Template:M intro isda ISDA purpose
In this backgrounder the JC will look deeply at what the basic point is of an ISDA Master Agreement. Why can’t you just crack on and trade swaps without all this dusty paperwork? What is wrong with long-form confirmations?
This might seem like pocket-calculator stuff to seasoned veterans, but it never hurts to stop and ponder what seems to be the bleeding obvious. The JC encountered his first Aïessdiyé fully thirty years ago now, and he still found himself discovering things he didn’t know, or hadn’t occurred to him, as he prepared this essay.
The ISDA Master Agreement is, as we know, a framework agreement under which parties can transact swap contracts. The ISDA has three main goals: it is a relationship contract; it is a credit risk management tool, and it is a capital optimisation tool.
Relationship contract
It is a legal agreement governing the general relationship between two parties, dispensing with housekeeping matters like contact details, simplifying and streamlining the transaction process and generally setting parameters within which the parties agree to transact from time to time. The ISDA does not of itself create any obligations or liabilities, or otherwise commit anyone to any Transaction in particular. It simply provides an architecture: walls within which they may safely play; a roof over their heads under which they may comfortably dance.
In that ISDAs are painful to put in place — if it only takes a couple of months you are doing well — the ISDA is also a commitment signal: it shows you care enough to engage your legal eagles in the painstaking process of working up “strong docs”.
Credit risk management
It is a credit management tool: it give each party the tools it needs to manage and reduce its credit exposure to the other party as a result of all this derivatives trading.
Here, there is a clear difference between the Master Agreement, which is all about reducing credit risk, and the Confirmation, which is designed to to precisely describe (but not reduce, as such) market exposure under a given Transaction. The point of derivatives trading is to take on market exposure, of course. Counterparty credit risk is an unwanted side effect: a tail event so the terms in the ISDA Master Agreement provide sort of “end of days” protection, like airbags or the inflatable slides on a plane: something we definitely want on board, but sincerely hope will never be needed.
We should distinguish between “expected events“ and “tail events”. “Expected events” are things you hope will happen as a result of signing the contract: the delivery of goods; performance of services, the payment of money and so on. “Tail events” are externalities: things you sincerely hope, will not happen, particularly ones that might upset the normal run of expected events. Your counterparty blowing up; war, pandemic, the great kind of terror coming down from the sky etc.[1]
It is in the nature of apocalyptic risks that we are prepared to spend far more time and resources than is rational preparing for them. Thus, the negotiation military-industrial complex, which spends comparatively little time documenting the economics of swap confirms — these days a lot of that is done by computer — but an awful lot negotiating point-to-point net asset value triggers. The dividend of all this conceptual haggling, if done well, is a mythical contractual utopia, beloved of senior credit officers but not really understood by anyone else, of “strong docs”. Anyway, I digress.
Capital optimisation
To give regulated institutions who are sensitive to their leverage ratio the tools they need to mitigate the effect derivatives trading has on their capital calculations.
Ninja point: it may look like it, but capital management is is not the same as credit risk management. Indeed, it is the converse: capital management covers the period until a counterparty credit loss actually happens, describing the minimum capital the bank must hold to ride out the shock of that default. Once the default has happened, of course, the capital calculation in itself has no bearing on the size of the credit loss; only the institution’s ability to weather it without blowing up itself. In this way, capital management it is more like own credit risk management — it ensures that when a counterparty blows up, it doesn’t take you with it.
Capital management is, nonetheless, 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[2] 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[3] — 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.[4]
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).
- ↑ The descension from the sky of the great king of terror is a bad tail event, because there is nothing you can really do about it by way of mitigation.
- ↑ 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.