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=== On becoming a shibboleth === | === On becoming a shibboleth === | ||
Through habit and inattention, we work ''around'' the [[Easance|easances]] | Through habit and inattention, we work ''around'' the [[Easance|easances]]<ref>Yes, the JC made this word up. Think of it most nearly as the opposite of a nuisance.</ref> we once made to our “built environment”. What started as the shortest route to market can, through acquiescent disregard, become a shibboleth: a ''hindrance'' on the road to transaction. | ||
So it is with the [[ISDA Master Agreement]]. Once precisely an [[easance]] — an artefact for quickly tidying up and dispensing with formalities it would be laborious to repeat for every trade — the ISDA became a mountain of its own. Sure, you only need to climb it, from the bottom, once, but that has become a three-month operation. Nor do you scale an ISDA master agreement the way Alex Honnold scales El Capitan, brave and alone, an [[Morgenröte|aeronaut of the spirit]]. You must take the entire modernist machinery of your institution with you. | So it is with the [[ISDA Master Agreement]]. Once precisely an [[easance]] — an artefact for quickly tidying up and dispensing with formalities it would be laborious to repeat for every trade — the ISDA became a mountain of its own. Sure, you only need to climb it, from the bottom, once, but that has become a three-month operation. Nor do you scale an ISDA master agreement the way Alex Honnold scales El Capitan, brave and alone, an [[Morgenröte|aeronaut of the spirit]]. You must take the entire modernist machinery of your institution with you. | ||
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Some miss the good old days. Once, the aggravation of a “[[long-form confirmation]]” was the mischief an ISDA was designed to solve. Where bank legal departments have not legislated outright against them — most have, long since — the temptation now is to ask, “Must we have an ISDA? Would not a [[long-form confirmation]] do? | Some miss the good old days. Once, the aggravation of a “[[long-form confirmation]]” was the mischief an ISDA was designed to solve. Where bank legal departments have not legislated outright against them — most have, long since — the temptation now is to ask, “Must we have an ISDA? Would not a [[long-form confirmation]] do? | ||
There are other good reasons for a master agreement, as we will see, but none necessitates all the bureaucratic machinery that has grown around the ISDA. This is how the [[military-industrial complex]] of agency operates: it shapeshifts to create work to occupy the available rent.[[ | There are other good reasons for a master agreement, as we will see, but none necessitates all the bureaucratic machinery that has grown around the ISDA. This is how the [[military-industrial complex]] of agency operates: it shapeshifts to create work to occupy the available rent.<ref>see the [[eighteenth law of worker entropy]]. Remind me to do an article on the [[rent carrying capacity]] of financial services.</ref> | ||
== The three aims of an ISDA == | == The three aims of an ISDA == | ||
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=== Relationship contract === | === Relationship contract === | ||
[[File:Wedding.jpg|250px|thumb|right|A relationship contract, yesterday.]] | |||
Firstly, the Master Agreement is a [[relationship contract]]: an agreement sealing a pact of amity and good dealing between two strangers in the jungle. It is, of sorts, a peace treaty: it establishes basic terms between the parties upon which they may deal, reciting their aspirations, outlining their cultural idiosyncrasies and behavioural red lines, and dealing with housekeeping matters like contact details, account numbers and authorised agents, and generally gathering up all the manifold dreary details needed to ease the experience of transacting with each other. | Firstly, the Master Agreement is a [[relationship contract]]: an agreement sealing a pact of amity and good dealing between two strangers in the jungle. It is, of sorts, a peace treaty: it establishes basic terms between the parties upon which they may deal, reciting their aspirations, outlining their cultural idiosyncrasies and behavioural red lines, and dealing with housekeeping matters like contact details, account numbers and authorised agents, and generally gathering up all the manifold dreary details needed to ease the experience of transacting with each other. | ||
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The ISDA gives each party the rights it needs to manage and reduce its [[credit exposure]] to ''the other party'' as a result of all this derivatives trading. These include [[Credit Support - ISDA Provision|Credit Support]] and [[Close-out Amount - ISDA Provision|Close-out]] rights. | The ISDA gives each party the rights it needs to manage and reduce its [[credit exposure]] to ''the other party'' as a result of all this derivatives trading. These include [[Credit Support - ISDA Provision|Credit Support]] and [[Close-out Amount - ISDA Provision|Close-out]] rights. | ||
[[Credit Support - ISDA Provision|Credit Support]] may comprise margin “posted” by the counterparty against its exposure, or [[Guarantee|guarantees]], keep-wells, [[letters of credit]] and so on provided by third parties on its behalf. This leads to an amount of fusspottery in the agreement: should credit triggers that catch the counterparty’s own deteriorating prospects also be triggered if only the credit support provider deteriorates? In a basic sense, yes, obviously — but should the failure of an unaffiliated arm’s length credit insurer be grounds for immediate closeout, or just on notice, should the insurer not quickly be replaced? | [[Credit Support - ISDA Provision|Credit Support]] may comprise margin “posted” by the counterparty against its exposure, or [[Guarantee|guarantees]], keep-wells, [[letters of credit]] and so on provided by third parties on its behalf. This leads to an amount of fusspottery in the agreement: should credit triggers that catch the counterparty’s own deteriorating prospects also be triggered if only the credit support provider deteriorates? In a basic sense, yes, obviously — but should the failure of an unaffiliated arm’s length credit insurer be grounds for immediate closeout, or just on notice, should the insurer not quickly be replaced?<ref>I mean, ''could'' a monoline credit insurer present a systemic risk to the financial system? Don’t answer that.</ref> | ||
[[Events of Default - ISDA Provision|Events of Default]] and [[Termination Events - ISDA Provision|Termination Events]] entitle you to [[close out]] [[Transactions - ISDA Provision|Transactions]] early, should your counterparty ''not'' perform (or should its creditworthiness deteriorate in oblique ways your credit department believes increase its risk of not performing). Most of these events address credit deterioration, but not all: some deal with other externalities — [[change in law]], [[force majeure]], [[Tax|adverse tax]] — that don’t directly affect either party’s credit position. | [[Events of Default - ISDA Provision|Events of Default]] and [[Termination Events - ISDA Provision|Termination Events]] entitle you to [[close out]] [[Transactions - ISDA Provision|Transactions]] early, should your counterparty ''not'' perform (or should its creditworthiness deteriorate in oblique ways your credit department believes increase its risk of not performing). Most of these events address credit deterioration, but not all: some deal with other externalities — [[change in law]], [[force majeure]], [[Tax|adverse tax]] — that don’t directly affect either party’s credit position. | ||
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That Darwinian effect is far less pronounced for “Tail events”. These are the externalities: things you ''don’t'' expect, but are resigned to, that might get in the way of you enjoying the financial risk and reward of the expected events. | That Darwinian effect is far less pronounced for “Tail events”. These are the externalities: things you ''don’t'' expect, but are resigned to, that might get in the way of you enjoying the financial risk and reward of the expected events. | ||
These tend to be easy to foresee in ''general'' but impossible in particular, precisely because they are rare, unwanted and, by nature, present themselves when and where no-one is looking: if your counterparty blows up or is nationalised, embargoed or sanctioned. If the law changes, making the Transaction illegal, difficult to perform or less valuable. If the Great King of Terror descends from the skies in a flaming chariot, etc. | These tend to be easy to foresee in ''general'' but impossible in particular, precisely because they are rare, unwanted and, by nature, present themselves when and where no-one is looking: if your counterparty blows up or is nationalised, embargoed or sanctioned. If the law changes, making the Transaction illegal, difficult to perform or less valuable. If the Great King of Terror descends from the skies in a flaming chariot, etc.<ref>The arrival of the Great King of Terror is a ''bad'' tail event: there is nothing you can really do to mitigate it. Best not write a swap on it.</ref> | ||
Articulation of tail risks is usually done by legal or — under legal’s supervision — the negotiation team. The language is baroque, sweeping and infrequently tested. When it is tested, by the courts, after times of crisis — it often turns out not to work as expected. | Articulation of tail risks is usually done by legal or — under legal’s supervision — the negotiation team. The language is baroque, sweeping and infrequently tested. When it is tested, by the courts, after times of crisis — it often turns out not to work as expected.<ref>Almost the entire international jurisprudence on section 2(a)(iii) arises from the Lehman collapse.</ref> | ||
==== Division of labour ==== | ==== Division of labour ==== | ||
In any case, there is a functional division of labour between the Master Agreement, under which you ''minimise'' and ''mitigate'' unlikely risks in ''general'', and the Confirmation, under which you ''assume'' and ''allocate'' likely risks in ''particular''.[[ | In any case, there is a functional division of labour between the Master Agreement, under which you ''minimise'' and ''mitigate'' unlikely risks in ''general'', and the Confirmation, under which you ''assume'' and ''allocate'' likely risks in ''particular''.<ref>This not, ah, a [[Bright-line test|bright-line distinction]], but it is a good rule of thumb. You might put some asset-specific “tail risk” Termination Events in the Confirmation, but for the most part you try to get them all into the Master Agreement.</ref> | ||
So: the Confirmation deals with what you think ''will'' happen and the Master Agreement deals with what you think ''won’t''. The Confirmation is GPS navigation; the Master Agreement is seatbelts, airbags and those neat inflatable slides that turn into liferafts when a plane crash-lands on water: something you’re glad you have, but hope not to use. | So: the Confirmation deals with what you think ''will'' happen and the Master Agreement deals with what you think ''won’t''. The Confirmation is GPS navigation; the Master Agreement is seatbelts, airbags and those neat inflatable slides that turn into liferafts when a plane crash-lands on water: something you’re glad you have, but hope not to use. | ||
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The principal tool for managing the capital cost of a swap master agreement is [[Close out netting|close-out netting]]. | The principal tool for managing the capital cost of a swap master agreement is [[Close out netting|close-out netting]]. | ||
Derivatives are odd contracts. They are inherently levered, and therefore extremely volatile. They have large notional | Derivatives are odd contracts. They are inherently levered, and therefore extremely volatile. They have large notional<ref>Almost all swaps start off “at-market”. Starting off the market implies a one-way initial payment under the Transaction, by way of premium, to the party who starts “out-of-the-money”. Otherwise, it would be economically irrational to enter into the Transaction.</ref> values, but, usually, much lower [[mark-to-market]] values. An “at-market” swap<ref>Almost all swaps start off “at-market”. Starting off the market implies a one-way initial payment under the Transaction, by way of premium, to the party who starts “out-of-the-money”. Otherwise, it would be economically irrational to enter into the Transaction.</ref> starts with zero exposure, either way, and thereafter can fluctuate in either direction. | ||
Compare this with a traditional loan, which starts with an exposure equal to its principal amount — the lender goes “in-the-money” for the full principal size of the instrument, and borrower “out-of-the-money” — and the “mark-to-market value” of the loan — I know, this terminology is wrong in so many ways — then fluctuates narrowly around the amount borrowed, to account for accrued interest, changing interest rates, and the borrower’s changing credit profile, until it is all repaid, in one go, at maturity. There is no scenario in which the lender owes the borrower. The loan covenants reflect this. | Compare this with a traditional loan, which starts with an exposure equal to its principal amount — the lender goes “in-the-money” for the full principal size of the instrument, and borrower “out-of-the-money” — and the “mark-to-market value” of the loan — I know, this terminology is wrong in so many ways — then fluctuates narrowly around the amount borrowed, to account for accrued interest, changing interest rates, and the borrower’s changing credit profile, until it is all repaid, in one go, at maturity. There is no scenario in which the lender owes the borrower. The loan covenants reflect this. | ||
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Given that the “amount originally borrowed” under a swap is, nominally, zero, the raw market exposure of a portfolio of swaps can be huge compared with that original capital commitment. The total of all your [[out-of-the-money]] positions, which you can assume you must perform, versus all your in-the-money positions, for payment of which you will be an unsecured creditor. | Given that the “amount originally borrowed” under a swap is, nominally, zero, the raw market exposure of a portfolio of swaps can be huge compared with that original capital commitment. The total of all your [[out-of-the-money]] positions, which you can assume you must perform, versus all your in-the-money positions, for payment of which you will be an unsecured creditor. | ||
But here is the beauty of the Single Agreement: if you can offset your [[out-of-the-money]] positions against your in-the-money positions, and be an unsecured creditor only for the difference between them — especially, as is usual these days, the bank has [[variation margin]] reflecting the difference | But here is the beauty of the Single Agreement: if you can offset your [[out-of-the-money]] positions against your in-the-money positions, and be an unsecured creditor only for the difference between them — especially, as is usual these days, the bank has [[variation margin]] reflecting the difference</ref>Though bilateral variation margin has its dark nemesis. There will be a separate essay about this.</ref> — things look a lot rosier from a regulatory capital perspective. On “margined” transactions, the parties’ net mark-to-market exposure resets to zero every day.<ref>The capital calculation is extremely complicated, but this offsetting effect is powerful.</ref> | ||
The “standard of proof” for “netting down” transaction exposures in this way is also huge: regulations require banks to obtain and keep up-to-date a battery of external [[Netting opinion|legal opinion]]<nowiki/>s — one for each counterparty type in each jurisdiction that the bank trades against, for each type of master agreement — that the netting contract actually [[Would-level opinion|''will'']] — not just ''should'' — work in all relevant jurisdictions: the bank’s, the counterparties, its branches, and the location of any assets. We have more to say about [[Netting opinion|netting opinions elsewhere]]. | The “standard of proof” for “netting down” transaction exposures in this way is also huge: regulations require banks to obtain and keep up-to-date a battery of external [[Netting opinion|legal opinion]]<nowiki/>s — one for each counterparty type in each jurisdiction that the bank trades against, for each type of master agreement — that the netting contract actually [[Would-level opinion|''will'']] — not just ''should'' — work in all relevant jurisdictions: the bank’s, the counterparties, its branches, and the location of any assets. We have more to say about [[Netting opinion|netting opinions elsewhere]]. | ||
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But when it comes to Additional Termination Events, expect a firefight. | But when it comes to Additional Termination Events, expect a firefight. | ||