Template:M intro isda ISDA purpose
In this backgrounder the JC will look deeply into what is the basic point of an ISDA Master Agreement. What does it do, why do you need one, and why can’t you just crack on and trade swaps without all this dusty paperwork?
Now this might seem like pocket-calculator stuff to you, my seasoned veterans, but it never hurts to stop and ponder the ostensibly bleeding obvious.
Going back to basics is bracing for the spirit. The JC encountered his first Aïessdiyé fully thirty years ago now — shout out to the GFF — and is still finding things out about it. Plenty did, as he prepared this essay.
On becoming a shibboleth
Through habit and inattention, we work around the easances[1] we once made to our built environment. What started out as a the shortest route to market can, through acquiescent disregard, become its own shibboleth: an obstacle on the road to transaction.
So it is with the ISDA Master Agreement. Once precisely a easance — an artefact for quickly tidying up and dispensing with formalities it would be laborious to repeat for every trade — it became a mountain of its own. Sure, you only need to climb it, from the bottom, once, that has become a three-month operation. You do not scale an ISDA master agreement the way Alex Honnold scales El Cap. You must take the entire modernist machinery of your institution with you.
There are those who miss the good old days. Once the aggravation of a “long-form confirmation” was the mischief an ISDA was designed to solve. Where bank legal departments have not legislated outright against them — most have, long since — the temptation now is to ask “must we really have an ISDA? Would not a long-form confirmation do? There other good reasons for a master agreement, as we will see, but none of these necessitate the operation machinery that has grown around the ISDA.
This is how the military-industrial complex of agency operates: it shapeshifts to create work to occupy the available rent.[2]
The three aims of an ISDA
The ISDA Master Agreement is a framework under which two “counterparties” can transact over-the-counter derivatives — mainly, but not only, swaps. Besides its original appeal as an easance the ISDA has three main aims: it is a relationship contract; a credit risk management tool, and a capital optimisation tool.
Relationship contract
Firstly, the Master Agreement is a relationship contract: an agreement sealing a pact of amity and good dealing between two strangers in the jungle. It is, of sorts, a peace treaty: it establishes basic terms between the parties upon which they may deal, reciting their aspirations, outlining their cultural idiosyncrasies and behavioural red lines, and dealing with housekeeping matters like contact details, account numbers and authorised agents, and generally gathering up all the manifold dreary details needed to ease the experience of transacting with each other.
The Master Agreement does not itself create any obligations or liabilities. It does not commit anyone to any Transaction. Therefore, curiously, it does not provide at all for termination without fault on notice. While no Transactions are on foot, the ISDA doesn’t do anything: it just provides an architecture: walls within which parties may safely play; a roof beneath which they may comfortably dance if they both feel like it. If they don’t, no one says they have to. You can’t actually, terminate an ISDA. Even total close-out doesn’t terminate the master agreement. If your relationship ceases — should your pact break down — the ISDA just lies there, fallow, like a seed in the desert awaiting rain.[3]
In that an ISDA is painful to put in place — if it only takes a couple of months you have done well — it is also a commitment signal. It shows you care enough to engage in the painstaking process of working up “strong docs”.
If the counterparties do decide to dance, they agree economic terms of a Transaction and sign a Confirmation that sets out those terms and inherits the remaining terms of their ISDA.
Risk management
Secondly, once the parties have decided to dance, the ISDA is a risk management tool. The risks of an ISDA are largely, but not entirely, credit-related.
The ISDA gives each party the rights it needs to manage and reduce its credit exposure to the other party as a result of all this derivatives trading. These include Credit Support and Close-out rights.
Credit Support may comprise margin “posted” by the counterparty against its own exposure, or guarantees, keep-wells and letters of credit provided by third parties on its behalf. This leads to an amount of fuss pottery in the agreement: should credit triggers that catch the counterparty’s own deteriorating prospects key off credit support deteriorations too? In a basic sense, yes, obviously — but should the failure of an unaffiliated arm’s length credit insurer be grounds for immediate closeout, or just on notice, should the insurer not quickly be replaced?[4]
Events of Default and Termination Events entitle you to close out Transactions early, should your counterparty not perform (or should its creditworthiness deteriorate in oblique ways your credit department believes increase its risk of not performing).
Most Events of Default and Termination Events, therefore, address that credit deterioration, but not all: some deal with other externalities — change in law, force majeure, adverse tax — that don’t directly affect either party’s credit position.
Expected events and tail events
We can, in any case, distinguish between “expected events” and “tail events”.
“Expected events” are welcome: we assume these explicitly, by entering the Transaction. They are economic events that may happen to the instruments underlying our Transaction. If they do not turn out as we hoped, we have no complaint: that was the bargain we struck.
Expected events tend to be particularised, delimited and finely detailed. They need to be: they directly affect what you pay or receive under the Transaction, so their articulation must be exact and important. Interestingly, documentation is generally left to trading and operations staff, not legal staff. Their drafting conventions have been tested to destruction over thirty years. The rate of outright dispute on the meaning of trade terms in confirmations is generally low, and their resolution is typically quick and pragmatic. Lessons are learned: trade terms winnow themselves down to the genuinely critical over time.
“Tail events” are the externalities: things that might get in the way of you enjoying the financial risk and reward of the expected events.
These tend to be foreseeable as general categories but not in the particular, because these events are rare, unwanted, and by nature the way in which they present is unexpected. (Those that are expected are headed off): if your counterparty blows up. It It suffers sanctions. If the contract is declared illegal. If relevant tax laws suddenly change. If the Great King of Terror descends in a flaming chariot, etc.[5]
Articulation if tail risks is done by legal and negotiation staff, is generic, sweeping, and infrequently tested. Where it is tested, by the courts, after times of crisis — it often turns out not to work as expected.[6]that is to say, bad In any case we can see a clear division of labour between the Master Agreement, under which you minimise and mitigate tail risks that probably won’t happen under all Transactions, and the Confirmation, under which you precisely describe and allocate (but do not reduce, as such) risks that certainly will.[7]
So the ISDA Master Agreement provides a sort of “end of days” protection for the tail risks that could upset your Transactions. If a Confirmation is the GPS, the Master Agreement is the seatbelts, airbags or those inflatable slides on a plane that turn into life rafts: something we certainly want, but sincerely hope we will never need.
We are loss-averse: we tend to be prepared to spend far more time and resources than is rational preparing for apocalyptic risks. Thus, the negotiation military-industrial complex spends comparatively little time documenting the economics of swap Confirmations — these days a lot of that is done by computerised document assembly — but an awful lot negotiating point-to-point net asset value triggers that are almost certain never to be invoked.
The dividend of all this conceptual haggling, if done well, is a mythical contractual utopia, beloved of senior credit officers but poorly understood by anyone else, of “strong docs”. Anyway, I digress.
Capital optimisation
Thirdly, the ISDA Master is carefully designed to yield a specific regulatory capital treatment for those financial institutions who are sensitive to their leverage ratio.
Ninja point: it may look like it, but capital optimisation is not the same as credit risk management. As a matter of fact, it is the converse: capital management addresses the period until a counterparty credit loss actually happens, defining the minimum capital a dealer must hold to ride out the credit loss following a counterparty default.
Whereas credit mitigation comes into play when a counterparty has defaulted, capital optimisation works during the period beforehand. Once a counterparty has defaulted, your capital calculation is of no further use: you just hope it was enough. It makes no difference to the size of your loss; only your ability to weart the loss without failing. In this way, capital optimisation is more like own credit risk management and counterparty risk management: it ensures that when your counterparty blows up, it doesn’t take your arms and legs with it.
Capital management is, therefore, also an expected event a tool for managing “expected events” and not “tails events” as such because it has a daily direct impact on the bank’s risk weighting calculations, and therefore how much capital the bank is allowed to put at risk. It is a cost management tool, not a risk management tool, that is to say.
The principal tool for managing the capital cost of a swap master agreement is close-out netting.
Derivatives are odd contracts because they are inherently levered, and therefore extremely volatile. They have large notional values, but lower mark-to-market values. An “at-market” swap[8] starts with zero exposure, either way, and thereafter can fluctuate wildly in either direction. Compare this with a traditional loan, where the transaction starts with an exposure equal to its notional amount — lender goes “in the money”, borrower “out-of-the-money” — and the value of the loan to the lender then fluctuates narrowly around that notional amount (to account for accrued interest, changing interest rates, and the borrower’s changing credit profile) until it is all repaid, in one go, at maturity. The exposure profile of a swap is very different. The raw market exposure of a portfolio of swap transactions can, thus, be huge compared with the original capital committed (i.e. zero): the total of all your out-of-the-money positions, which you can assume you must perform, versus all collateral you hold, which you should assume you will be required to return.
If you can treat that overall total exposure as the net sum of the offsetting positive and negative exposures — especially where the bank also requires variation margin[9] — the capital requirement is much more manageable — on margined trades, net mark-to-market exposure is reset to zero every day. The capital calculation on that is extremely complicated, but this offsetting effect is powerful. It would be a whole lot higher if you couldn’t take account of close out netting.
The “standard of proof” for “netting down” Transaction exposures is also huge: regulations require banks to obtain an external legal opinion that the netting contract actually will — not just should — work. This is a “beyond reasonable doubt” sort of standard. By contrast, when setting a “credit line” the credit department is not directly constrained.[10]
There was once a time where the credit team might take a more lenient view for credit risk management purposes than the treasury team could for capital purposes. As the global financial crisis wore on, this sort of cavalier “IBGYBG” attitude gave way to a new austerity and credit teams started to think the better of this. (It probably didn’t make a lot of difference, really: you can make your credit line as big as you like, but if you have to gross your exposures for capital purposes you won’t be competitive in the market).
Qualities of a good ISDA
Clear
The many purposes of the ISDA, most deal with the present (such as the availability of netting) or the past (reps, warranties and conditions to transacting), but only one deals with the future. The credit terms. These will only come into serious contemplation at times of extreme stress. The more you stand to lose the more extreme circumstances are likely to be. Your management will certainly be going mad— take that for granted — but likely so will market, and quite possibly the geopolitical situation too. There are also likely to be multiple counterparty failures at once. All kinds of things will be stretching your attention and management's. Patience and a sense of humour will be in short supply. People will want short, clipped answers.The last thing anyone wants to hear is, “it’s complicated ” or “god forbid, the contract is not clear.
Consistent
Simple
- ↑ Yes, the JC made this word up. Think of it most nearly as the opposite of a nuisance.
- ↑ see the eighteenth law of worker entropy. Remind me to do an article on the rent carrying capacity of financial services.
- ↑ This is, indeed, the premise of Muriel Repartee’s Z-Grade Fi-Fi schlock horror ISDA: Dawn of the Dead.
- ↑ I mean, could a monoline credit insurer present a systemic risk to the financial system? Don’t answer that.
- ↑ The arrival of the Great King of Terror is a bad tail event: there is nothing you can really do to mitigate it. Best not write a swap on it.
- ↑ Almost the entire international jurisprudence on section 2(a)(iii) arises from the Lehman collapse.
- ↑ This not, ah, a bright-line distinction, but it is a good rule of thumb. You might put some asset-specific “tail risk” Termination Events in the Confirmation, but for the most part you try to get them all into the Master Agreement.
- ↑ Almost all swaps start off as at-market. Starting your swap off the market implies a one-way initial payment under the transaction, by way of premium, to the party who starts “out-of-the-money”. Otherwise, it would be economically irrational to enter into the Transaction.
- ↑ Though VM has its dark nemesis: see our essay when variation margin attacks.
- ↑ As ever, our old friend Lucky provides a great example. During Archegos the risk team repeatedly changed the applicable risk model to something more benign so they could continue to trade.