Bilaterality
Bilateral
/ˌbaɪˈlætᵊrᵊl/ (adj.)
Having, or relating to, two sides; affecting both sides equally.
In this episode 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. 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 a “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
Abelief in even-handedness gripped the ones whose deep magic forged the runes of that ancient First Swap. It has 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.
In the ISDA there is not — necessarily — a large “have” indulging a small “have-not” with favours of loaned money, for which 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, righteous sort of thing under whose auspices, one is neither lender nor borrower, but simply an honest rival for the favour of Lady Fortune, however capricious may she be. Those who swap things are not master and servant, but rivals.
“Let us call them Counterparties.”
This foundation myth imagines “swaps” in a pure, innocent, trading-bubble-gum-cards-in-the-playground way.
“I have two Emerson Fittipaldis, you have two Mario Andrettis, we can increase each other’s net happiness and thereby the world’s 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.[1]
And, to be sure, swaps are different from loans and brokerage arrangements. They start “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”) at different times as the transaction wends its way to maturity.
Covenants, 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. Mums and dads, 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.[2] The ISDA is for grown-ups. Equals.
So much so that, other than below the dotted lines where you type the counterparty names, the pre-printed part of ISDA Master Agreement itself does not even use the expressions “Party A” or “Party B”. 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.
The parties 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 labels, we are equal.
But they are maddeningly forgettable labels: 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.[3] This is not just a matter of having to play in your “away 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 quite energising, if you pick them up during the “four eyes check” at the conclusion of onboarding.[4] Less so, when Briggs J catches them for you when handing down a judgment from the commercial division of the High Court.[5]
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See also
References
BINO — bilateral in name only
But with the exception of that a class of inter-dealer swap relationships, ISDA Master Agreements are “bilateral” only really in name: one party — the swap dealer, provides swap products to a client, who consumes them. The client provides the impulse to trade; the client elects when to exercise options and terminate positions. The dealer hedges calculates values, and is burdened with regulatory capital charges if it doesn’t get its close-out netting documentation right.
This has led to two kinds of bother: firstly a bit of a squabble as to who gets to be Party A and who Party B; since 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 be unseemly. At least one swap dealer solved this problem by electing to be Party B as standard, which only confused its big Asset Management clients who were unused to being Party A.
Furthermore, when labouring over some neatly iatrogenic co-calculation agent fallback dispute mechanism upon which your opponent is hotly insisting — and be assured, you will spend far more time doing this than can ever be justified by your reward, in heaven or on earth, for doing so — it is all to easy to get your “Party As” and “Party Bs” back to front, thus burying deep in your fossil record a technical deficiency that no-one will notice until, eighteen years later, when the world once again nearing Apocalypse, the chief credit officer is running around with her hair on fire, and everyone is glaring at the docs team because the key goddamn protection has a drafting glitch in it.
The real distinction: dealer and customer
And — beyond the small class of interdealer swap contracts that constitute a dealer’s funding programme — there is a material distinction between the parties. The real source of asymmetry is not whether one is long or short, or buyer or seller but whether a given party comes to the relationship as customer or dealer.
A “customer” or “end user” uses the ISDA Master Agreement to change its absolute exposure to a given risk or underlier. To take a risk or to lay one off.
A dealer uses the ISDA Master Agreement to earn a commission. It does this, yes, by providing someone else (the customer) a changed absolute exposure, but at the same time carefully 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. The ISDA Master Agreement is as much a broker/customer document as any other.
In any case almost all ISDA Master Agreements will be between a customer and a dealer. A few will be inter-dealer. Almost none will be inter-customer.
See also
- ↑ Oh, wait. Hang on. There was. It was Peason Minor in 3B. That made a two-way market in foopballers, F1 drivers and Top Trumps military planes and supercars. That guy was incredible. Wonder what he’s doing now. [CIO at GSAM — Ed.] Okay so most metaphors don’t bear close examination.
- ↑ They may trade contracts for difference and make spread bets with brokers, but these are standardised, smaller contracts.
- ↑ They are not.
- ↑ You won’t.
- ↑ He will.