What is the significance of the maximumnotice period of 20 days that one may use to close out the ISDA Master Agreement? Poor defaulted Counterparty is in pieces, on its knees, bleeding out, but really, as long as it gets some notice, does it really care how much? Surely, the longer the period, the more hope you have? While the agreement remains in termination but un-terminated, en route to that crater in the ground but not there yet — the chance remains, however remote, that things will come right; that you, its counterparty, will see sense, or unexpectedly discover the one compassionate bone in your body that, until now, has gone wholly unnoticed and, in a cloying bout of clemency, will change your mind and withdraw your notice of termination? Well, a little hedge fund can dream, can’t it? So why deprive it, and yourself, of that option?
Now, this is deep ISDA lore. It is of the First Men[1]. As such — since they didn’t have a written tradition back in 1986; since legends were passed down orally from father to son[2] and much has been lost to vicissitude and contingency — it is not a subject on which there is much commentary: That dreadful FT book about derivatives sagely notes that, usually, much less notice is given than 20 days (I mean, you don’t say) but doesn’t give a reason for this curious outer bound in the same way it doesn’t give a reason for much else in the ISDA Master Agreement. Nor for that matter does the User’s Guide to the 2002 ISDA Master Agreement.
One is just expected to know.
Well, companions, just now knowing things is not how we contrarians roll. So, in the absence of a credentialised source for the reason, let us speculate.
Remember the ISDA Master Agreement was invented by banking folk: people who who view the cosmos chiefly through the prism of indebtedness[3]. A lender whose borrower has defaulted will not dilly dally: she will bang in a default notice and seize whatever assets she can get her hand in poste haste. I lend, you owe. I don’t muck about. Breakage costs on a loan are easy to calculate and they are not especially volatile. The longer i take to terminate my exposure and set about recovering, the larger my exposure is likely to be.
But, but, but. ISDAs are different. They are not, principally[4], a contract of indebtedness, and while a large uncollateralised mark-to-marketexposure[5] is economically the same as indebtedness, the contract is bilateral, and who is indebted at any time is dependent on the net exposure: it can swing around.
Also, the mark-to-market exposure on swap transaction is a wildly volatile thing: With a loan, less so: you know you have (a) principal, (b) accrued interest and (c) break costs — the last of which might be significant for a long term fixed rate loan[6], but generally will pale in comparison to the principal sum owed.
So a swap counterparty who terminates might be out of the money, and disinclined to terminate just now, hoping that a more benign market environment might be just around the corner to dig it out of its hole so that when it does terminate, the Close-Out Amount will be favourable. This is still taking quite the market punt on a bust counterparty — by means of a European option — of course, and not the sort of thing a prudent risk manager would do[7], but I don’t suppose banking folk can be expected to have understood this in 1986.
Actually, even that makes little sense, since such a counterparty wouldn't be obliged to close out at all, but could just suspend its obligations under Section 2(a)(iii) - something which it can (or could, at any rate, when the 20 day notice period was devised, in 1987) do indefinitely.
So we get back to an alternative, more tedious explanation. It is pure flannel.
↑I know, I know — or women, but that spoils the Game of Thrones reference, you know?
