Template:M intro isda on termination

Commerce gives the lie to the idea that life is a zero-sum game. This was Adam Smith’s great liberating insight: life need not be nasty, brutish and short after all. Each of us will only strike a bargain if, on our own terms, we will be better off as a result. That being the case, there need is no logical to a commercial relationship: it is an infinite game. If we are flexible enough, open-minded enough, and good enough at playing infinite games we can keep this positive feedback loop going indefinitely. Infinitely, even.

Therefore, we wish our relationships well, pray for them godspeed for a long life and, should it come to it, a peaceful ultimate transition from the flush of vital ardour into the restful stasis of the hereafter, but we know this is not always possible. Things do not always work out.

Therefore, we pack our trunk with tools and weapons with which, if needed, we can engineer an exit. There is no more sacred time in the life of our commercial arrangements than our departure from their earthly clutch. But we do not talk about it enough. Below, JC comes over all over-analytical and counts the ways we do this.

Customers and service providers

Now the great majority of financial contracts are between a “provider” on one side — a bank, broker or dealer who provides a service, broadly described: money outright, finance against an asset, or a financial exposure — and a “customer” on the other who buys that service. The customer is, as ever, king: the services exist for its benefit exclusively: the provider’s net interest is limited to managing the financial exposure that comes from providing that service, and taking some kind of fee, commission or economic rent on top of that by way of consideration.

Providers do not mean to be economically “the other side” of the services they provide. They are, loosely, intermediaries. Agents. They do not take a direct opposite exposure. All being well, they are indifferent to how well the instruments to provide perform — so, as long as they manage the risks of providing their services, should have no need to terminate them, and every incentive to keep providing them, seeing how that is how they earn a crust.

So expectations from the contract are different: the customer is on risk and it is her prerogative to change her mind and go off risk as she sees fits. She can always exit a financial contract whenever she wants, by paying her provider’s outstanding fees and whatever it needs to terminate the arrangements it made to provide the service rendered — its “breakage costs”. The ability to ensure this makes the whole business worth the provider’s while, however long it lasts.

But all else being equal, the provider cannot just exit without the customer’s permission. A financial contract with a fixed term, therefore, binds the provider but not the customer to that term. But things can change during that term The customer’s financial prospects may take a turn for the worse. She may turn out to be a cad. The regulatory environment may change, making the services harder or more expensive to provide.

Hence, the provider must have a set of “weapons” it can use to get out of a financial contract where it can no longer vouchsafe its expected financial return. These fall into a bunch of different categories.

Categories of termination

We would put these “exit scenarios” into three categories: terminations “without cause” terminations due to unforeseen external events; and terminations due to counterparty failure. This last category — which we might also label “default” — in turn breaks into two: non-performance and credit deterioration. There is also an odd category of pseudo-termination rights that a dealer must have, but would never insist on using and, curiously, relate to concerns about its own solvency.

Without cause

Terminations without cause: they arise just because — no fault, no pressing need; just a gradual drifting apart of interests. As we grow in life, the things we value change. Passions of youth dampen, we tend more towards songs of experience than those of innocent exuberance, and we sing those to a different tune. Here we prescribe a notice period long enough to allow our counterparty to make alternative arrangements it needs to keep its own house in order, but otherwise, we wish each other well and carry along on our way.

Pseudo termination rights

There is a fourth category: the pseudo-termination right: this is a right the provider needs for formalistic or regulatory reasons, but which it never expects to actually use. These may include, for example, a dealer’s right to terminate on say 30 days’ notice from a synthetic equity derivative contract — this entitles the dealer to treat the exposure as a “short-term obligation” for regulatory purposes, dramatically reducing its capital cost of offering the business, but it is not aright the dealer would ever expect to exercise except in the direst of circumstances (where its own survival was threatened).