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{{quote|{{D|Bilateral|/ˌbaɪˈlætᵊrᵊl/|adj}}Having, or relating to, two sides; affecting both sides equally.}}
{{quote|{{D|Bilateral|/ˌbaɪˈlætᵊrᵊl/|adj}}Having, or relating to, two sides; affecting both sides equally.}}


{{smallcaps|[[Party A and Party B - ISDA Provision|In this episode]]}} of the JC’s series of deep explorations of superficial things in the [[ISDA]] metaverse, we 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]]”.  
{{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.  


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).  
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).  


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}}”.
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.


Why? Well, we learn it from our first encounter of an ISDA Schedule. ''[[The bilaterality, or not, of the ISDA|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}}”.


===Bilaterality===
Why? Well, we learn it from our supervising associate, when we first encounter a [[Schedule - ISDA Provision|Schedule]].  
{{smallcaps|A belief in}} even-handedness gripped the ones whose [[deep magic]] forged the runes from which the [[First Swap]] was born.  


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.
''[[The bilaterality, or not, of the ISDA|Bilaterality]]''.


But [[swaps]], as the [[First Men]] saw them, are not like that.
===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.  
“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.
 
“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.
 
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>
 
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}}.
 
So we agree: for this relationship we will call you “Party B”, and me “Party A”.
 
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.
 
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.
You quickly get over them when you realise it is your error of construal, not the negotiator’s of articulation.
 
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''.
 
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”.


This thought grew and grew and now there is a [[A swap as a loan|whole new article about it]].
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.
====“BINO” — bilateral in name only====
{{smallcaps|But except for}} that a class of [[Inter-dealer|inter-dealer]] swap relationships, {{isdama}}s are “bilateral” only really in ''name'': one party — the [[swap dealer]], provides exposures to another, the customer, who consumes them. The customer provides the impulse to trade; the customer elects when to exercise options and terminate positions. The [[dealer]] hedges, calculates values and is burdened with additional [[regulatory capital]] charges if it doesn’t get its [[close-out netting]] right.


This has led to two kinds of bother: first, a bit of a squabble as to who gets to be Party A and who Party B; since [[swap dealer]]s set up their templates to assume ''they'' will be Party A and their customers Party B, when immovable object meets irresistible force it can spark an unseemly dispute from which the dealer will inevitably have to back down. At least one swap dealer solved this problem by deciding to be “Party B” as standard. This only confused clients who were unused to being “Party A”.  
[[Swaps]], as the [[First Men]] saw them, would not be like that. Not ''necessarily''.


Furthermore, when labouring over some neatly [[iatrogenic]] [[co-calculation agent]] fallback dispute mechanism — and be assured, you will spend far more time doing this than can ever be justified by your reward, in heaven or on earth, for doing so — it is easy to get your “[[Party A]]s” and “[[Party B]]s” mixed up. Doing so buries, deep in the [[fossil record]], a technical deficiency that may go entirely unrecognised for ''decades''.  
“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''.  


Roll forward eighteen years. The world is again on the brink of financial [[Apocalypse]]. The customer is now a [[systemically important financial institution|systemically-important]] leviathan, largely thanks to years of optimistically lax credit sanctioning. But suddenly, it is teetering. The [[Credit officer|chief credit officer]] runs about with her hair on fire and for the first time, ''everyone is staring forensically at the docs''. Suddenly that co-calculation agent fallback dispute mechanism is all that stands between the firm and a three billion dollar abyss. And guess what? ''Some clot transposed Party A and Party B''.
“Let us call them ''Counterparties''.”


====The real distinction: [[dealer]] and [[customer]]====
This foundation myth imagines “swaps” in a pure, innocent, trading-bubble-gum-cards-in-the-playground way.  
{{smallcaps|Beyond that small}} class of [[inter-dealer]] swap contracts that make up a dealer’s funding and hedging programme — there ''is'' a material distinction between the parties to an swap contract. The asymmetry comes not from whether one is [[long]] or [[short]], or buyer or seller, but from who is ''customer'' and who is ''dealer''.


A customer or “[[end user]]” uses the {{isdama}} to ''change'' its absolute exposure to a given risk or underlier. To take, or lay off, a risk.
“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.”


A [[dealer]] uses the {{isdama}} to earn a [[commission]]. It does this, yes, by providing its customers a changed absolute exposure, but at the same time carefully hedges that exposure so that, but for those fees, the dealer is market ''flat''. Now, it is the nature of the beast that a dealer can’t always ''stay'' market flat: it is too dependent upon the performance of its customers, counterparties and models for that — but this is not for want of trying. The {{isdama}} is as much a borrower/lender arrangement as most other banking arrangements. See [[a swap as a loan|the JC’s long-form essay]] about this.
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>


In any case, almost all {{isdama}}s will be between a ''customer'' and a ''dealer''. A few will be [[inter-dealer]]. Almost ''none'' will be inter-customer.<ref>I know, I know: the first ever swap was, though, right?</ref>
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.


====Why does it matter?====
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.
{{smallcaps|What is in}} a name?


This may be to draw a long bow, but you could argue that emphasising bilaterality has led the regulatory dance into the wrong corner of the dancefloor. The JC does.
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.


The logic is this: this is a contract of equals. Each poses an equal, but offsetting, risk to the other. Therefore credit concern cuts both ways, so any regulatory impositions should — ''must'' — also apply both ways.
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.


And so we have seen: [[swap dealer]]s have to post [[Regulatory initial margin|regulatory initial]] and [[Variation margin|variation margin]] to their customers, just the same way their customers must post it to them.
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.  


''But this is nuts''. Swap dealers are regulated financial institutions providing a service for a fixed commission. When dealing they don’t take on outright market positions. They must hold [[regulatory capital]] against their dealing activity. That this means of managing systemic risk hasn’t always ''worked'' fabulously well is not the point: the principle is sensible: ensure financial institutions are sound by obliging them to ''hold on'' to money, rather than making them give it away.
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}}.  


And a customer who frets about its outsized exposure to a dealer has a ready solution: ''move its business away''. Diversifying the portfolio encourages competition in the market and introduces a healthy redundancy.<ref>In “[[Normal Accidents: Living with High-Risk Technologies|normal accidents]]” terminology financial markets are [[Tight coupling|tightly-coupled]], [[Complexity|non-linear]] systems where “slack” loosens that coupling and reduces the risk of catastrophic failure.</ref> Overall, encouraging customers to limit their outright exposure to dealers enhances the market’s overall resilience.  
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}}.


Obliging dealers to [[Variation margin|cash-collateralise]] customers’ open positions creates the ''opposite'' incentives. Customers are encouraged not to diversify their risk, but to concentrate it, with the [[dealer]]s offering the most aggressive margin rates. And the dealer market is competitive to the point of being paranoid, as we learned from [[Archegos]]. Dealers will cut their required margins to the bone, thereby increasing their risk of loss.
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.


By contrast, [[end user]]s are not regulated. They are often thinly capitalised funds, trading with leverage on someone else’s money: guess who? ''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.  


The real source of systemic [[dealer]] risk, is the [[Second-order derivative|second-order risk]] presented by the dealer’s ''customers'' blowing up.
{{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)}}


This is a situation a dealer is more likely to get itself into if it has to pay away wodges of regulatory margin to collateralise un-realised customer gains, giving those customers, already betting with the broker’s money, even more of it. We have a separate essay on this: See ''[[when variation margin attacks]]''.
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.


Might the market have gravitated this way were it not for our fiction of pretending this is a bilateral relationship?
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>

Latest revision as of 09:38, 4 February 2024

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]

  1. ↑ 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.
  2. ↑ They may trade contracts for difference and make spread bets with brokers, but these are standardised, smaller contracts.
  3. ↑ They are not.
  4. ↑ You won’t.
  5. ↑ He will.
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