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, imagines some kind of collective co-calculation agent regime where the parties each have their own Man In Havana making independent calculations with the intention of split whatever difference there may be.

But alas, having had the energy to contemplate this vanishingly remote scenario, our ninja friends didn’t have the diligence left to write out what should happen properly, and as a result, what Section 12.7(c)(ii) 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 as an excuse: if you insist on contemplating something stupid, you should at least work it through properly, so stupid parties who fall into the trap of thinking you knew what you were doing when you drafted the option, and who therefore select it, don’t get themselves into bother later, which we regret to say they will, if they select two Determining Parties. Not many do, but it is not unheard of.

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, and not just the Calculation Agent, in the first place. It is specifically for calculating Cancellation Amounts when nixing a trade that has suffered a catastrophic Additional Disruption Event:

...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 by using its deep connections into the world’s equities and futures markets. Customer, that is to say, and service-provider. The swap dealer has no skin in the game: it has no stake in the performance of the underlier. It will be hedging delta-one, usually by buying (or short-selling) the underlier outright. Other than to the extent that price keeps its customer happy and returning for more business, it is indifferent to the price of the underlier, as long as it can pass it on to its client. It has every incentive to get the best price it can: that is the commercial imperative.

Now, 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. It went out and bought the hedge, in fair times, and now it has to sell it, while times are foul.

To be clear this is no idle intellectual speculation: liquidating a hedge is not simply looking at some fantastical model dreamt up by the most delusional quant on the trading floor, arriving at some mad price that will ruin the client for nothing. No. The Hedging Party is actually long the risk. It will have to crystallise real liability, using money from its own pocket to flatten out that risk. The amount it pays away is exactly what it will expect its client to suffer. That is the deal.

running a synthetic equity is a boring, fraught job. The Hedging Party will 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.

But it is Determining Party, not Hedging Party

This is true: it may be yet more unnecessary over-elaboration on ISDA’s crack drafting squad™’s part — it may not have made a difference (and might have avoided this very article) had the ’squad not created an extra label, but we are where we are. It is possible, we suppose that the dealer hedges with a swap, and the actual price discovery happens away from the Hedging Party along a chain somewhere).

Why, if you must insist on having two Determining Parties, this clause doesn’t work

This is the clincher. the co-Determining Party language doesn’t work. Say we have, with heavy heart, acquiesced, and agreed two Determining Parties. Let’s further say there has been an Extraordainry Event, such that Cancellation Amount is required. We reach for Section 12.7(c). Each Determining Party does its thing: the swap dealer’s sees 102, and the client’s sees 104.

Logic should say the number we are after is 103, yes? The average. But that is not what Section 12.7(c) delivers.

“...an amount will be payable equal to one-half of the difference between the Cancellation Amount of the party with the higher Cancellation Amount (“X”) and the Cancellation Amount of the party with the lower Cancellation Amount (“Y”) and Y shall pay it to X.”

The difference between X and Y (104 - 102) is two. Half of that difference is one. This Cancellation Amount is, to put not too fine a point on it, wildly wrong.