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| In this backgrounder the JC will look deeply into what is the basic point of an {{isdama }}. What does it do, why do you need one, and why can’t you just crack on and trade swaps without all this dusty paperwork?
| | {{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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| Now this might seem like pocket-calculator stuff to you, my seasoned veterans, but it never hurts to stop and ponder what seems to be the bleeding obvious.
| | 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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| Going back to basics is bracing for the spirit. The JC encountered his first {{aies}} fully thirty years ago now — shout out the GFF — and he still finds himself discovering things he didn’t know, or having things dawn upon him. Plenty did, as he prepared this essay.
| | 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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| ====On becoming a shibboleth====
| | ===On becoming a shibboleth === |
| Through habit and inattention we work around the [[affordance]]s of our business. What starts as a practical shortcut — the shortest possible route to market — can, through acquiescent disregard become a sacred cow — a shibboleth — an ''obstacle'' on the road to transaction. So it is with the {{isdama}}. Once precisely an ''[[affordance]]'' —an artefact for quickly tidying up and dispensing with formalities it would be laborious to repeat for every trade — it became a mountain of its own. Sure, you only need to climb it, from the bottom, once, but it has become a three-month climb. And one does not scale an ISDA master agreement the way Alex Honnolt scales El Cap. There is the entire modernist machinery of the multi-national corporation campaign that you must take with you. | | 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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| There are those who miss the good old days. Where bank legal departments have not legislated outright against them — most have — the temptation now is to ask “must we really have an ISDA? Would not a [[long-form confirmation]] do?
| | 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. |
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| This is how the military-industrial complex of agency operates: it shapeshifts to create work to occupy the available rent.<ref>Remind me to do an article on the [[rent carrying capacity]] of financial services.</ref>
| | 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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| ====The three aims of an ISDA====
| | 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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| The {{isdama}} is, as we know, a framework under which two “[[counterparties]]” can transact [[over-the-counter]] derivatives — [[swap]] contracts. Besides its original appeal as an [[affordance]] it has three main aims: it is a [[relationship contract]]; it is a [[Credit risk mitigation|credit risk management tool]], and it is a [[capital optimisation]] tool.
| | 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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| ===== Relationship contract ===== | | ==The three aims of an ISDA== |
| [[File:Wedding.jpg|250px|thumb|right|A relationship contract, yesterday.]]
| | {{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. |
| Firstly, the Master Agreement is a [[relationship contract]]: a legal agreement establishing the basic relationship between the parties, reciting their aspirations, dealing with housekeeping, setting out contact details and process agents, setting up the transaction process to make trade time as simple and streamlined as possible, and generally setting up the economic parameters within which the parties agree to transact [[from time to time]].
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| The Master Agreement does not of itself create any obligations or liabilities, or otherwise commit anyone to any Transaction in particular. For this reason, and curiously, the ISDA Master does not provide ''at all'' for termination without fault on notice. This is because, absent Transactions, the ISDA doesn’t ''do'' anything: it simply provides architecture: walls within which parties may safely play; a roof over their heads under which they may comfortably dance ''if they both want to''. If they don’t fancy dancing, no one says they have to. | |
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| In that ISDAs are painful to put in place — if it only takes a couple of months you are doing well — the ISDA is also a [[commitment signal]]: it shows you care enough to engage your [[legal eagles]] in the painstaking process of working up “[[strong docs]]”.
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| If the parties do decide to dance they execute a {{isdaprov|Confirmation}}, under the auspices of the Master Agreement that inherits its terms and sets out the economic terms of the {{isdaprov|Transaction}}.
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| ===== Credit risk management=====
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| Secondly, once the parties ''have'' decided to dance, the ISDA is a [[Credit risk management|credit management]] tool. It gives each party the rights it needs to manage and reduce its [[credit exposure]] to ''the other party'' as a result of all this derivatives trading. These include {{isdaprov|Credit Support}} and [[Close-out Amount - ISDA Provision|Close-out]] rights.
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| {{isdaprov|Credit Support}} may take the form of margin “posted” by the counterparty itself against its own exposure and [[guarantee]]s, keep-wells and [[letters of credit]] provided by third parties on the counterparty’s behalf.
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| {{isdaprov|Events of Default}} and {{isdaprov|Termination Events}} permit an innocent party to [[close out]] {{isdaprov|Transactions}} early, should the counterparty breach the agreement, or its creditworthiness deteriorate in more or less oblique ways contrived by the credit department. Some of the Termination Events are concerned with other externalities — change in law, force majeure, tax matters — that don’t directly affect either party’s credit position.)
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| ======Expected events and tail events======
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| We can, in any case, distinguish between welcome “expected events” and unwelcome “[[tail events]]”.
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| “Expected events” are the risks you assume by entering the swap in the first place: the economically significant things you believe may, or may not, happen. If these things do not go how you hoped, there is no complaint: that is the bargain you struck. The forward value of goods and rates you agree to exchange.
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| “Tail events” are externalities: things that might get in the way of you enjoying the financial risk and reward of the expected events. Your counterparty blowing up or being subject to sanctions; the contract being declared illegal; relevant tax laws suddenly changing, the Great King of Terror descending in a flaming chariot, etc.<ref>The arrival of the Great King of Terror is a ''bad'' tail event: there is nothing you can really do to mitigate it. Best not write a swap on it.</ref>
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| In any case we can see a clear division of labour between the Master Agreement, under which you ''minimise and mitigate'' potential tail risks under all {{isdaprov|Transactions}}, and the {{isdaprov|Confirmation}}, under which you precisely ''describe'' (but do not ''reduce'', as such) ''market'' risk for individual {{isdaprov|Transaction}}s.<ref>This not, ah, a [[Bright-line test|bright-line distinction]], but it is a good rule of thumb. You might put some asset-specific “tail risk” Termination Events in the Confirmation, but for the most part you try to get them all into the Master Agreement.</ref>
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| So the {{Isdama}} provides a sort of “end of days” protection for the tail risks that could upset your Transactions. If a Confirmation is the GPS, the Master Agreement is the seatbelts, airbags or those inflatable slides on a plane that turn into life rafts: something we certainly want, but sincerely hope we will never need.
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| We are loss-averse: we tend to be prepared to spend far more time and resources than is rational preparing for apocalyptic risks. Thus, the [[negotiation]] [[military-industrial complex]] spends comparatively little time documenting the economics of swap {{isdaprov|Confirmations}} — these days a lot of that is done by computerised [[document assembly]] — but an awful lot negotiating point-to-point [[NAV trigger|net asset value trigger]]s that are almost certain never to be invoked.
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| The dividend of all this conceptual haggling, if done well, is a mythical contractual utopia, beloved of senior [[credit officer|credit officers]] but poorly understood by anyone else, of “[[strong docs]]”. Anyway, I digress.
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| ===== Capital optimisation=====
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| Thirdly, the ISDA Master is carefully designed to yield a specific regulatory capital treatment for those financial institutions who are sensitive to their [[leverage ratio]].
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| Ninja point: it may look like it, but ''capital optimisation is not the same as credit risk management''. As a matter of fact, it is the ''converse'': capital management addresses the period until a counterparty credit loss actually happens, defining the minimum capital a dealer must hold to ride out the credit loss following a counterparty default.
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| Whereas credit mitigation comes into play when a counterparty has defaulted, capital optimisation works during the period beforehand. Once a counterparty has defaulted, your capital calculation is of no further use: you just hope it was enough. It makes no difference to the size of your loss; only your ability to weart the loss without failing. In this way, capital optimisation is more like ''own'' credit risk management and counterparty risk management: it ensures that ''when'' your counterparty blows up, it doesn’t take your arms and legs with it.
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| Capital management is, therefore, also an expected event 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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| ====Qualities of a good ISDA====
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| =====Clear=====
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| The many purposes of the ISDA, most deal with the present (such as the availability of netting) or the past (reps, warranties and conditions to transacting), but only one deals with the future. The credit terms. These will only come into serious contemplation at times of ''extreme stress''. The more you stand to lose the more extreme circumstances are likely to be. Your management will certainly be going mad— take that for granted — but likely so will market, and quite possibly the geopolitical situation too. There are also likely to be multiple counterparty failures at once. All kinds of things will be stretching your attention and management's. Patience and a sense of humour will be in short supply. People will want short, clipped answers.The last thing anyone wants to hear is, “it’s complicated ” or “god forbid, the contract is not clear.
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| =====Consistent=====
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| =====Simple=====
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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.