Template:M summ Equity Derivatives 12.8

Section 12.8(a)

Cancellation Amount is a beast of a definition. But when you boil it down, it’s pretty straightforward. It applies when terminating a Transaction following an Extraordinary Event or an Additional Disruption Event. Importantly, by dint of Section 12.8(e), the Determining Party may pass through hedge breakage costs and losses.

Geopolitical events

Now, what gains or losses might the Determining Party incur in replacing the material terms of the Transaction if, due to wars, sanctions and other miscellaneous geopolitical hanky-panky, a market gets totally shut down? If, for example, the outside world has imposed economic sanctions on the jurisdiction in which your Shares trade (as, at the time of writing, seems far possible for Russia), of if the Shares’ jurisdiction itself imposes sanctions on money coming in from or going out to the outside world (as did Greece, for a brief moment, in 2015)?

Well, worst case, the holder of a long swap position might get a doughnut. The holder of a short position could, conceivably, lose even more, were the value of affected Shares to spike during the sanctions, but that seems practically unlikely: the nature of economic sanctions and geopolitical turmoil tends not to boost local equity markets and, we imagine, generally would make affected shares go down in price. Here the problem might instead be that the holder of the short position can’t close out, despite desperately wanting to.

In either case, the dealer’s attitude is likely to be the same: “I can’t see a bid-ask to do what I need to do to [keep a long position going/close a short position out] (delete as applicable). If you can find me such a bid or ask I can trade on I will, but if not, I regret to say you may get bupkis.”

Now the nature of geopolitical events is to be unpredictable. They may manifest themselves in different and unexpected ways, so — while no-one likes to rag on ISDA’s crack drafting squad™ more than the JC does, readers, you know that — you can’t really blame the ’squad for not setting out the myriad of unintended knock-on consequences there might be to your equity derivative portfolio as a result of an unwarranted military incursion in the Urals.

Talk to your clients

That said, it is all about managing expectations. The other typical characteristic of geopolitical hanky-panky is that it rarely comes out of the blue: it brews, there is posturing, brinkspersonship, manoeuvering before anything happens. This is a good time to get out and talk to your clients. Remember the name of the game is to manage client expectations: a client who didn’t know it had some risk, even though it should have known (or, in fact did know but in a moment of motivated irrationality had conveniently forgotten) is more likely to be upset when that risk materialises than one who did know, because you reminded it. Your goal, remember, is not to win litigation with your customers, but avoid it.

Section 12.8(b)

What to make of that loaded expression commercially reasonable? A good place to look is Barclays v Unicredit, which considered what a party must do if it is required to act “in a commercially reasonable manner”. Basically it is sensible and solemn and workable — you are entitled to consider your own book, your own models and your own axes, and can’t be second guessed by some appeal to the hypothetical.

As a corrective to any irrationally giddy feelings of happiness this may induce, see also Crowther v Arbuthnot Latham & Co Ltd — yes, you can legitimately consider your own risk situation, and you are best placed to judge it, but all the same this is not a licence to do what the hell you like.

If a discretion is designed for one purpose, you can’t use it, to the exclusion of that purpose, to achieve another.

Wise words.

Section 12.8(c)

From the “I never said you couldn’t” school of drafting. When acting in a commercially reasonable manner, the Calculation Agent may can consider dealer quotes, market data and its internal models. Glory be.

Section 12.8(d)

If, having gone out and got some dealer quotations or market data for the purpose of determining the Cancellation Amount, the Calculation Agent doesn’t like what it got, it has to use it unless with a straight face it can say to do so would be to produce some manifestly erroneous outcome. This keeps the Calculation Agent — which will be one of the parties, remember; usually the dealer — honest (if its regulatory obligations to treat customers fairly, not be a dork and so on, doesn’t).

Section 12.8(e)

This makes it clear that on a Hedging Disruption, for example, the Determining Party can pass on at least the market risk of replacing any disrupted hedge (and probably the credit risk too, though where the hedge is a cash trade settling DVP there would be no credit exposure).

Section 12.8(f)

The Determining Party only ever has to determine a Cancellation Amount, Cancellation and Payment or Partial Cancellation and Payment under 12.8, and that will only happen in only when a Transaction terminates following an Extraordinary Event or an Additional Disruption Event.

Calculation Agent vs. Determining Party

Why: The Equity Derivatives recognise that while most calculations could be performed by whoever is appointed Calculation Agent, determination of a Cancellation Amount is inextricably related to the hedge and — especially where there is a disrupted market – this is best to be calculated by the one whose problem it is to unwind that hedge: namely, the Hedging Party.

In theory (though almost never in practice) the Hedging Party might not be the Calculation Agent.

In theory, too, the Hedging Party might not be named the Determining Party. Which is kind of awkward, since the Cancellation Amount is couched in terms of the cost to the determining Party of unwinding, liquidating or re-establishing its hedge — which it would only do if it was, like, hedging.

Lastly, note that if your investment bank is as left-handedly configured as some the JC has come across, the group entity writing the equity swaps might not be the same as the one doing the physical hedging of those swap obligations (with a back-to-back trade between them, for example), so the Hedging Party/Determining Party might not be either party to the actual ISDA Master Agreement at all.

The User’s Guide

We have noted elsewhere that the User’s Guide is less forthcoming than one might like it to be on what the Determining Party is for, and when (or why) there might ever be two. But it does say this:

“In calculating a Cancellation Amount, a Determining Party is required to act in good faith and to use commercially reasonable procedures. It should be noted that quotations are not necessarily required, as depending on the Transaction in question, the cost of liquidating hedges may be a more appropriate basis for determining a Cancellation Amount than soliciting quotations.

Parties should note that the Determining Party is the party that will be calculating its own cost of replacing or providing the economic equivalent of a terminated Transaction. The Calculation Agent may be a party to the Transaction, but when performing its duties as Calculation Agent it is acting as a neutral party. The Calculation Agent as such will not have a replacement cost or economic equivalent and therefore should not be designated as the Determining Party.”

If this is meant to help, it singularly fails to, except to recognise that the Determining Party is acting in its capacity as a Hedging Party, and not in its gnomic, wise, dispassionate role as impartial determiner of abstract values. This explains, maybe, why ISDA’s crack drafting squad™ thought it worthwhile to have distinct roles of Calculation Agent and Determining Party — it is not saying (as far as we can tell) that the party who is Calculation Agent cannot be Determining Party at all, but only that when it is being a Determining Party it is not being Calculation Agent: the two roles wear different trousers, so to speak.

But what it does confirm is that the Determining Party is meant to refer to the person who is actually hedging the trade, and that what they will be doing is liquidating hedges to get prices.

Two Determining Parties?

Yes, it does say this, but no, you shouldn’t go there. For a lengthy disquisition on why not, see the commentary to Section 12.7(c).

Fewer than one Determining Party?

But do at least try to have one: the ’squad, in their infinite wisdom — or perhaps indulging in some cosmic sense of humour, did not provide for a fallback should you neglect to appoint a Determining Party in your Confirmation at all (it would be nice if it defaulted to the Hedging Party, of even the Calculation Agent, so at least there was someone in charge of calculating what happens on an Additional Disruption Event, but no. Otherwise it might make for some squeaky bottoms should things suddenly, collectively, go tetas arriba, for there is no-one on hand to calculate the all-important Cancellation Amount.

For those who do forget we can offer only moral support: in spirit — for whatever that is worth — it should be the person doing the hedging, but good luck persuading your client of that, when le monde est allé en enfer dans un panier du main, everyone has their hair on fire etc etc.