Template:M intro isda on termination: Difference between revisions

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Created page with "{{drop|T|here is no}} more sacred time in the life of a commercial arrangement than our departure from its earthly clutch. We wish our relationships well, pray for their long life and a peaceful ultimate transition from them into the hereafter, but we know this is not always possible. Commerce gives the lie to the idea that life is a zero-sum game. We will only strike a bargain if, on our own terms, each of us will be better off afterwards. That being the case, there n..."
 
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{{drop|T|here is no}} more sacred time in the life of a commercial arrangement than our departure from its earthly clutch. We wish our relationships well, pray for their long life and a peaceful ultimate transition from them into the hereafter, but we know this is not always possible.  
{{drop|C|ommerce gives the}} lie to the idea that life is a [[zero-sum game]]. This was [[Adam Smith]]’s great liberating insight: life need not be [[Thomas Hobbes|nasty, brutish and short]] after all. Each of us will only strike a bargain if, on our own terms, we will be better off as a result. That being the case, there need is no logical to a commercial relationship: it is an [[infinite game]]. If we are flexible enough, open-minded enough, and good enough at playing [[Finite and Infinite Games|infinite games]] we can keep this positive feedback loop going indefinitely. ''Infinitely'', even.  


Commerce gives the lie to the idea that life is a zero-sum game. We will only strike a bargain if, on our own terms, each of us will be better off afterwards. That being the case, there need be no end to a commercial relationship: if we are flexible enough, open-minded enough, and good enough at playing [[Finite and Infinite Games|the infinite game]] we can keep this positive feedback loop going indefinitely. Infinitely, even.  
Therefore, we wish our relationships well, pray for them godspeed for a long life and, should it come to it, a peaceful ultimate transition from the flush of vital ardour into the restful stasis of the hereafter, but we know this is not always possible. Things do not always work out.


But things do not always work out. Therefore, we pack our trunk with tools and weapons with which, if needed, we can engineer an exit.  
Therefore, we pack our trunk with tools and weapons with which, if needed, we can engineer an exit. There is no more sacred time in the life of our commercial arrangements than our departure from their earthly clutch. But we do not talk about it enough. Below, JC comes over all over-analytical and counts the ways we do this.


====Customers and service providers====
====Customers and service providers====
{{drop|N|ow the great}} majority of [[financial contract]]s are between a “provider” on one side — a bank, broker or dealer who provides money outright, against an asset, or an exposure to an asset — and a “customer” on the other. And the customer is always king: these arrangements exist for the customer’s major benefit: the provider’s net interest is limited to flattening its financial exposure under the contract and earning a [[fee]], [[commission]] or economic [[rent]] of some kind.
{{drop|N|ow the great}} majority of [[financial contract]]s are between a “provider” on one side — a [[bank]], [[broker]] or [[dealer]] who provides a ''service'', broadly described: money outright, finance against an asset, or a financial exposure — and a “customer” on the other who buys that service. The customer is, as ever, king: the services exist for its benefit exclusively: the provider’s net interest is limited to managing the financial exposure that comes from providing that service, and taking some kind of [[fee]], [[commission]] or economic [[rent]] on top of that by way of consideration.  


Generally, the customer can always exit a financial contract whenever it wants by paying outstanding fees and whatever the provider needs to terminate the arrangements it made to provide the service rendered — its hedge break costs. This makes the whole business worth the provider’s while.
Providers do not mean to be economically “the other side” of the services they provide. They are, loosely, ''intermediaries''. Agents. They do not take a direct opposite exposure. All being well, they are indifferent to how well the instruments they provide perform — so, as long as they manage the risks of providing their services, they should not need to ''terminate'' them and indeed should want to keep them going, seeing how that is how they earn a crust.
 
So expectations on either side of a service contract are different: the customer has market risk and it is her prerogative to go ''off'' risk as she sees fit. She can exit whenever she wants, by paying the provider’s outstanding fees and whatever it needs to terminate the arrangements it made to provide the service rendered — its “[[breakage costs]]”.
 
But [[ceteris paribus|all else being equal]], the provider ''cannot'' just exit without the customer’s permission. A [[financial contract]] with a fixed term, therefore, binds the ''provider'' but not the ''customer'' to that term.
 
But things can change. The customer’s financial outlook may darken. She may not be as good as her word. The regulatory environment may change, making the services harder or more expensive to provide.
 
Hence, the provider must have a set of “weapons” it can use to get out of such a term arrangement where it can no longer be sure of its expected return. These fall into a bunch of different categories, as we shall see:


But, [[ceteris paribus|all else being equal]], the provider ''cannot'' just exit without the customer’s permission. In as much as a [[financial contract]] has a fixed term, therefore, it binds the ''provider'' and not the ''customer''. Hence, the provider must have a suite of weapons it can use to get out of a [[financial contract]] where it can no longer vouchsafe its expected financial return. These fall into a bunch of different categories.
====Categories of termination====
====Categories of termination====
We would put these “exit scenarios” into three categories: terminations “''without cause''”<ref>You hear these described as “no-fault” terminations, but there is no ''fault'' in a termination brought about by unforeseen externalities, either.</ref> terminations due to ''unforeseen external events''; and terminations due to ''counterparty failure''. This last category — which we might also label “default” — in turn breaks into two: ''non-performance'' and ''credit deterioration''. There is also an odd category of ''pseudo''-termination rights that a dealer must have, but would never insist on using and, curiously, relate to concerns about its ''own'' solvency.
We would put these “termination scenarios” into three categories: “''without cause''”<ref>You hear these described as “no-fault” terminations, but there is no ''fault'' in a termination brought about by unforeseen externalities, either.</ref>; ''unforeseen external events'' and ''counterparty failure''. This last category — which we might also label “default” — in turn breaks into two: ''direct misbehaviour'' and ''indirect credit deterioration''.  
 
There is also an odd category of ''pseudo''-termination rights that some regulated financial institutions must have, but would never intend to use which, curiously, relate to concerns about its ''own'' solvency.
 
=====“Without cause”=====
{{drop|T|erminations “without cause”}} arise ''just because'' — no fault, no pressing need; just a gradual drifting apart of interests. As we grow in life, the things we value change. Passions of youth dampen, we tend more towards songs of experience than those of innocent exuberance, and we sing those to a different tune. Here we prescribe a notice period long enough to allow our counterparty to make alternative arrangements it needs to keep its own house in order, but otherwise, we wish each other well and carry along on our way. These will generally be “clean-up” rights and they will exist under framework contracts, not specific transactions, and they will be expressed not to impact on the validity of in-flight services.
 
They are mainly of use to clear out low-value and dormant clients from the administrative record: there may be ongoing credit sanctioning or KYC obligations that the firm would rather not have to keep carrying out on a customer that no longer transacts any business.
 
=====“Pseudo-termination rights”=====
{{drop|W|here you do}} see [[dealer]] rights to terminate on notice without cause these will typically be ''pseudo''-termination rights: here a regulated institution must have the power to terminate transactions for formalistic or regulatory capital reasons, even though it never expects to actually use them.<ref>See here {{isdaprov|Automatic Early Termination}}, which is an extreme example of such pseudo termination right: in that it triggers automatically. Much more to say about that on the {{isdaprov|AET}} page.</ref>  For example, a dealer’s right to terminate a [[synthetic equity swap|synthetic equity derivative]] contract on notice. This entitles the dealer to treat the equity derivative exposure as a “short-term obligation” for regulatory purposes — because it could get out, if it wanted to— and this is enough to get optimised regulatory capital treatment. But a dealer ''having'' such a right is a different thing from a dealer ever in its right mind actually ''exercising'' it. It might be ''forced'' to, in the direst of circumstances (where its own survival was threatened) — but in that case — the dealer would be teetering — and the customers would likely long since have moved their positions away in any case.
====“Termination Events”: regrettable, but no-one’s fault====
{{drop|I|t is in}} the nature of uncertainty that unexpected things can happen, Thanks to the machination of events beyond the knowledge or control of either party. [[Force majeure]], [[change in law|changes in law]], changes in [[tax]]ation and [[regulatory capital]] treatment can make the continued provision of a service uneconomic or impractical.
 
These events, under the ISDA framework, are described as {{isdaprov|Termination Event}}s. They typically are measured {{isdaprov|Transaction}}-by-{{isdaprov|Transaction}}, so do not have the necessary consequence of shutting down ''all'' exposure under the agreement in one fell swoop; only under those {{isdaprov|Transaction}}s which are directly [[Affected Transaction - ISDA Provision|affected]].  


Secondly, there is generally more flexibility and leeway granted for the parties to explore workarounds and solutions to avoid having to terminate transactions, seeing as no one is at fault.


=====Without cause=====
Thirdly, the ultimate replacement costs of the transaction will be situated at pure mid-market rather than on the dealer's side of the market, again reflecting the fact that no one is at fault. The suite of ISDA Termination Events have that quality of not being the {{isdaprov|Affected Party}}’s fault as such: {{isdaprov|Illegality}}; {{isdaprov|Force Majeure Event}}; {{isdaprov|Tax Event}}; {{isdaprov|Tax Event Upon Merger}} and {{isdaprov|Credit Event Upon Merger}}.
Terminations without cause: they arise ''just because'' — no fault, no pressing need; just a gradual drifting apart of interests. As we grow in life, the things we value change. Passions of youth dampen, we tend more towards songs of experience than those of innocent exuberance, and we sing those to a different tune. Here we prescribe a notice period long enough to allow our counterparty to make alternative arrangements it needs to keep its own house in order, but otherwise, we wish each other well and carry along on our way.  
====“Default Events”: do we have a problem here?====
=====Pseudo termination rights=====
{{drop|T|hen}} there are termination rights that flow from something untoward about your counterparty. This being a contract, the main category of “untoward facts” about your counterparty will be things it is meant to do under the contract that it has failed to:
There is a fourth category: the ''pseudo''-termination right: this is a right the provider needs for formalistic or regulatory reasons, but which it never expects to actually use. These may include, for example, a dealer’s right to terminate on say 30 days’ notice from a synthetic equity derivative contract — this entitles the dealer to treat the exposure as a “short-term obligation” for regulatory purposes, dramatically reducing its capital cost of offering the business, but it is not aright the dealer would ever expect to exercise except in the direst of circumstances (where its own survival was threatened).

Revision as of 17:00, 28 October 2024

Commerce gives the lie to the idea that life is a zero-sum game. This was Adam Smith’s great liberating insight: life need not be nasty, brutish and short after all. Each of us will only strike a bargain if, on our own terms, we will be better off as a result. That being the case, there need is no logical to a commercial relationship: it is an infinite game. If we are flexible enough, open-minded enough, and good enough at playing infinite games we can keep this positive feedback loop going indefinitely. Infinitely, even.

Therefore, we wish our relationships well, pray for them godspeed for a long life and, should it come to it, a peaceful ultimate transition from the flush of vital ardour into the restful stasis of the hereafter, but we know this is not always possible. Things do not always work out.

Therefore, we pack our trunk with tools and weapons with which, if needed, we can engineer an exit. There is no more sacred time in the life of our commercial arrangements than our departure from their earthly clutch. But we do not talk about it enough. Below, JC comes over all over-analytical and counts the ways we do this.

Customers and service providers

Now the great majority of financial contracts are between a “provider” on one side — a bank, broker or dealer who provides a service, broadly described: money outright, finance against an asset, or a financial exposure — and a “customer” on the other who buys that service. The customer is, as ever, king: the services exist for its benefit exclusively: the provider’s net interest is limited to managing the financial exposure that comes from providing that service, and taking some kind of fee, commission or economic rent on top of that by way of consideration.

Providers do not mean to be economically “the other side” of the services they provide. They are, loosely, intermediaries. Agents. They do not take a direct opposite exposure. All being well, they are indifferent to how well the instruments they provide perform — so, as long as they manage the risks of providing their services, they should not need to terminate them and indeed should want to keep them going, seeing how that is how they earn a crust.

So expectations on either side of a service contract are different: the customer has market risk and it is her prerogative to go off risk as she sees fit. She can exit whenever she wants, by paying the provider’s outstanding fees and whatever it needs to terminate the arrangements it made to provide the service rendered — its “breakage costs”.

But all else being equal, the provider cannot just exit without the customer’s permission. A financial contract with a fixed term, therefore, binds the provider but not the customer to that term.

But things can change. The customer’s financial outlook may darken. She may not be as good as her word. The regulatory environment may change, making the services harder or more expensive to provide.

Hence, the provider must have a set of “weapons” it can use to get out of such a term arrangement where it can no longer be sure of its expected return. These fall into a bunch of different categories, as we shall see:

Categories of termination

We would put these “termination scenarios” into three categories: “without cause[1]; unforeseen external events and counterparty failure. This last category — which we might also label “default” — in turn breaks into two: direct misbehaviour and indirect credit deterioration.

There is also an odd category of pseudo-termination rights that some regulated financial institutions must have, but would never intend to use which, curiously, relate to concerns about its own solvency.

“Without cause”

Terminations “without cause” arise just because — no fault, no pressing need; just a gradual drifting apart of interests. As we grow in life, the things we value change. Passions of youth dampen, we tend more towards songs of experience than those of innocent exuberance, and we sing those to a different tune. Here we prescribe a notice period long enough to allow our counterparty to make alternative arrangements it needs to keep its own house in order, but otherwise, we wish each other well and carry along on our way. These will generally be “clean-up” rights and they will exist under framework contracts, not specific transactions, and they will be expressed not to impact on the validity of in-flight services.

They are mainly of use to clear out low-value and dormant clients from the administrative record: there may be ongoing credit sanctioning or KYC obligations that the firm would rather not have to keep carrying out on a customer that no longer transacts any business.

“Pseudo-termination rights”

Where you do see dealer rights to terminate on notice without cause these will typically be pseudo-termination rights: here a regulated institution must have the power to terminate transactions for formalistic or regulatory capital reasons, even though it never expects to actually use them.[2] For example, a dealer’s right to terminate a synthetic equity derivative contract on notice. This entitles the dealer to treat the equity derivative exposure as a “short-term obligation” for regulatory purposes — because it could get out, if it wanted to— and this is enough to get optimised regulatory capital treatment. But a dealer having such a right is a different thing from a dealer ever in its right mind actually exercising it. It might be forced to, in the direst of circumstances (where its own survival was threatened) — but in that case — the dealer would be teetering — and the customers would likely long since have moved their positions away in any case.

“Termination Events”: regrettable, but no-one’s fault

It is in the nature of uncertainty that unexpected things can happen, Thanks to the machination of events beyond the knowledge or control of either party. Force majeure, changes in law, changes in taxation and regulatory capital treatment can make the continued provision of a service uneconomic or impractical.

These events, under the ISDA framework, are described as Termination Events. They typically are measured Transaction-by-Transaction, so do not have the necessary consequence of shutting down all exposure under the agreement in one fell swoop; only under those Transactions which are directly affected.

Secondly, there is generally more flexibility and leeway granted for the parties to explore workarounds and solutions to avoid having to terminate transactions, seeing as no one is at fault.

Thirdly, the ultimate replacement costs of the transaction will be situated at pure mid-market rather than on the dealer's side of the market, again reflecting the fact that no one is at fault. The suite of ISDA Termination Events have that quality of not being the Affected Party’s fault as such: Illegality; Force Majeure Event; Tax Event; Tax Event Upon Merger and Credit Event Upon Merger.

“Default Events”: do we have a problem here?

Then there are termination rights that flow from something untoward about your counterparty. This being a contract, the main category of “untoward facts” about your counterparty will be things it is meant to do under the contract that it has failed to:

  1. You hear these described as “no-fault” terminations, but there is no fault in a termination brought about by unforeseen externalities, either.
  2. See here Automatic Early Termination, which is an extreme example of such pseudo termination right: in that it triggers automatically. Much more to say about that on the AET page.