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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.}}


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.  


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).  


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.


===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.  


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]].  


But [[swaps]], as the [[First Men]] saw them, are not like that.  
''[[The bilaterality, or not, of the ISDA|Bilaterality]]''.


“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.
 
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 buy bonds, but they din’t, and never have, entered {{isdama}}s.<ref>They may enter [[contracts for difference]] and spread bets from 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. The labels are arbitrary assignations that apply at trade level. Thus, they only appear 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''.
 
===''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 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”.
 
We should not let ourselves forget: 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 preponderance of all ISDA arrangements. The ''customer'' and a ''dealer'' roles are different. They do not depend on who is “long” and who “short”, or who pays the fixed rate and who the floating. Hence the expressions “[[sell side|sell-side]]” — the dealers, who sell exposure — and “[[buy side|buy-side]]” — their customers, who buy it.  


For a customer, the object of trading a swap is somehow to ''change'' its market exposure: to get into a positions it did not have before.  
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.


For a dealer, the object of trading a swap is to earn a commission ''without'' changing its market exposure. Seeing as providing swap exposure to a customer necessarily changes the dealer’s market exposure, the dealer must then “delta hedge” that position by taking on an equal and offsetting position somewhere else. There are many ways of doing this: the most straightforward is to simply buy (or [[Short sell|short]]) the underlying asset; but a dealer may equally hedge its market risk on one customer’s “long” swap position by matching it off with another customer’s “short” swap position in the same underlying asset.  
[[Swaps]], as the [[First Men]] saw them, would not be like that. Not ''necessarily''.


In any case, the basic idea of swap dealing, as with any kind of brokerage, is for the dealer to be as far as possible “market neutral”. Provided the dealer knows what it is about, its main risk in running a swap portfolio is therefore not market risk but ''counterparty'' risk. This, as we have seen repeatedly, is a big risk. Hence, adequate collateralisation is very important to dealers.
“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''.  


===== Swaps are usually synthetic loans =====
“Let us call them ''Counterparties''.”


But how does this translate into a synthetic loan? Well, consider what happens in the case of an actual loan.
This foundation myth imagines “swaps” in a pure, innocent, trading-bubble-gum-cards-in-the-playground way.  


{{Quote|{{divhelvetica|
“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.”
====Scenario====
[[Hackthorn Capital Partners]] owns USD10m of [[Lexrifyly]] and wishes to buy USD10m of Stock [[Cryptöagle]]. It can either: '''sell''' Lexrifyly and use the proceeds to buy Cryptöagle, or '''keep''' Lexrifyly, borrow USD10m and use that to buy Cryptöagle.
=====Sale=====
If it sells Lexrifyly, Hackthorn’s position is as follows:
:Sold: 10m Lexrifyly
:Borrowed: -
:Amount owed: -
:Bought: 10m of Cryptöagle
:Amount due: [[total return swap|total return]] on 10m Cryptöagle
=====Loan=====
If it keeps Lexrifyly and borrows money, Hackthorn’s position is as follows:
:Sold: -
:Borrowed: USD10m
:Amount owed: Floating Rate USD 10m
:Bought 10m of Cryptöagle
:Amount due: [[total return swap|total return]] on 10m Lexrifyly and 10m Cryptöagle}}}}


Note the cashflows in the loan scenario: Pay Floating Rate on 10m, receive total return on Cryptöagle. These are the same cashflows you would expect under a delta-one equity derivative on [[Cryptöagle]]. Like a loan, an equity swap allows a customer to create a new exposure to [[Cryptöagle]] while not giving up its existing portfolio of exposures, which it would have to do if it were to buy Cryptöagle outright.  
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>


were it t by paying you a rate I am deploying my capital assets to gain access to a new capital asset, without having to get rid of the old one. Me paying a fixed rate implies I have a corresponding asset which will finance my swap payments. I am able to hold on to that and get synthetic exposure to a new asset paying say a floating rate, because my dealer has funded that asset for me.
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.  


Isn't that also true of the dealer? No, generally not, because the dealer itself will be hedged. To pay your return it will have an offsetting transaction. It is not “keeping“ that floating rate risk, but offsetting it, perhaps with another client position.
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.  


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” 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, has forged rules which overlook this.
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.


A notable example is the coordinated worldwide approach to regulatory margin.
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.


Banks are independently capital regulated for solvency.
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.  


Swap counterparties are sophisticated professionals with the tools and resources to monitor credit exposure to their brokers. (We take it that the [[financial weapons of mass destruction]] that these sophisticates truck in require more expertise than does weighing up the likely failure of a regulated financial institution).
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}}.  


It is a much better discipline for sophisticated counterparts to manage their credit exposure — spread it around, so to speak, than to require their banks to send hard cash out the door as collateral to clients with outsized exposures.  
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}}.


Every dollar these banks pay away reduces the capital buffer the bank has available for everyone else.  It also provides the customer with free money on an unrealised [[mark-to-market]] position. This is like paying out while the roulette wheel is still spinning, in the expectation of where the ball might land. That is a loan: if the customer doubles down and loses, you don’t get your money back.  
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.


Daily mark to market moves are mainly noise. Yet this is what we collateralise. The signal 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]].
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.  


***
{{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)}}


The increased systemic exposure of banks failing — which is what the margin regs were designed to address — is not caused by the banks themselves, but by their client exposures. Client exposures in turn are a function of client failures, which are in turn a function of leverage
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.


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.
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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