Template:M summ Equity Derivatives 12.7

Section 12.7(c) and the curious question of the multiple Determination Agents

Now, here is a funny thing.

In its ever-unquenched thirst to cater for every conceivable eventuality, however inconceivable, the ’squad devoted themselves in Section 12.7(c)(ii) to the contingency that there might be two Determining Parties appointed to hash out the Cancellation Amount that applies for a Transaction. This, we think, is intended to imagine some kind of co-calcuklation agent regime where the parties make independent calculations and split the difference.

Unfortunately, having had the energy to contemplate this vanishingly remote scenario, our ninjarey friends didn’t have anything left to write the clause properly, and as a result what it tells the co-Determining Parties to do doesn’t make any sense. In fairness, simply having co-Determining Parties doesn’t make any sense, but that won’t do: if you insist on contemplating something stupid, you should at least work it through properly, so stupid parties who fall into the trap of selecting the option don’t get themselves into bother later, which we regret to say they will do if they select two Determining Parties.

But first things first.

Why it makes no sense to have two Determining Parties

Cast your mind back to the reason we have a Determining Party in the first place:

...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.

Now, remember what is going on here. We have a client, going long or short some Equity underlier without actually having to buy it, and a swap dealer, providing that exposure. The swap dealer has no skin in the game: it will be hedging delta-one, usually by buying (or short-selling) the underlier outright. It has no particular interest in the prince of the share, as long as it can pass it on to its client.

If the Transaction has been disrupted so badly it is to be cancelled, this means is hard to get a price in the underlier, That, in turn, means it is hard to liquidate the hedge. Whose problem is that? The Hedging Party’s. To be clear this is no idle intellectual speculation: there is no looking at some fantastical model dreamt up by the most delusional quant on the trading floor to derive some mad price that will ruin the client for nothing. No. The Hedging Party is actually long the risk. It will pay out of its own pocket to get out of that risk. The amount it pays away is exactly what it will expect its client to suffer. That is the deal.

The Hedging Party will, therefore, be most unamused if the client asks it to countenance some alternative price someone else has come up with to value its own hedge liquidation. It will, tersely, say, “Look, I know you have a great relationship with Wickliffe Hampton and everything, but I could not care a row of buttons where it sees the value of my hedge, frankly, unless it is prepared to by my actual hedge, from me, in which case let’s go.”

At the point where Wickliffe Hampton does that, it is agreeing with the Hedging Party on its valuation and does not, Q.E.D. need to be co-determining party.