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 what seems to be the bleeding obvious.
Going back to basics is bracing for the spirit. The JC encountered his first Aïessdiyé fully thirty years ago now — shout out the GFF — and he still finds himself discovering things he didn’t know, or having things dawn upon him. Plenty did, as he prepared this essay.
On becoming a shibboleth
Through habit and inattention we work around the affordances of our business. What starts as a practical shortcut — the shortest possible route to market — can, through acquiescent disregard become a sacred cow — a shibboleth — an obstacle on the road to transaction. So it is with the ISDA Master Agreement. Once precisely an affordance —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, but it has become a three-month climb. And one does not scale an ISDA master agreement the way Alex Honnolt scales El Cap. There is the entire modernist machinery of the multi-national corporation campaign that you must take with you.
There are those who miss the good old days. Where bank legal departments have not legislated outright against them — most have — the temptation now is to ask “must we really have an ISDA? Would not a long-form confirmation do?
This is how the military-industrial complex of agency operates: it shapeshifts to create work to occupy the available rent.[1]
The three aims of an ISDA
The ISDA Master Agreement is, as we know, a framework under which two “counterparties” can transact over-the-counter derivatives — swap contracts. Besides its original appeal as an affordance it has three main aims: it is a relationship contract; it is a credit risk management tool, and it is a capital optimisation tool.
Relationship contract
Firstly, the Master Agreement is a relationship contract: a legal agreement establishing the basic relationship between the parties, reciting their aspirations, dealing with housekeeping, setting out contact details and process agents, setting up the transaction process to make trade time as simple and streamlined as possible, and generally setting up the economic parameters within which the parties agree to transact from time to time.
The Master Agreement does not of itself create any obligations or liabilities, or otherwise commit anyone to any Transaction in particular. For this reason, and curiously, the ISDA Master does not provide at all for termination without fault on notice. This is because, absent Transactions, the ISDA doesn’t do anything: it simply provides architecture: walls within which parties may safely play; a roof over their heads under which they may comfortably dance if they both want to. If they don’t fancy dancing, no one says they have to.
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”.
If the parties do decide to dance they execute a Confirmation, under the auspices of the Master Agreement that inherits its terms and sets out the economic terms of the Transaction.
Credit risk management
Secondly, once the parties have decided to dance, the ISDA is a credit management tool. It 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 take the form of margin “posted” by the counterparty itself against its own exposure and guarantees, keep-wells and letters of credit provided by third parties on the counterparty’s behalf.
Events of Default and Termination Events permit an innocent party to close out Transactions early, should the counterparty breach the agreement, or its creditworthiness deteriorate in more or less oblique ways contrived by the credit department. Some of the Termination Events are concerned with other externalities — change in law, force majeure, tax matters — that don’t directly affect either party’s credit position.)
Expected events and tail events
We can, in any case, distinguish between welcome “expected events” and unwelcome “tail events”.
“Expected events” are the risks you assume by entering the swap in the first place: the economically significant things you believe may, or may not, happen. If these things do not go how you hoped, there is no complaint: that is the bargain you struck. The forward value of goods and rates you agree to exchange.
“Tail events” are externalities: things that might get in the way of you enjoying the financial risk and reward of the expected events. Your counterparty blowing up or being subject to sanctions; the contract being declared illegal; relevant tax laws suddenly changing, the Great King of Terror descending in a flaming chariot, etc.[2]
In any case we can see a clear division of labour between the Master Agreement, under which you minimise and mitigate potential tail risks under all Transactions, and the Confirmation, under which you precisely describe (but do not reduce, as such) market risk for individual Transactions.[3]
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[4] 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[5] — 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.[6]
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).
- ↑ Remind me to do an article on the rent carrying capacity of financial services.
- ↑ 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.
- ↑ 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.