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| [[Party A and Party B - ISDA Provision|In this episode]] of the JC’s series of unfeasibly deep explorations of superficially odd things in the [[ISDA]] metaverse, consider the bilateral nature of the {{isdama}} and its curious designators: “{{isdaprov|Party A}}” and “{{isdaprov|Party B}}”, and that curious descriptor of both of them: “[[counterparty]]”.
| | {{quote|{{D|Bilateral|/ˌbaɪˈlætᵊrᵊl/|adj}}Having, or relating to, two sides; affecting both sides equally.}} |
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| These set the ISDA apart; give it a sort of otherworldly aloofness; a sense almost of social justice. Other banking and broking transactions use labels which help you orient who, in the [[power structure]], is who: a loan has a “Lender” (always the bank) and “Borrower” always the punter. A brokerage has “Broker” (master) and “Customer” (servant).
| | {{drop|[[The bilaterality, or not, of the ISDA|I]]|n this episode}} [[JC]] considers the “bilateral” nature of the {{isdama}}, why swap participants alone amongst financial players are called “[[counterparty|counterparties]]”, and what this confusing “{{isdaprov|Party A}}” and “{{isdaprov|Party B}}” business is all about. |
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| But not the {{isdama}}. From the outside its framers — the [[First Men]] — opted for the more gnomic, interchangeable “{{isdaprov|Party A}}” and “{{isdaprov|Party B}}”.
| | The unpresumptuous way it labels the parties to a Transaction sets the ISDA apart from its fellow [[finance contract]]s. They give it a sort of otherworldly aloofness; a sense of utopian equality. Other [[finance contract]]s label their participants to make it clear who, in the [[power structure]], is who: a [[loan]] has a “[[Lender]]” — the [[bank]]; always the master — and a “[[Borrower]]” — the punter; always the servant. A brokerage agreement has a “[[Broker]]” (master) and a “[[Customer]]” (servant). |
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| Why? Well, we learn it from our first encounter of an ISDA Schedule. ''[[The bilaterality, or not, of the ISDA|Bilaterality]]''.
| | Okay, I know ''theoretically'' the master/servant dynamic is meant to be the other way around — the customer is king and everything — but come on: when it comes to finance it isn’t, is it? We are ''users'', all hooked up to the great battery grid, for the pleasure of our banking overlords and the [[The domestication of law|pan-dimensional mice]] who control them. |
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| ===Bilaterality===
| | But not when it comes to the {{isdama}}. From the outset, the [[First Men]] who framed it opted for the more gnomic, interchangeable and ''equal'' labels “{{isdaprov|Party A}}” and “{{isdaprov|Party B}}”. |
| A belief in even-handedness gripped the ones whose [[deep magic]] forged the runes from which the [[First Swap]] was born.
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| For most finance contracts imply some sort of dominance and subservience: a large institutional “have” indulging a small commercial “have-not” with debt finance for the privilege of which the larger “have” extracts excruciating covenants and enjoys a preferred place in the queue for repayment among the have-not’s many scrapping creditors.
| | Why? Well, we learn it from our supervising associate, when we first encounter a [[Schedule - ISDA Provision|Schedule]]. |
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| But [[swaps]], as the [[First Men]] saw them, are not like that.
| | ''[[The bilaterality, or not, of the ISDA|Bilaterality]]''. |
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| “A swap contract,” they intoned, “is an exchange among peers. It is an equal-opportunity sort of thing; Biblically righteous in that, under its awnings, one be neither lender nor borrower, but an honest rival for the favour of the Lady Fortune, however capricious may she be.
| | ===Bilaterality=== |
| | | {{drop|A|belief in}} even-handedness gripped the ones whose [[deep magic]] forged the runes of that ancient [[First Swap]]. It has not just a two-sided structure — most private contractual arrangements have that — but a ''symmetrical'' one, lacking the dominance and subservience that traditional finance contracts imply. |
| “We are equals. Rivals. ''Counterparties''”. Covenants, privileges of credit support and so on may flow either way. They may flow ''both'' ways. In our time of [[regulatory margin]], they usually do.
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| And, to be sure, swaps ''are'' different from loans and brokerage arrangements. They start off “at market” where all is square. Either party may be long or short, fixed or floating. At the moment the trade is struck, the world infused with glorious ''possibility''. One fellow’s fortunes may rise or fall relative to the other’s and, as a result, she may ''owe'' (“[[out-of-the-money]]”) or ''be owed'' (“[[in-the-money]]”). And swaps, too, are professional instruments. Moms and pops, [[Belgian dentist]]s and the like may take loans and buy bonds, but they don’t, and never have, entered {{isdama}}s.<ref>They may trade [[contracts for difference]] and make spread bets with brokers, but these are standardised, smaller contracts.</ref>
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| Now the {{isdama}} ''itself'' never uses the terms “Party A” or “Party B”. Being genuinely bilateral, it never has to. Being arbitrary assignations at trade level the labels only get a mention once the symmetry breaks down in the {{isdaprov|Schedule}} and in {{isdaprov|Confirmation}}s, to be clear who is who on a given trade: who is paying the fixed rate and who the floating; which thresholds, maxima, minima, covenants, details, agents and terms apply to which counterparty. This much is necessarily different. Nothing beyond: the {{isdama}} assumes you already know who is who, having agreed it in the {{isdaprov|Schedule}}.
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| So we agree: for this relationship we will call you “Party B”, and me “Party A”.
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| These colourless and generic terms hark from a time where, we presume, the idea of “find and replace all” in an electronic document seemed some kind of devilish black magic. Some kind of [[Tipp-Ex]]-denying subterfuge.
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| But anyway. These generic labels still lead to practical difficulties. A [[dealer]] with ten thousand counterparties in its portfolio wants to be “Party A” every time, just for peace of mind and literary continuity when perusing its collection of Schedules, as we know [[dealer]]s on occasion are minded to do.<ref>They are not.</ref> If, here and there, a dealer must be “Party B”, this can lead to anxious moments should one misread such a Schedule and infer its infinite [[IM]] {{csaprov|Threshold}} applies to the other guy, when really, as it ought, it applies to you. Frights like this are, in their way, quite energising.
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| You quickly get over them when you realise it is your error of construal, not the negotiator’s of articulation.
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| Less energising are actual errors: as a group, [[negotiator]]s are redoubtable, admirable creatures but, like all of us fallible and prone to oversight: they may, by lowly force of habit, forget to invert the “Party” labels when inserting the boilerplate {{isdaprov|PPF Event}} rider for that one time in a thousand when the firm is not “Party A”. It is easily done, and just the sort of thing a [[four-eyes check]] will also miss: If it does, no-one will never know — ''unless and until it is too late''.
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| ===''Is'' it bilateral though?=== | |
| But there is a better objection: for all our automatic protestations to the contrary, the ISDA is not ''really'' a bilateral contract, and it ''is'' often a financing contract, in economic effect even if not in formal structure. Where there is a customer gaining exposure to a risk and a dealer providing delta-hedged exposure to that risk, a swap is a sort of “synthetic loan”.
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| You could analyse an interest rate swap as off-setting fixed rate and floating rate loans. Seeing as the same amount of principal in the same currency flows in both directions at the same time, the principal flows cancel each other out — they “net” to zero.
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| “Aha, JC: quite so. But this implies, does it not, that the parties are ''not'' lending to each other?”
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| Well, yes: but the difference is in how the two sides manage their respective positions. Beyond the cramped star system of inter-dealer relationships, there is a boundless universe where one party is a “dealer” and the other a “customer”. This is the great majority of all swap arrangements.
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| The difference between ''customer'' and ''dealer'' does not depend on who is “long” and who “short” — customers can be long ''or'' short — nor on who pays fixed and who pays floating.
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| For the customer the object of transacting is to ''change'' its market exposure: to get into a positions it did not have before, or get out of one it did. This sounds obvious. But, being a bilateral contract, you might think it follows that the dealer is changing its position, too. But it is not. A dealer is there to provide exposure without taking any itself, and thereby to earn a commission. The dealer intends to say ''flat''.
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| ==== Swaps are usually synthetic loans ====
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| But how does this make a swap into a “synthetic loan” from the dealer to the customer? Let’s take an example. The JC’s fictional hedge fund [[Hackthorn Capital Partners]] owns USD10m of [[Lexrifyly]], and wants to get into the fabulous new start-up [[Cryptöagle]]. It can do one of three things:
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| (i) sell [[Lexrifyly]] outright and buy [[Cryptöagle]];
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| (ii) hold [[Lexrifyly]] and borrow to buy [[Cryptöagle]];
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| (iii) hold [[Lexrifyly]] and get synthetic exposure to [[Cryptöagle]] via a swap.
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| For argument’s sake let’s say on the investment date, both [[Cryptöagle]] and [[Lexrifyly]] trade at USD1 per share, so the acquired and sold positions are each for 10m shares. Here are the positions:
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| {{Quote|{{divhelvetica| | |
| '''Outright sale'''<br>
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| If it sells its [[Lexrifyly]] outright, the position is as follows:
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| :''Sold: USD10m [[Lexrifyly]].
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| :''Borrowed'': Zero.
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| :''Amount owed'': Zero.
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| :''Bought'': 10m [[Cryptöagle]].
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| :''Net position'': ''10m [[Cryptöagle]] shares + zero [[Lexrifyly]] + zero loan''
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| '''Loan'''<br>
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| If it keeps its [[Lexrifyly]] and borrows, the position is as follows:
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| :''Sold: Zero.
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| :''Borrowed: USD10m.
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| :''Bought'': USD10m [[Cryptöagle]].
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| :''Net position'': ''10m [[Lexrifyly]] shares + 10m [[Cryptöagle]] shares - USD10m - accrued interest''
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| '''Swap'''<br>
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| If it keeps its [[Lexrifyly]] and puts on a swap struck at USD10m, the position is as follows:
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| :''Sold: Zero.
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| :''Borrowed: Zero.
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| :''Swap outgoings'': Floating rate on USD10m
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| :''Swap incomings'': USD10m [[Cryptöagle]] - USD10m.
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| :''Net position'': ''10m [[Lexrifyly]] shares + 10m [[Cryptöagle]] shares - USD10m - accrued interest''
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| }}}} | |
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| Even though there is no physical loan, the investor’s payment profile is the same. It pays a floating rate, and has the USD10m notional value of the loan deducted from its pay-out. And like a loan, the equity swap gives Hackthorn exposure to [[Cryptöagle]] whilst keeping its existing portfolio, which Hackthorn uses to fund cashflows on its new capital asset. This is a form of ''[[leverage]]''. The floating rate Hackthorn pays is ''implied funding''. The dealer will only accept this if it is satisfied Hackthorn has enough capital to finance its swap payments and settle any differences at termination. This is the same risk calculation a bank lender would make.<ref>To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.</ref>
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| But, hang on: this is a bilateral arrangement, right, so isn’t the converse true of the dealer? Isn’t the dealer, in a sense, “borrowing” by paying the total return of the asset to get “exposure” to the floating rate in the same way? Indeed, is not a “short” swap position, for a dealer, exactly the same as a “long” swap position for a customer?
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| Generally not, because in providing these swap exposures to its customers, the dealer is not changing its own market position. It delta-hedges. At the same moment it puts on a swap, it executes an offsetting hedge. The customer ''buys'' an exposure: that is, starts ''without'' and ends up ''with'' a “position”; the dealer manufactures and then sells exposure: it starts ''without'' a position, takes an order, creates a position and then transfers it to the customer, leaving the dealer where it started, ''without'' a position. Hence, the expressions “[[sell side|sell-side]]” — the dealers — and “[[buy side|buy-side]]” — their customers.
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| Now, a swap is a principal obligation, so transferring exposure “''+x''” to a customer necessarily involves the dealer acquiring exposure “''-x''” — but that “''-x''” exposure corresponds to a “+''x''” exposure the dealer has already acquired by “[[Delta-hedging|delta hedging]]” in the market.<ref>The dealer may need to borrow money to fund its hedge, but this is exactly what the customer’s floating rate pays for. This is “borrowing on the customer’s behalf”.</ref> It might do this by buying the underlying asset, of futures, or entering into a offsetting swap by which matches off its “long” exposure against another “short” exposure with another counterparty.
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| Customer’s final position is ''+x''.
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| Dealer’s is ''(-x +x)'', or zero.
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| Provided the [[dealer]] knows what it is about, its main risk in running a swap portfolio is not therefore market risk — it should not have any — but ''customer credit'' ''risk''. Should a customer fail, the dealer’s book is no longer matched: its delta-hedge is now an outright long or short position.
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| Hence, having collateral from each customer is important for the dealer. As long as each of the dealer’s other customers it providing it collateral, and the dealer is competently delta-hedging, being paid cash collateral by the dealer is far less important for the customer.
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| Is that the sound of [[Lehman]] [[horcrux]]<nowiki/>es sparking up I hear?
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| ==== Fixed/floating swaps ====
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| {{Quote|{{Script|Nuncle}}: ’Tis none so mincey as a Farrington chop<br>And nowt so [[loansome]] as a fixed rate swap.<ref>Are you ''loansome'' tonight?</ref>
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| :—{{buchstein}}, {{dsh}}
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| }}
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| But are [[synthetic equity swap]]s an odd use case? Aren't other swaps more bilateral, and less “lendy” in nature? What about interest rate swaps? Surely ''paying'' a fixed rate while ''receiving'' a floating rate has none of the characteristics of borrowership and loanery about it?
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| The first point to make here is that in the real universe, ''fixed or floating rate cashflows do exist independently. They always come attached to an asset of some kind''. They are the ''return'' of an investment. In the normal, non swappist world, to get exposure to a rates is to buy a whole principal investment. If you want a floating rate, you put down a hundred bucks and buy a floating rate note. It was only once the [[Children of the Woods|Children of the Forest]] wrought their wristy magic on the [[First Men]] as they fought through the dark [[Bretton Woods|Woods of Bretton]] that the Ways of the [[Single agreement|Single Agreement]] came into common understanding.
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| A swap can have disembodied fixed and floating rates only because, when set against each other, the principal investments they would normally be attached to ''cancel each other out''. The principal investments are there, but they are just ''assumed''.
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| Again, the key is to consider the respective parties’ economic positions before and after trading. The customer does change its net position; the [[dealer]] does not. Swapping a fixed cashflow for a floating one is to ''keep'' the “asset” that funds that cashflow (which logically must be a “fixed-rate asset”), and to acquire a new floating-rate asset in the same principal amount. This is also the principal amount of the implied loan the customer must take out to acquire the floating-rate asset. That being the case, the principal of the floating-rate asset cancels out against the principal of the loan, and the customer left with just the floating rate cashflows, for which it must pay the fixed rate it has agreed. The customer’s position is the present value of the floating rate it has bought minus the present value of the fixed rate of its financing.
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| Without a loan, the customer would have to sell its whole fixed-rate asset and use the proceeds to buy a floating-rate bond from the dealer. That is, pay the principal amount to the dealer, and acquire the interest and principal cashflows of a floating rate asset. Here the customer is not borrowing anything.
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| “But, but, but JC: can’t you see? If you pay someone 100 and they pay you the return of an instrument worth 100 and interest, you have loaned them interest?”
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| Quite so: but that is the nature of a floating-rate bond. It ''is'' a loan. But it is ''not a loan to the dealer''. It is a loan to the issuer of the floating-rate bond. If the dealer is paying you the return of a floating-rate bond you may be assured it has used your money to buy a floating-rate bond, to hedge itself. You have not, net, lent the dealer ''anything''.
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| === On the case for one-way margin ===
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| In recent years — ironically, just as the “dealer” vs “customer” dynamic has become more pronounced<ref>After the [[GFC]], bank proprietary trading fell away to almost nothing.</ref> — the global regulatory-industrial complex,<ref>This label is not just sardonic: there really is a cottage industry of of “regulatory change management professionals”, in-house and out, who owe their last decade’s livelihood to ''accommodating'' quixotic regulatory initiatives like this. They are a powerful lobby with a direct interest in maintaining the rate of regulatory churn.</ref> still fighting last decade’s war, forged rules which overlook this plain asymmetry. Notably, the coordinated worldwide approach to bilateral [[regulatory margin]]. As swap positions move in and out of the market, counterparties must post each other the cash value of the net market movements each day. This is a little like closing positions out at the end of each day and settling up, with a key difference: you ''don’t'' close out your positions. The valuations at which the parties exchange margin are guesstimates. The parties stay on risk.
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| Well — ''one'' of them does — as per the above, the customer has risk; the dealer does not. The customer was the one who initiated the trade, to put itself into a market position of some sort. The dealer didn’t initiate the trade, but accommodated it in the expectation only of commission and on the explicit grounds that its market position would not change and the customer’s credit position would be satisfactory.
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| Requiring margin — even guesstimated margin —from a ''customer'' who is net [[out-of-the-money]] makes sense: if the customer fails, the dealer’s hedges are defeated and it will be have open market exposures to the customer’s positions. From the point of view of systemic risk, the last thing anyone wants is a dealer whose hedges fail. That is when it can go bust. So, daily [[variation margin]] ''to the dealer'' mitigates that risk to date; [[initial margin]] covers it for the future, should the dealer have to close out hedges against a defaulting customer.
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| As long as the dealer is covered, there will be minimal market disruption and the dealer’s own solvency is not threatened.
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| But requiring a ''dealer'' to post margin to its customer to cover the customer’s net in-the-money positions makes no sense whatsoever.
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| First, customers — and here I mean [[buy-side]] market participants ''who do not themselves post systemic risk''<ref>There are different considerations for those who do pose systemic risk, but these should be dealt with by equivalent capital regulation and limitations on leverage and so on: in a perfect world, buy-side entities would never get so big as to pose systemic risk.</ref> — are trading on their capital, dealers are not.<ref>Dealers hold capital primarily against counterparty failure, remember, not market risk itself: absent counterparty failure they should have none.</ref> They ''willingly'' put themselves in “harm’s way” in the hopeful expectation of a return on their equity. Dealers do not. ''Customers take risk'': that is what they are there for. Except through customer misadventure, ''dealers do not''.
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| Of course, dealers ''do'' present some risk of insolvency, and customers should only tolerate so much exposure to that risk, but the customer has other levers to manage it. They can close out their positions, take profits and re-establish their position at the current level, or with another dealer, for one thing. If they do that, the dealer can close out its hedge, pass on gains whilst being off risk, and then restrike its hedges and initial margin at the higher level if need be.<ref>A grave factor in [[Credit Suisse]]’s losses on [[Archegos]] was “margin erosion” caused by massive appreciation on its swap positions. While Credit Suisse was unusual in not using “dynamic margining” (which solves the “margin erosion” problem) to its [[Synthetic prime brokerage|synthetic equity derivatives]] book, “static” [[initial margin]] is the rule for other asset classes, and for [[regulatory IM]].</ref> ''This is not the same as paying out the [[mark-to-market]] of a unrealised swap''.
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| To be sure, customers might not ''like'' doing this — realising a taxable gain and having to stump up more [[initial margin]] when re-establishing positions blows the kumara, for sure — but none of these are good reasons for anyone but the customer. Withholding [[variation margin]] on profitable positions gives customers the choice: you can ''either'' keep your position open, but your money with the dealer, avoid tax and live with the “dealer risk”, ''or'' book your gain and get your money back and start again. This encourages prudent behaviour. If nothing else, it incentivises customers to diversify their risk across dealers.
| | In the ISDA there is not — ''necessarily'' — a large “have” indulging a small “have-not” with favours of loaned money, for which it extracts excruciating [[covenant]]s, gives not a jot in return, and enjoys a preferred place amongst the [[customer]]’s many scrapping creditors. |
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| And it does not automatically lever up the customer’s portfolio. For what do we think a customer will ''do'' with all that free cash [[VM]] its dealer keeps sending it? If it was planning to just sit on it, wouldn’t just — ''leave it at the bank''?
| | [[Swaps]], as the [[First Men]] saw them, would not be like that. Not ''necessarily''. |
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| Secondly, [[dealer]]s and [[bank]]s are already capitalised and regulated for systemic risk.<ref>[[Broker/dealer]]s that are not deposit-taking banks are more lightly capitalised. But nor — for that very reason — can they hold customer assets and cash on their balance sheet, but must hold it on trust for customers with a client money bank that ''is'' capital regulated.</ref> There are already constraints on how they must operate, and how much capital they must hold against the contingency of portfolio losses. Dealers hold this capital, in large part, to protect against the risks presented to them ''by customers''. Customers like thinly capitalised, highly-levered, investment funds. If no customer ever fails, nor will a delta-hedging dealer.
| | “A swap shall be an exchange among peers: an equal-opportunity, righteous sort of thing under whose auspices, one is neither lender nor borrower, but simply an honest rival for the favour of Lady Fortune, however capricious may she be. Those who ''swap'' things are not master and servant, but ''rivals''. |
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| That risk is amplified if dealers must pay away their own cash to reflecting their customers’ unrealised gains on a derivative portfolio ''already 70% financed by the dealer''. It’s just mad: “Hi. You already owe me 70% of the value of the stock you bought largely with my money, and you want ''me'' to pay you margin if the stock goes up?”
| | “Let us call them ''Counterparties''.” |
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| This is all the more mad if the dealer is hedging with a physical asset. ''No-one pays variation margin on gains on a physical asset''.<ref>Dealers can, and do, manage this by financing their physical portfolios. They would do this anyway, but variation margin requirements more or less oblige then to.</ref> | | This foundation myth imagines “swaps” in a pure, innocent, trading-bubble-gum-cards-in-the-playground way. |
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| Now you might make the case, and some have,<ref>Notably Gerd Gigerenzer, who has tracked the expansion in length of the Basel accords against the persistent rate of bank failure.</ref> that capital regulation has been a bit of disaster, but one lot of crappy regulations is not a prescription for ''more'' crappy regulations. Even if, as in this case, the new regulations were also proposed by the Basel committee too.
| | “I have two Emerson Fittipaldis, you have two Mario Andrettis, we can increase each other’s net happiness and thereby the world’s by swapping so we both have one of each.” |
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| For this is ''exactly'' what bilateral variation margin does. Capital is the measure of “unallocated cash” available to meet the claims of general creditors. Cash being fungible, ''any'' cash on the balance sheet counts towards the capital ratio. A counterparty with an uncollateralised paper gain of $100m against a dealer still has a claim to that $100m: it can close out at any time, and even if the dealer fails first ''it still has a claim on that amount from the dealer’s capital reserves''. It is just lining up with other creditors who also have claims.
| | In the playground there are no brokers or dealers of bubble gum cards to intermediate, make markets and provide liquidity, let alone a trusted central clearer. It is a peer-to-peer, decentralised marketplace.<ref>Oh, wait. Hang on. There ''was''. It was Peason Minor in 3B. That made a two-way market in foopballers, F1 drivers and Top Trumps military planes and supercars. That guy was incredible. Wonder what he’s doing now. [''CIO at GSAM — Ed.''] Okay so most metaphors don’t bear close examination.</ref> |
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| ==== Other dumb use cases ====
| | And, to be sure, swaps ''are'' different from [[loan]]s and brokerage arrangements. They start “at market”, where all is square. Either party may be long or short, fixed or floating: at the moment the trade is struck, the world infused with glorious possibility. |
| And leaving aside the risk consequences of bilateral variation margin, don’t forget the ''operational hassle'' it presents. The financial system is complicated enough without gobs of cash flying to and fro just to offset changing risk positions on principal contracts. All other things being equal, it would be better not to post margin than to post it. | |
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| If we accept for a minute dealers shouldn’t have to margin customers without good reason, we notice a class of transactions in which customers presents ''no'' risk to the system at all but, because of the bilaterality of margin regulations, they are obliged to receive, and then return, daily margin anyway. These are fully-paid option contracts. Here, the customer pays its premium up front. Anything it can be liable for, it pays at inception. Thereafter, worst case, the option expires out-of-the-money and the customer gets nothing.
| | One fellow’s fortunes may rise or fall relative to the other’s and, as a result, she may ''owe'' (in the vernacular, be “[[out-of-the-money]]”) or ''be owed'' (“[[in-the-money]]”) at different times as the transaction wends its way to maturity. |
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| But if the option trades into the money, the dealer is obliged to pay variation margin to the customer.
| | Covenants, collateral, credit support and so on may, thereby, flow either way. They may flow ''both'' ways. In our time of [[regulatory margin]], they usually do. |
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| Not only is this counterproductive to the interests of systemic stability, as per the above, but it also means the customer has to get involved with margining and cash management, because it will have to post this excess margin back to the dealer if the position moves back the other way. This is operational faff for no good reason.
| | And swaps, too, are the preserve of professional investors, who know what they are doing. Usually, they know it better than the bank employees they face, having once themselves ''been'' bank employees. Mums and dads, [[Belgian dentist]]s and the like may take loans, buy bonds, have a flutter on the share market and even trade cryptocurrencies but they don’t, and never have, entered {{isdama}}s.<ref>They may trade [[contracts for difference]] and make spread bets with brokers, but these are standardised, smaller contracts.</ref> The ISDA is for grown-ups. Equals. |
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| ===Voluntary margin===
| | So much so that, other than below the dotted lines where you type the counterparty names, the pre-printed part of {{isdama}} itself does not even use the expressions “{{isdaprov|Party A}}” or “{{isdaprov|Party B}}”. Being genuinely bilateral, it never has to. |
| Now, none of this stops a dealer recognising the “equity” in a customer’s unrealised [[mark-to-market]] gains and lending against it. This is what [[Margin lending|margin lenders]] and physical prime brokers do every day of the week. But this kind of lending is ''discretionary''. Dealers don’t have to do it, and if they do, they can apply whatever [[haircut]]<nowiki/>s, credit terms and diversification criteria they like.
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| As a customer’s unrealised profit increases in value, you would expect the dealer’s lending appetite to diminish. But regulatory VM rules ''force'' the dealer to lend in full, and in cash. Imagine if retail banks were forced to cash collateralise mortgage customers the value of unrealised gains on their properties!
| | Party-specific labels are only needed once the studied symmetry of the Master Agreement gives way to the need, articulated in in the {{isdaprov|Schedule}} and {{isdaprov|Confirmation}}s, to stipulate who is taking which side on a given trade, giving which covenant or submitting to which {{isdaprov|Additional Termination Event}}. |
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| “But, but, but, JC: there is a difference. A mortgage customer ''owns'' her house. She has no credit exposure to the bank for the house. If the bank fails, the customer keeps the house. With a swap, the dealer owns the hedge. If it fails, the customer would lose everything.”
| | The parties may be equals, but we still need to know who is going to pay the [[fixed rate]] and who the [[Floating rate|floating]]; which thresholds, maxima, minima, covenants, details, agents and terms apply to which party. This much is necessarily different. Nothing beyond: the {{isdama}} assumes you already know who is who, having agreed it in the {{isdaprov|Schedule}}. |
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| All this is true. But, equally, the customer’s personal capital outlay for that house — her real investment — is small. A house is a levered play. A customer might technically “own” her house, but only in the very contingent sense that she keeps up her mortgage payments. ''She only owns the house as long as the bank gets its money''.
| | So we agree: for this swap trading relationship we will call you “Party B”, and me “Party A”. Beyond these colourless labels, we are equal. |
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| The same is true of an equity swap. It is, as above, an implied loan. The customer puts down initial margin — economically equivalent to a deposit — and gets a levered return on the whole asset. The dealer earns only its commission on the opening and closing of the trade and, because it is funding its own hedge, takes a funding rate from the customer. Economically, the dealer has lent 70% of the initial value of the asset. If the customer wants to isolate its exposure to the dealer for its equity, it can take out a margin loan against a physical asset, just like a mortgage. Or it could close out its trade, take its profit and restrike par with the dealer.
| | But they are maddeningly forgettable labels: harking from a time where the idea of “find and replace all” in an electronic document seemed like [[Tipp-Ex]]-denying, devilish magic. It might have been easier — and saved some curial angst— had parties been able to use ''unique'' identifying labels across their agreement portfolios. |
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| [[Buy-side]] counterparties are, [[Q.E.D.]], sophisticated professionals.<ref>They don’t get through onboarding if they are not. Sophistication is a condition to entry to the game.</ref> They have the tools, resources and skills to monitor their dealers’ credit standing. It is a ''much'' better discipline for them to prudently manage their own dealer credit exposure than to have dealers send them hard cash so they don’t have to. Their failure shouldn’t, typically, be a systemic risk unless their unusually size, interconnectedness or unintended system effects ''make'' them systematically important, in which case they should be regulated if they are systemically important, and made to hold capital, and (b) they have the market position and bargaining power to negotiate margin terms.
| | {{Quote|It was, I am afraid, a rather sloppily drafted document. First, it described LBIE as Party A and LBF as Party B, contrary to the Schedule which gave them the opposite descriptions. |
| | :—Briggs, J, in ''Lehman Brothers International (Europe) v. Lehman Brothers Finance S.A.'' [2012] EWHC 1072 (Ch)}} |
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| Every dollar of margin a dealer pays to one customer reduces the capital it has available for everyone else. Dealer margin is a preference to that creditor over others. Daily [[mark-to-market]] moves are ''mainly'' ''noise''. Signal emerges only over time. A great deal of the back-and-forth of variation margin is, therefore, ''accommodating noise''. The signal only emerges over a prolonged duration. Over the short run posted collateral can, as we know a system effect: if I double down on an illiquid position, it will tend to rise, and I will get more margin, and — this is the story of [[Archegos]].
| | Being ''so'' generic, the “Party A” and “Party B” labels can lead to practical difficulties: a [[dealer]] with thirty thousand counterparties wants to be “Party A” every time, just for peace of mind and literary continuity when perusing its collection of Schedules, as we know [[dealer]]s on occasion are minded to do.<ref>They are not.</ref> This is not just a matter of having to play in your “away strip” every now and then: if, here and there, a dealer must be “Party B”, having lost the toss to a counterparty who also insists on being Party A, this can lead to anxious moments, should one have momentarily forgotten the switch during the negotiation and assigned your carefully-argued infinite [[IM]] {{csaprov|Threshold}} to the other guy. |
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| The systemic risk caused by interconnected financial institutions failing — which is what the margin regs were designed to address — is not caused by the banks themselves, but by their customer exposures. Dealer risk is a function of customer failures, which in turn are a function of leverage. Paying variation margin to customers invites more leverage.
| | Frights like this are quite energising, if you pick them up during the “four eyes check” at the conclusion of [[onboarding]].<ref>You won’t.</ref> Less so, when Briggs J catches them for you when handing down a judgment from the commercial division of the High Court.<ref>He will.</ref> |
Bilateral
/ˌbaɪˈlætᵊrᵊl/ (adj.)
Having, or relating to, two sides; affecting both sides equally.
In this episode JC considers the “bilateral” nature of the ISDA Master Agreement, why swap participants alone amongst financial players are called “counterparties”, and what this confusing “Party A” and “Party B” business is all about.
The unpresumptuous way it labels the parties to a Transaction sets the ISDA apart from its fellow finance contracts. They give it a sort of otherworldly aloofness; a sense of utopian equality. Other finance contracts label their participants to make it clear who, in the power structure, is who: a loan has a “Lender” — the bank; always the master — and a “Borrower” — the punter; always the servant. A brokerage agreement has a “Broker” (master) and a “Customer” (servant).
Okay, I know theoretically the master/servant dynamic is meant to be the other way around — the customer is king and everything — but come on: when it comes to finance it isn’t, is it? We are users, all hooked up to the great battery grid, for the pleasure of our banking overlords and the pan-dimensional mice who control them.
But not when it comes to the ISDA Master Agreement. From the outset, the First Men who framed it opted for the more gnomic, interchangeable and equal labels “Party A” and “Party B”.
Why? Well, we learn it from our supervising associate, when we first encounter a Schedule.
Bilaterality.
Bilaterality
Abelief in even-handedness gripped the ones whose deep magic forged the runes of that ancient First Swap. It has not just a two-sided structure — most private contractual arrangements have that — but a symmetrical one, lacking the dominance and subservience that traditional finance contracts imply.
In the ISDA there is not — necessarily — a large “have” indulging a small “have-not” with favours of loaned money, for which it extracts excruciating covenants, gives not a jot in return, and enjoys a preferred place amongst the customer’s many scrapping creditors.
Swaps, as the First Men saw them, would not be like that. Not necessarily.
“A swap shall be an exchange among peers: an equal-opportunity, righteous sort of thing under whose auspices, one is neither lender nor borrower, but simply an honest rival for the favour of Lady Fortune, however capricious may she be. Those who swap things are not master and servant, but rivals.
“Let us call them Counterparties.”
This foundation myth imagines “swaps” in a pure, innocent, trading-bubble-gum-cards-in-the-playground way.
“I have two Emerson Fittipaldis, you have two Mario Andrettis, we can increase each other’s net happiness and thereby the world’s by swapping so we both have one of each.”
In the playground there are no brokers or dealers of bubble gum cards to intermediate, make markets and provide liquidity, let alone a trusted central clearer. It is a peer-to-peer, decentralised marketplace.[1]
And, to be sure, swaps are different from loans and brokerage arrangements. They start “at market”, where all is square. Either party may be long or short, fixed or floating: at the moment the trade is struck, the world infused with glorious possibility.
One fellow’s fortunes may rise or fall relative to the other’s and, as a result, she may owe (in the vernacular, be “out-of-the-money”) or be owed (“in-the-money”) at different times as the transaction wends its way to maturity.
Covenants, collateral, credit support and so on may, thereby, flow either way. They may flow both ways. In our time of regulatory margin, they usually do.
And swaps, too, are the preserve of professional investors, who know what they are doing. Usually, they know it better than the bank employees they face, having once themselves been bank employees. Mums and dads, Belgian dentists and the like may take loans, buy bonds, have a flutter on the share market and even trade cryptocurrencies but they don’t, and never have, entered ISDA Master Agreements.[2] The ISDA is for grown-ups. Equals.
So much so that, other than below the dotted lines where you type the counterparty names, the pre-printed part of ISDA Master Agreement itself does not even use the expressions “Party A” or “Party B”. Being genuinely bilateral, it never has to.
Party-specific labels are only needed once the studied symmetry of the Master Agreement gives way to the need, articulated in in the Schedule and Confirmations, to stipulate who is taking which side on a given trade, giving which covenant or submitting to which Additional Termination Event.
The parties may be equals, but we still need to know who is going to pay the fixed rate and who the floating; which thresholds, maxima, minima, covenants, details, agents and terms apply to which party. This much is necessarily different. Nothing beyond: the ISDA Master Agreement assumes you already know who is who, having agreed it in the Schedule.
So we agree: for this swap trading relationship we will call you “Party B”, and me “Party A”. Beyond these colourless labels, we are equal.
But they are maddeningly forgettable labels: harking from a time where the idea of “find and replace all” in an electronic document seemed like Tipp-Ex-denying, devilish magic. It might have been easier — and saved some curial angst— had parties been able to use unique identifying labels across their agreement portfolios.
It was, I am afraid, a rather sloppily drafted document. First, it described LBIE as Party A and LBF as Party B, contrary to the Schedule which gave them the opposite descriptions.
- —Briggs, J, in Lehman Brothers International (Europe) v. Lehman Brothers Finance S.A. [2012] EWHC 1072 (Ch)
Being so generic, the “Party A” and “Party B” labels can lead to practical difficulties: a dealer with thirty thousand counterparties wants to be “Party A” every time, just for peace of mind and literary continuity when perusing its collection of Schedules, as we know dealers on occasion are minded to do.[3] This is not just a matter of having to play in your “away strip” every now and then: if, here and there, a dealer must be “Party B”, having lost the toss to a counterparty who also insists on being Party A, this can lead to anxious moments, should one have momentarily forgotten the switch during the negotiation and assigned your carefully-argued infinite IM Threshold to the other guy.
Frights like this are quite energising, if you pick them up during the “four eyes check” at the conclusion of onboarding.[4] Less so, when Briggs J catches them for you when handing down a judgment from the commercial division of the High Court.[5]
- ↑ Oh, wait. Hang on. There was. It was Peason Minor in 3B. That made a two-way market in foopballers, F1 drivers and Top Trumps military planes and supercars. That guy was incredible. Wonder what he’s doing now. [CIO at GSAM — Ed.] Okay so most metaphors don’t bear close examination.
- ↑ They may trade contracts for difference and make spread bets with brokers, but these are standardised, smaller contracts.
- ↑ They are not.
- ↑ You won’t.
- ↑ He will.