Template:M intro isda Party A and Party B

Bilateral
/ˌbaɪˈlætᵊrᵊl/ (adj.)
Having, or relating to, two sides; affecting both sides equally.

In this episode the 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; social justice almost. Other finance contracts are more visceral. They 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 “Borrower” — the punter; always the servant. A brokerage agreement has a “Broker” (master) and “Customer” (servant). Okay, I know theoretically it is meant to be the other way around; the customer is meant to be king and everything; but when it comes to finance it isn’t, is it? We are all hooked up to the great battery grid, for the pleasure of our banking overlords and the pan-dimensional mice that 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

A belief in even-handedness gripped the ones whose deep magic forged the runes of that ancient First Swap. Traditional finance contracts imply a relationship of dominance and subservience: a large, institutional “have” indulging a small commercial “have-not” with debt finance, for which privilege it extracts excruciating covenants, gives not a jot in return, and enjoys a preferred place in the queue among the customer’s many scrapping creditors.

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

“A swap,” they decreed, “shall be an exchange among peers. It is an equal-opportunity sort of thing; righteous in that, under its auspices, one is neither lender nor borrower, but simply an honest rival for the favour of the Lady Fortune, however capricious may she be.”

“Thus, those who swap things are not master and servant, but equals. Rivals. Counterparties”.

Covenants, privileges of 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, 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 (in the vernacular, be “out-of-the-money”) or be owed (“in-the-money”). And swaps, too, are the preserve of professionals, who know what they are doing. Usually, they know it better than the bank employees they face, having once been bank employees. Moms and pops, 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. The ISDA is for equals.

That said, the pre-printed part of ISDA Master Agreement itself does not use the expressions “Party A” or “Party B”. Have a look, if you don’t believe me. 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 in Confirmations, to be clear who is taking which side on a given trade, or who is giving which customised covenant. They 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. These generic terms hark from a time where the idea of “find and replace all” in an electronic document seemed like Tipp-Ex-denying, devilish magic.

But anyway. Being so generic, the “Party A” and “Party B” labels still 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. If, here and there, a dealer must be “Party B”, this can lead to anxious moments should one misread one such Schedule and conclude the carefully-argued 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.

“BINO” — bilateral in name only

But there is a better objection: for all our automatic protestations to the contrary, the ISDA is not really a bilateral contract. It is often a financing contract, in economic effect even if not in formal structure. Where one side is a customer gaining exposure to a market risk and the other wise is 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.

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. The customer punts.

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 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 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.

Why does it matter?

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.

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?