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 buy bonds, but they din’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. The labels are arbitrary assignations that apply at trade level. Thus, they only appear 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 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”.

We should not let ourselves forget: 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 preponderance of all ISDA arrangements. The customer and a dealer roles are different. They do not depend on who is “long” and who “short”, or who pays the fixed rate and who the floating. Hence the expressions “sell-side” — the dealers, who sell exposure — and “buy-side” — their customers, who buy it.

For a customer, the object of trading a swap is somehow to change its market exposure: to get into a positions it did not have before.

For a dealer, the object of trading a swap is to earn a commission without changing its market exposure. Seeing as providing swap exposure to a customer necessarily changes the dealer’s market exposure, the dealer must then “delta hedge” that position by taking on an equal and offsetting position somewhere else. There are many ways of doing this: the most straightforward is to simply buy (or short) the underlying asset; but a dealer may equally hedge its market risk on one customer’s “long” swap position by matching it off with another customer’s “short” swap position in the same underlying asset.

In any case, the basic idea of swap dealing, as with any kind of brokerage, is for the dealer to be as far as possible “market neutral”. Provided the dealer knows what it is about, its main risk in running a swap portfolio is therefore not market risk but counterparty risk. This, as we have seen repeatedly, is a big risk. Hence, adequate collateralisation is very important to dealers.

Swaps are usually synthetic loans

But how does this translate into a synthetic loan? Well, consider what happens in the case of an actual loan.

Hackthorn Capital Partners owns USD10m of Lexrifyly and wishes to buy USD10m of Stock Cryptöagle. It can either: sell Lexrifyly and use the proceeds to buy Cryptöagle, or keep Lexrifyly, borrow USD10m and use that to buy Cryptöagle.

Sale
If it sells Lexrifyly outright, the position is as follows:

Sold: 10m Lexrifyly

Borrowed: -

Amount owed: -

Bought: 10m of Cryptöagle

Amount due: total return on 10m Cryptöagle

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

Sold: -

Borrowed: USD10m

Amount owed: Floating Rate USD 10m

Bought 10m of Cryptöagle

Amount due: total return on 10m Lexrifyly and 10m Cryptöagle

Note the cashflows in the loan scenario:

During loan:

Customer pays floating rate on USD10m

Customer receives total return on Cryptöagle.

To terminate loan: Customer repay USD10m
To finance loan repayment: Customer sells Cryptöagle.

If Cryptöagle sale proceeds are not enough to repay the entire USD10m, customer finances the difference from its general assets. If they are, customer keeps excess sale proceeds after repayment of USD10m.

⇒ Customer’s net exposure is USD10m - Cryptöagle spot price

These are the same cash flows you would expect under a delta-one equity derivative:

During swap:

Customer pays floating rate on USD10m

Broker pays total return on Cryptöagle.

To terminate swap: USD10m - Cryptöagle spot price

If termination amount is negative, customer pays broker.

If termination amount is positive, broker pays customer.

Like a loan, the equity swap gives the customer exposure to Cryptöagle without having to give up its existing portfolio of exposures, which it would do were it to buy Cryptöagle outright. The customer is using its existing capital to gain exposure to a new capital asset. This is a form of leverage. The floating rate the customer pays is implied funding. The dealer will only accept this if it is satisfied the customer has enough capital to finance its swap payments and settle any differences at termination. This is exactly the risk calculation a lender makes.

But in a bilateral swap arrangement, isn’t the converse also true of the dealer? Isn’t the dealer paying a rate to get exposure to the synthetic cashflow of an asset in the same way, so in a sense borrowing? Is not a “short” equity derivative, for a dealer, exactly the same as a “long” equity derivative for a customer?

Generally not, because the dealer is delta-hedging: it is not changing its market exposure. At the moment it puts on a trade with the customer, it executes an exactly offsetting one as a hedge. The clearest case is in a delta-one equity derivative: Customer buys swap on Cryptöagle with an implied loan; dealer buys Cryptöagle outright, which involves actually funding that acquisition.

To pay your return it will have an offsetting transaction. It is not “keeping” that floating rate risk, but offsetting it, perhaps with another client position.

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, has forged rules which overlook this.

A notable example is the coordinated worldwide approach to regulatory margin.

Banks are independently capital regulated for solvency.

Swap counterparties are sophisticated professionals with the tools and resources to monitor credit exposure to their brokers. (We take it that the financial weapons of mass destruction that these sophisticates truck in require more expertise than does weighing up the likely failure of a regulated financial institution).

It is a much better discipline for sophisticated counterparts to manage their credit exposure — spread it around, so to speak, than to require their banks to send hard cash out the door as collateral to clients with outsized exposures.

Every dollar these banks pay away reduces the capital buffer the bank has available for everyone else. It also provides the customer with free money on an unrealised mark-to-market position. This is like paying out while the roulette wheel is still spinning, in the expectation of where the ball might land. That is a loan: if the customer doubles down and loses, you don’t get your money back.

Daily mark to market moves are mainly noise. Yet this is what we collateralise. The signal 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 increased systemic exposure of banks failing — which is what the margin regs were designed to address — is not caused by the banks themselves, but by their client exposures. Client exposures in turn are a function of client failures, which are in turn a function of leverage

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.