Undead ISDA
The status of every defunct ISDA master agreement, once all transactions have terminated, whether through the exigencies of a stressed close-out, or simply through the entropy and general lassitude of a modern life in which many erstwhile ISDA devotees grew bored, or adversely regulated, and gave up on swaps, or just let the last remaining Transactions to roll off and scamper, free, into the fragrant meadows of oblivion, leaving the rusting hulk of a master agreement extant, dilapidating, attracting weeds, vermin and adolescent dope smokers and gradually leaching its crumbling toxins into the soil, salting it into barren, desolate badlands of financial improbity.
Every now and then someone like Parsons, that pedantic oik from the credit department, will stop by your desk, eyes a-glitter, drop a sheaf upon it and casually impose upon you the burden of disposing of it.
Parsons: I say, Molesworth, the H.O.D. bid me ask if you would kindly do the honours — you know, the necessary, to terminate this defunct ISDA.
Molesworth: What do you mean?
Parsons: (Affecting shock at the display of ignorance) You know, send out a 6(g) notice or something. Whatever verbiage it is that you legal eagles do.[1]
If, like JC, you find the credit department’s penchant for stupid notices particularly irksome, you will enjoy composing and equally nonchalant reply.
Molesworth: No.
Parsons: I beg your pardon?
Molesworth: Well, no. I’m afraid the answer is no.”
For while you can terminate a Transaction under an ISDA Master Agreement — and all of them at once, if things really come to that — none of the ISDA’s printed forms envisages the parties terminating the Master Agreement itself.[2] Not even following a close-out.
There is no contractual right to terminate on notice
Alone in the firmament of finance relationship contracts the ISDA Master Agreement has no general no-fault termination provisions.[3] It cannot be unilaterally killed off. So, unless you and your counterparty can confect a means between you of putting the old bag down — and for that you will need the communion wine, garlic, wooden stakes and so on of consensus — a discarded ISDA arrangement will just lie there, locked-in, mute, transfixed, plastered to the infinite like some ghostly apparition, frozen at the event horizon of financial probity for ever — surviving, indefinitely, some say even beyond the mortal existence of they whose trading relationship it once described.
This unnerves those of delicate or superstitious mien. For if it is still there, however immobile, can it not cause mass destruction through inattention?
Normally it does not matter
Some would say this is a trifle ; a curio, but ultimately a non-point — as unalive as the ISDA that presents it. For an ISDA Master Agreement, under which there are no extant Transactions, of itself carries no financial obligations. It presents no risk. It is as safe as a rusty Luger with the firing pin removed.
If no Transactions remain that one can close out, what earthly concern is it, for either party, if notional non-payment obligations go unfulfilled? What kind of paranoid weirdo would take the point that one’s continuing covenants — to send annual reports within three months of their publication, for good example — are being broken?[4] And what of those financial meta-obligations? That two-edged Cross Default clause? Could it ... ?
You may laugh, but note only this: they who so haughtily wave such trifles away yet still go quiet and dare not speak of the Dark Lord of the Swaps.
When it sort of does matter
JC is blessed with inquisitive, thoughtful and voluminous correspondents. He relies on them to keep the old goat on his toes and plugged into the finer points of swappery. One recently raised this juicy hypothetical:
What if I have posted a static, upfront Independent Amount under a Credit Support Annex, but in the traditional fashion? That is, not an amount specifically tied to a Transaction, but a genuinely independent Independent Amount paid as the price of entering the ISDA Master Agreement in the first place. Say all my Transactions have terminated and I’m not expecting to enter any more, how do I get my IA back, if I can’t terminate the ISDA)?
This is a very good, if theoretical, point. Well — JC thought it was theoretical: surely, no-one in this day and age demands genuinely independent Independent Amounts, do they? — but apparently, they do. Swap dealers may, as consideration for even opening a credit line, let alone trading upon it, ask prospective customers to deposit a wodge of cash or securities as general collateral. Particularly, we hear, corporate and non-financial end users whose bona fides the dealer has difficulty assessing. But it may also come in use for programme traders and those who can put a dealer into a swap position by give up before the dealer even knows it’s happened. This is common in the equity derivatives market. Still, it seems perverse — a reversal of the natural order of things in which it is typically dealers who provide finance to their customers and not the other way round — but there we have it: as a price of entering the derivatives trading game you might have to stump up half a mill in hard folding stuff to your dealer.
Strictly, that cash is deposited under the CSA and not the ISDA proper — though that is a fine distinction indeed if the CSA counts as a Transaction under the ISDA Master Agreement[5] — and in any case it is academic, as the CSA doesn’t have any termination provisions in it either.
So, questions: firstly if all my existing business has rolled off and I don’t intend to trade again, can I get my Independent Amount back?
There is a theoretical answer to this and a practical one.
Practically, yes
Practically, yes, of course, you can get your IA back. just ask for it. If you notify your dealer that you intend to shut up shop, it will close down your credit line and set about offboarding you as a client and as part of that process return any Independent Amounts, letters of credit and any other sums or sureties it happens to be holding against your obligations under the trading relationship.
It is well incentivised to do this: not only must the holder of an Independent Amount manufacture income or pay interest at market rates on whatever is deposited but, as a regulated financial institution it must keep laborious and expensive KYC processes in place for all legal entities with which it has a current business relationship. The cost of this will merrily outweigh any value to be had by clinging onto an Independent Amount.
If your relationship is at an end, that is to say, your dealer will be highly motivated to extract itself from the KYC process. It will gladly give you your Independent Amount back and be done with it.
Theoretically, no
But that is not to say it has to. For the theoretical answer is difficult: there is an odd lacuna in the drafting of the Credit Support Annex which in thirty years the ’squad has not seen fit to fix.
Clearly, the Independent Amount is designed as an input into the “Exposure” calculation, and that is only relevant if a party has any Exposure, which it will only do if there are any outstanding Transactions.
You can see this from the mechanics of original payment: while the Independent Amount is designated in the Elections paragraph, you wouldn’t be required to actually pay it until you executed your first Transaction. Thereafter, the Transfer Amounts that flow back and forth to reflect changes in Exposure under the CSA do so over the threshold effectively established by the Independent Amount.[6]
As the last Transaction terminates, the Transfer Amount required to be sent back to the customer will be only the excess of its Credit Support Balance less that Independent Amount, which thereafter is just trapped with the dealer and with no means — beyond falling upon the good graces of the dealer to be a good egg and do the right thing — to recover it.
See also
- Early Termination under the ISDA Master Agreement
- No-fault termination
- The Good Man
- The Dark Lord of the Swaps
References
- ↑ This is a little in-joke. There is no Section 6(g) notice. Senior silver bulleters from credit often bluff revealingly about ISDA terms.
- ↑ There are reasons for this, but they are tedious: If you terminate the whole agreement, not just the Transactions under it, then how are all those clever close out mechanics meant to work?
- ↑ The GMSLA, (Clause 16) OSLA (Clause 15) GMRA (16) all have Termination provisions.
- ↑ Only a person yet to meet an internal auditor could ask that question.
- ↑ For the labored story of when a CSA is and is not a “Transaction” under an ISDA Master Agreement, see Credit Support Document.
- ↑ Of course there is a specific definition of Threshold in the CSA (of which the IA is part; we are talking more in a general sense.