Template:M intro isda Party A and Party B

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 ISDA Master Agreement and its curious designators: “Party A” and “Party B”, and that curious descriptor of both of them: “counterparty”.

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).

But not the ISDA Master Agreement. From the outside its framers — the First Men — opted for the more gnomic, interchangeable “Party A” and “Party B”.

Why? Well, we learn it from our first encounter of an ISDA Schedule. Bilaterality.

Bilaterality

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.

But swaps, as the First Men saw them, are not like that.

“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 dentists and the like may take loans and buy bonds, but they don’t, and never have, entered ISDA Master Agreements.

Now the ISDA Master Agreement 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 Schedule and in Confirmations, 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 ISDA Master Agreement assumes you already know who is who, having agreed it in the 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 dealers on occasion are minded to do. 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 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, negotiators 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 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 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”.

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.

“Aha, JC: quite so. But this implies, does it not, that the parties are not lending to each other?”

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.

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.

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.

Swaps are usually synthetic loans

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:

(i) sell Lexrifyly outright and buy Cryptöagle;

(ii) hold Lexrifyly and borrow to buy Cryptöagle;

(iii) hold Lexrifyly and get synthetic exposure to Cryptöagle via a swap.

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:

Outright sale
If it sells its Lexrifyly outright, the position is as follows:

Sold: USD10m Lexrifyly.

Borrowed: Zero.

Amount owed: Zero.

Bought: 10m Cryptöagle.

Net position: 10m Cryptöagle shares + zero Lexrifyly + zero loan

Loan
If it keeps its Lexrifyly and borrows, the position is as follows:

Sold: Zero.

Borrowed: USD10m.

Bought: USD10m Cryptöagle.

Net position: 10m Lexrifyly shares + 10m Cryptöagle shares - USD10m - accrued interest

Swap
If it keeps its Lexrifyly and puts on a swap struck at USD10m, the position is as follows:

Sold: Zero.

Borrowed: Zero.

Swap outgoings: Floating rate on USD10m

Swap incomings: USD10m Cryptöagle - USD10m.

Net position: 10m Lexrifyly shares + 10m Cryptöagle shares - USD10m - accrued interest

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.

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?

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” — the dealers — and “buy-side” — their customers.

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” in the market. 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.

Customer’s final position is +x.

Dealer’s is (-x +x), or zero.

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.

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.

Is that the sound of Lehman horcruxes sparking up I hear?

Fixed/floating swaps

Nuncle: ’Tis none so mincey as a Farrington chop
And nowt so loansome as a fixed rate swap.

—Büchstein, Die Schweizer Heulsuse

But are synthetic equity swaps 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?

The first point to make here is that in the real universe of actual, non-synthetic things, fixed or floating rate cashflows do exist independently. They always come attached to an asset of some kind. They are the return on an investment of principal. In the normal, non-swappist world, to get exposure to a rate in a given “notional amount” is to make a principal investment in that amount. If you want a floating rate on a notional of a hundred bucks, you pony up a hundred bucks and buy a floating rate note.

It was only once the Children of the Forest wrought their wristy magic on the First Men in the dark thickets of Woods of Bretton that the ways of the Single Agreement came into common understanding. Only then were leaden, earth-bound notions of principal swept away; the swap market took wing upon the nuclear power of infinite leverage.

A swap can have disembodied fixed and floating rates only because, when they are set against each other, the principal investments they would normally be attached to cancel each other out. The principal investments are there, but just assumed.

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.

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.

“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?”

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.

On the case for one-way margin

In recent years — ironically, just as the “dealer” vs “customer” dynamic has become more pronounced — the global regulatory-industrial complex, 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.

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.

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.

As long as the dealer is covered, there will be minimal market disruption and the dealer’s own solvency is not threatened.

But requiring a dealer to post margin to its customer to cover the customer’s net in-the-money positions makes no sense whatsoever.

First, customers — and here I mean buy-side market participants who do not themselves post systemic risk — are trading on their capital, dealers are not. 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.

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. This is not the same as paying out the mark-to-market of a unrealised swap.

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.

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?

Secondly, dealers and banks are already capitalised and regulated for systemic risk. 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.

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?”

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.

Now you might make the case, and some have, 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.

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.

Other dumb use cases

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.

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.

But if the option trades into the money, the dealer is obliged to pay variation margin to the customer.

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.

Voluntary margin

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 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 haircuts, credit terms and diversification criteria they like.

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!

“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.”

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.

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.

Buy-side counterparties are, Q.E.D., sophisticated professionals. 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.

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.

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.