Template:M summ Equity Derivatives 12.7

The calculation of Cancellation Amounts following Extraordinary Events is one of those classic negotiation oubliettes that opposing counsel will gladly fall into, the way Unlucky Alf falls into open manholes. The JC has seen storied partners of serious law firms get in quite the lather about this, from positions of apparent ignorance, hotly insisting co-caclulation agency to be a matter of life or death, predicated on the assumption that given half a chance, these venal swap dealers won’t break a stride before ripping hunks off their customers’ faces.

They will say, “my customer must have the right to challenge your price. It must be allowed to consult its favourite dealer, and ask it what the Cancellation Amount should be. We must have a dealer poll. Something like that. Take the average. You know.”

This is a wonderful narrative, vouchsafing as it does tedious, remunerative arguments that their customers may indeed believe save them from great peril — but it really need not be that complicated.

Firstly: remember the commercial imperative. As the old saying has it, “he who burns his customer’s shed down, steals his oxen and sells his children into slavery cannot expect to sit at his customer’s annual broker review without the subject coming up”.

Secondly, ask why, if your customer’s other broker is so damn good, it didn’t get the trade in the first place?

Thirdly, remember what is going on here: the dealer — who the customer selected precisely because it is such a good broker, with unbeatable access to liquidity, flawless execution and competitive pricing, right? (and if not, why not?) — is struggling to find a good price for a stock because it has been de-listed, nationalised, gone insolvent, or been subject to some awful liquidity crunch. Your dealer, not having a dog in the fight, will want to get the best price it can to terminate the hedge as it will pass that on to its customer.

Extraordinary Events being, well, extraordinary, this will not happen often, and no dealer with a functioning brain will just terminate a position against its customer’s wishes without consulting its customer. It will say, “look, here’s the price we see: does this work for you?” If the customer can source a better price — as in, “firm, tradable price” then the dealer will happily take it. But honestly it isn’t that likely: all the customer can really do is ask another broker, who is likely to see a similar picture. Colour me wrong on that, but if so, happy days: as long as our Determining Party can lift the offer, it will take it and everyone will be simpatico. But, still, it is unlikely.

And in the mean time, while the customer is going through its agonised machinations — should I? shouldn’t I? — the price that its dealer did get can go quickly stale. Once it’s off the table, the customer loses its right to trade at that price. There needs to be this tension: dealers are not writing options here: the customer only gets a price the dealer can actually trade on.

Accordingly, the dealer will be most unamused if a customer asks it to consider an alternative price someone else has come up with to value its own hedge liquidation. This is like saying, to a football fan, “look, I know Crystal Palace lost to Scunthorpe in extra time at the weekend, but my mate is a football expert, and he says Palace were dead unlucky, hit the crossbar a couple of times, and that Scunthorpe goal should have been called off-side, so why don’t we call this 4:0 to Palace?”

So when a customer huffily expects a right to provide a second opinion that is not a tradable price, it — and its lawyers — can expect a rather plainly spoken response. To the complaint that, “but the stock has been delisted! There is no price in the market! I can’t be sure this price is right!” comes the answer: friend: that is exactly the risk you ran when you bought a swap on this stock. You are buying precisely the risk that it goes insolvent, gets nationalized or is delisted.