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.

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 whole new article about it.

“BINO” — bilateral in name only

But except for that a class of inter-dealer swap relationships, ISDA Master Agreements 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 dealers 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”.

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 As” and “Party Bs” mixed up. Doing so buries, deep in the fossil record, a technical deficiency that may go entirely unrecognised for decades.

Roll forward eighteen years. The world is again on the brink of financial Apocalypse. The customer is now a systemically-important leviathan, largely thanks to years of optimistically lax credit sanctioning. But suddenly, it is teetering. The 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.

The real distinction: dealer and customer

Beyond the 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 ISDA Master Agreement to change its absolute exposure to a given risk or underlier. To take, or lay off, a risk.

A dealer uses the ISDA Master Agreement 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 ISDA Master Agreement is as much a borrower/lender arrangement as most other banking arrangements. See the JC’s long-form essay about this.

In any case, almost all ISDA Master Agreements will be between a customer and a dealer. A few will be inter-dealer. Almost none will be inter-customer.

Why does it matter?

What is in a name?

This may be to draw a long bow, but the JC says that emphasising the ISDA’s bilaterality has led the regulatory dance into the wrong corner of the dancefloor.

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 so we have seen: swap dealers have to post regulatory initial and variation margin to their customers, just the same way their customers must post it to them.

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.

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. Overall, encouraging customers to limit their outright exposure to dealers enhances the market’s overall resilience.

Obliging dealers to cash-collateralise customers’ open positions creates the opposite incentives. Customers are encouraged not to diversify their risk, but to concentrate it, with the dealers 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.

By contrast, end users are not regulated. They are often thinly capitalised funds, trading with leverage on someone else’s money: guess who? The dealer.

The real source of systemic dealer risk, is the second-order risk presented by the dealer’s customers blowing up.

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.

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