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 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 a “Borrower” — the punter; always the servant. A brokerage agreement has a “Broker” (master) and “Customer” (servant). Okay, I know theoretically the master/servant dynamic is meant to be the other way around — the customer is king and everything — but come on: when it comes to finance it isn’t, is it? We are users, all hooked up to the great battery grid, for the pleasure of our banking overlords and the pan-dimensional mice who 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. Not just a two-sided structure — most private contractual arrangements have that — but a symmetrical one, lacking the dominance and subservience that traditional finance contracts imply. There is not necessarily a large, institutional “have” indulging a small commercial “have-not” with favours of loaned money or extended credit, for which privilege it extracts excruciating covenants, gives not a jot in return, and enjoys a preferred place amongst the customer’s many scrapping creditors.

Swaps, as the First Men saw them, would not be like that. Not necessarily.

“A swap shall be an exchange among peers: 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. Let us call them ‘Counterparties’.”

This imagines swaps in that pure, innocent, bubble-gum-cards-in-the-playground way. “I have two Emerson Fittipaldis, you have two Mario Andrettis, we can increase the net happiness of the world by swapping so we both have one of each.”

In the playground there are no brokers or dealers of bubble gum cards to intermediate, make markets and provide liquidity, let alone a trusted central clearer. It is a peer-to-peer, decentralised marketplace.

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”).

Covenants, privileges of collateral, 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 swaps, too, are the preserve of professional investors, who know what they are doing. Usually, they know it better than the bank employees they face, having once themselves 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 grown-ups. Equals.

That said, other than below the dotted lines where you type the counterparty names, 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 Confirmations, to stipulate who is taking which side on a given trade, giving which covenant or submitting to which Additional Termination Event. 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 and forgettable labels, we are equal. They are maddeningly forgettable: harking from a time where the idea of “find and replace all” in an electronic document seemed like Tipp-Ex-denying, devilish magic — it might have been easier — and saved some curial angst— had parties been able to use unique identifying labels across their agreement portfolios.

It was, I am afraid, a rather sloppily drafted document. First, it described LBIE as Party A and LBF as Party B, contrary to the Schedule which gave them the opposite descriptions.

—Briggs, J, in Lehman Brothers International (Europe) v. Lehman Brothers Finance S.A. [2012] EWHC 1072 (Ch)

Being so generic, the “Party A” and “Party B” labels can 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. This is not just a matter of having to play in your change strip every now and then: if, here and there, a dealer must be “Party B” having lost the toss to a counterparty who also insists on being Party A, this can lead to anxious moments, should one have momentarily forgotten the switch during the negotiation and assigned your carefully-argued infinite IM Threshold to the other guy.

Frights like this are, in their way, quite energising, if you pick them up during the “four eyes check” at the conclusion of onboarding. Less so, when Briggs J catches them for you in a judgment from the commercial division of the High Court.

“BINO” — bilateral in name only

But there is a better objection: for all our protestations to the contrary, the ISDA is not really a symmetrical contract of equals. It is usually, a financing contract, in economic effect, even if not in formal structure. Where one party is an customer gaining exposure to a market risk, and the other is a market professional dealer providing delta-hedged exposure to that risk, a swap is a sort of “synthetic loan”.

The arrival of the agents

Decentralised markets are not a stable equilibrium. Whenever one allocates large amounts of risk to a distributed community the opportunity arises for professional introducers to intermediate. To locate buyers and sellers and put them together. Swaps are no different. The swap is by nature a principal-to-principal contract, but the principle is the same: this class of intermediaries sleeve, aggregate and anonymise risk, but they don’t, as far as they can help it, take it. They are there for the commission. Their economic exposure to their customers resembles a lender’s to its borrowers. They are, effectively, providing finance.

Realising this may change how you think about ISDA negotiation. It did for the JC. So profound did this thought seem that it grew and grew and now there is a whole new article about it.

Because, except for a narrow class of inter-dealer swap relationships, ISDA Master Agreements are dealer-customer relationship contracts and these are “bilateral” only in name: the dealer provides exposures to customers, who consume them. The customers are, economically, principals: they provide the impulse to trade; they elect when to exercise options, they decide when to terminate positions. The dealer is — economically, even if not legally — an agent: it hedges, calculates values and is burdened with additional regulatory capital charges if it doesn’t get its close-out netting right. But, as long as the customer stays solvent, it is not on risk.

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, because the customer is always right. At least one swap dealer solved this problem by deciding to be “Party B” as standard. This only confused customers 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 for it, in heaven or on earth — 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 unrecognised for decades.

Roll forward eighteen years. The world is again on the brink of financial Apocalypse, as Slovenian drones overwhelm the port of Stuttgart. The customer — a Slovakian off-balance sheet financing vehicle, is now a systemically-important leviathan, largely thanks to years of optimistically lax credit sanctioning. But 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 agreements 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 — “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 without taking on risk. It does this, yes, by providing its customers a changed absolute exposure, but at the same time 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, and the JC does, make the case that over-emphasising formal' bilaterality, and ignoring substantive asymmetry, has led the regulatory dance into the wrong corner of the dancefloor.

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 capitalised 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 whose’s? 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 had to pay away wodges of regulatory margin to collateralise its customer’s un-realised 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?