market'' exposure under a given {{isdaprov|Transaction}}. The point of derivatives trading is to take on market exposure, of course. Counterparty credit risk is an unwanted side effect: a tail event so the terms in the {{Isdama}} provide sort of “end of days” protection, like airbags or the inflatable slides on a plane: something we definitely want on board, but sincerely hope will never be needed.
| | Once precisely an [[easance]] — an artefact for quickly tidying up and dispensing 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 {{Plainlink|https://films.nationalgeographic.com/free-solo|the way Alex Honnold scales El Capitan}}, brave and alone, an [[Morgenröte|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. |
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| We should distinguish between “expected events“ and “tail events”. “Expected events” are things you ''hope'' will happen as a result of signing the contract: the delivery of goods; performance of services, the payment of money and so on. “Tail events” are externalities: things you sincerely hope, will not happen, particularly ones that might upset the normal run of ''expected'' events. Your counterparty blowing up; war, pandemic, the great kind of terror coming down from the sky etc.<ref>The descension from the sky of the great king of terror is a bad tail event, because there is nothing you can really do about it by way of mitigation.</ref>
| | Once, the aggravation of a “[[long-form confirmation]]” was the mischief the ISDA should to solve. Some miss the good old days. Where bank 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? |
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| It is in the nature of apocalyptic risks that we are prepared to spend far more time and resources than is rational preparing for them. Thus, the negotiation military-industrial complex, which spends comparatively little time documenting the economics of swap confirms — these days a lot of that is done by computer — but an awful lot negotiating point-to-point [[NAV trigger|net asset value trigger]]<nowiki/>s. The dividend of all this conceptual haggling, if done well, is a mythical contractual utopia, beloved of senior credit officers but not really understood by anyone else, of “[[strong docs]]”. Anyway, I digress.
| | There are other good reasons for a master agreement, as we will see, but none necessitates all the bureaucratic machinery that has grown around the ISDA. This is how the [[military-industrial complex]] of agency operates: it shapeshifts to create work to occupy the available rent.<ref>see the [[eighteenth law of worker entropy]]. Remind me to do an article on the [[rent carrying capacity]] of financial services.</ref> |
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| ===== Capital optimisation===== | | ==The three aims of an ISDA== |
| To give regulated institutions who are sensitive to their [[leverage ratio]] the tools they need to mitigate the effect derivatives trading has on their capital calculations.
| | {{drop|T|he [[ISDA Master Agreement]]}} is a framework under which two “[[counterparties]]” can transact [[over-the-counter]] derivatives — mainly, but not only, [[Swap|swaps]]. Besides its original appeal as an [[easance]], the ISDA has three main aims: it is a [[relationship contract]]; a [[Credit risk mitigation|credit risk management tool]], and — for those who need it — a capital optimisation tool. |
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| Ninja point: it may look like it, but ''capital management is is not the same as credit risk management''. Indeed, it is the converse: capital management covers the period until a counterparty credit loss actually happens, describing the minimum capital the bank must hold to ride out the shock of that default. Once the default has happened, of course, the capital calculation in itself has no bearing on the size of the credit loss; only the institution’s ability to weather it without blowing up itself. In this way, capital management it is more like ''own'' credit risk management — it ensures that ''when'' a counterparty blows up, it doesn’t take you with it.
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| Capital management is, nonetheless, a tool for managing “expected events” and not “tails events” as such because it has a daily direct impact on the bank’s risk weighting calculations, and therefore how much capital the bank is allowed to put at risk. It is a cost management tool, not a risk management tool, that is to say.
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| The principal tool for managing the capital cost of a swap master agreement is [[close out netting|close-out netting]].
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| Derivatives are odd contracts because they are inherently levered, and therefore extremely volatile. They have large notional values, but lower mark-to-market values. An “at-market” swap<ref>Almost all swaps start off as at-market. Starting your swap off the market implies a one-way initial payment under the transaction, by way of premium, to the party who starts “out-of-the-money”. Otherwise, it would be economically irrational to enter into the Transaction.</ref> starts with zero exposure, either way, and thereafter can fluctuate wildly in either direction. Compare this with a traditional loan, where the transaction starts with an exposure equal to its notional amount — lender goes “in the money”, borrower “out-of-the-money” — and the value of the loan to the lender then fluctuates narrowly around that notional amount (to account for accrued interest, changing interest rates, and the borrower’s changing credit profile) until it is all repaid, in one go, at maturity. The exposure profile of a swap is very different. The raw market exposure of a portfolio of swap transactions can, thus, be huge compared with the original capital committed (i.e. zero): the total of all your [[out-of-the-money]] positions, which you can assume you must perform, versus all collateral you hold, which you should assume you will be required to return.
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| If you can treat that overall total exposure as the net sum of the offsetting positive and negative exposures — especially where the bank also requires [[variation margin]]<ref>Though VM has its dark nemesis: see our essay [[when variation margin attacks]].</ref> — the capital requirement is much more manageable — on margined trades, net mark-to-market exposure is reset to zero every day. The capital calculation on that is extremely complicated, but this offsetting effect is powerful. It would be a whole lot higher if you couldn’t take account of close out netting.
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| The “standard of proof” for “netting down” Transaction exposures is also huge: regulations require banks to obtain an external [[netting opinion|legal opinion]] that the netting contract actually ''[[Would-level opinion|will]]'' — not just ''should'' — work. This is a “beyond reasonable doubt” sort of standard. By contrast, when setting a “[[credit line]]” the credit department is not directly constrained.<ref>As ever, our old friend [[Credit Suisse|Lucky]] provides a great example. During [[Archegos]] the risk team repeatedly changed the applicable risk model to something more benign so they could continue to trade.</ref>
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| There was once a time where the credit team might take a more lenient view for credit risk management purposes than the treasury team could for capital purposes. As the global financial crisis wore on, this sort of cavalier “[[IBGYBG]]” attitude gave way to a new austerity and credit teams started to think the better of this. (It probably didn’t make a lot of difference, really: you can make your credit line as big as you like, but if you have to gross your exposures for capital purposes you won’t be competitive in the market).
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In which the 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 you, my 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 — shout out to GFF, still at it, down in the southern wilds — and is still discovering new things about it every week.
On becoming a shibboleth
Through bad habits and inattention, humans tend to work around the easances[1] we once made to our “built environment”.
So it is with the ISDA Master Agreement. What started as the shortest route to market can, through acquiescent disregard, become a shibboleth: a hindrance on the road to transaction.
Once precisely an easance — an artefact for quickly tidying up and dispensing 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 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 should to solve. Some miss the good old days. Where bank 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 a master agreement, as we will see, but none necessitates all the bureaucratic machinery that has grown around the ISDA. This is how the military-industrial complex of agency operates: it shapeshifts to create work to occupy the available rent.[2]
The three aims of an ISDA
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.