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 easances1 we once made to our “built environment”. What started as the shortest route to market can, through acquiescent disregard, become a shibboleth: a hindrance on the road to transaction.

So it is with the ISDA Master Agreement. Once precisely an easance — an artefact for quickly tidying up and dispensing with formalities it would be laborious to repeat for every trade — the ISDA became a mountain of its own. Sure, you only need to climb it, from the bottom, once, but that has become a three-month operation. Nor do you scale an ISDA master agreement the way Alex Honnold scales El Capitan, brave and alone, an aeronaut of the spirit. You must take the entire modernist machinery of your institution with you.

Some 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 have an ISDA? Would not a long-form confirmation do?

There are other good reasons for a master agreement, as we will see, but none necessitates all the bureaucratic 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. This is, indeed, the premise of Muriel Repartee’s Z-Grade Fi-Fi schlock horror ISDA: Dawn of the Dead.

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 exposure, or guarantees, keep-wells, letters of credit and so on provided by third parties on its behalf. This leads to an amount of fusspottery in the agreement: should credit triggers that catch the counterparty’s own deteriorating prospects also be triggered if only the credit support provider deteriorates? 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?3

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 of these events address 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 the economic events that may happen to the instruments underlying our Transaction. Reference Entity Credit Events, rate rises, rate falls, option triggers and so on. If the underliers do not behave as we hoped, we have no complaint: that was the bargain we struck.

Expected events tend to be particularised, delimited and finely detailed. By necessity: they directly affect what you pay or receive under the Transaction, so their articulation must be exact, and room for debate minimal.

Interestingly, their documentation is generally left to trading and operations, not legal. But drafting conventions have been tested to destruction over thirty years. The rate of outright dispute on the basic meaning of trade terms is generally low, and resolution is typically quick and pragmatic. Lessons are learned: trade terms winnow themselves down to the genuinely critical over time. The drafting self-improves in that evolutionary process.

That Darwinian effect is far less pronounced for “Tail events”. These are the externalities: things you don’t expect, but are resigned to, that might get in the way of you enjoying the financial risk and reward of the expected events.

These tend to be easy to foresee in general but impossible in particular, precisely because they are rare, unwanted and, by nature, present themselves when and where no-one is looking: if your counterparty blows up or is nationalised, embargoed or sanctioned. If the law changes, making the Transaction illegal, difficult to perform or less valuable. If the Great King of Terror descends from the skies in a flaming chariot, etc.4

Articulation of tail risks is usually done by legal or — under legal’s supervision — the negotiation team. The language is baroque, sweeping and infrequently tested. When it is tested, by the courts, after times of crisis — it often turns out not to work as expected.5

Division of labour

In any case, there is a functional division of labour between the Master Agreement, under which you minimise and mitigate unlikely risks in general, and the Confirmation, under which you assume and allocate likely risks in particular.6

So: the Confirmation deals with what you think will happen and the Master Agreement deals with what you think won’t. The Confirmation is GPS navigation; the Master Agreement is seatbelts, airbags and those neat inflatable slides that turn into liferafts when a plane crash-lands on water: something you’re glad you have, but hope not to use.

We are loss-averse: we spend more time and resources than is rational preparing for apocalyptic risks.

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 is carefully designed to yield a specific regulatory capital treatment for regulated financial institutions. Regulatory capital is a big topic, well beyond the scope of this article.

Ninja point: it may look like it, but capital optimisation and credit risk management are not the same. Quite the converse: capital management addresses the period until a counterparty blows up; credit risk management addresses what happens when it blows up. Capital rules define the amount of spare cash — “capital” — a dealer must keep uninvested to ride out the losses it suffers should a counterparty default.

The tools of capital management, therefore, address an “expected event”, the event being “the amount of money the bank must hold as capital each day”. They don’t address the tail event that the bank holds capital against itself. They assume it will happen. The capital calculation has a daily direct impact on the bank’s capital position, its leverage ratio, therefore how much capital the bank can put at risk. In that very narrow sense, it is a “cost-of-doing-business” management tool, not, strictly, a risk management tool.

The principal tool for managing the capital cost of a swap master agreement is close-out netting.

Derivatives are odd contracts. They are inherently levered, and therefore extremely volatile. They have large notional7 values, but, usually, much lower mark-to-market values. An “at-market” swap8 starts with zero exposure, either way, and thereafter can fluctuate in either direction.

Compare this with a traditional loan, which starts with an exposure equal to its principal amount — the lender goes “in-the-money” for the full principal size of the instrument, and borrower “out-of-the-money” — and the “mark-to-market value” of the loan — I know, this terminology is wrong in so many ways — then fluctuates narrowly around the amount borrowed, 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. There is no scenario in which the lender owes the borrower. The loan covenants reflect this.

Given that the “amount originally borrowed” under a swap is, nominally, zero, the raw market exposure of a portfolio of swaps can be huge compared with that original capital commitment. The total of all your out-of-the-money positions, which you can assume you must perform, versus all your in-the-money positions, for payment of which you will be an unsecured creditor.

But here is the beauty of the Single Agreement: if you can offset your out-of-the-money positions against your in-the-money positions, and be an unsecured creditor only for the difference between them — especially, as is usual these days, the bank has variation margin reflecting the difference9 — things look a lot rosier from a regulatory capital perspective. On “margined” transactions, the parties’ net mark-to-market exposure resets to zero every day.10

The “standard of proof” for “netting down” transaction exposures in this way is also huge: regulations require banks to obtain and keep up-to-date a battery of external legal opinions — one for each counterparty type in each jurisdiction that the bank trades against, for each type of master agreement — that the netting contract actually will — not just should — work in all relevant jurisdictions: the bank’s, the counterparties, its branches, and the location of any assets. We have more to say about netting opinions elsewhere.

For now, suffice to say the standard of certainty the bank must obtain for each opinion is extremely high. The chance of netting failure was no doubt material when it was new technology in 1987, for an exotic contract, poorly understood beyond a narrow range of specialists in London and New York. Swaps nowadays being a well-recognised and understood category of financial instrument, the risk of “netting failure” in most jurisdictions is probably minimal.

There was once a time when the credit team might take a more lenient view for credit risk management purposes than the treasury team could for regulatory 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 it. (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).

Conclusion

Of these three purposes, the one that occupies the most attention during the negotiation process is credit risk management. Achieving “net” treatment is in both parties’ interests, and the mechanism for achieving it is inviolate — the famous “Single Agreement” provision at Section 1(c) of the ISDA, sometimes the definition of Bankruptcy and for Germanic types, designating Automatic Early Termination. Likewise, no-one haggles too hard about your address for notices, who your process agent is. whether or not you are a multi-branch party, or who does what when it comes to portfolio reconciliation and dispute resolution on trade reporting.

But when it comes to Additional Termination Events, expect a firefight.

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 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.

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

A relationship contract, yesterday.

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.

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?

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. Interestingly, their 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 events tend to be easy to foresee in general but impossible to predict in particular, precisely because they are rare, unwanted, and by nature present themselves where no-one happens to be looking. If your counterparty blows up or is nationalised, embargoed or sanctioned. If the law changes and makes the contract illegal or less valuable. If the Great King of Terror descends from the skies in a flaming chariot, etc.

Articulation of tail risks is usually done by legal or — under legal’s careful supervision, the negotiation team. The language is baroque, sweeping and infrequently tested. Where it is tested, by the courts, after times of crisis — it often turns out not to work as expected.

Division of labour

In any case there is a functional division of labour between the Master Agreement, under which you generallyminimise and mitigate tail risks that probably won’t happen, and the Confirmation, under which you precisely describe and allocate (but do not reduce, as such) risks that definitely will.

So the ISDA Master Agreement provides a sort of “end of days” protection for the tail events 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 when it crash lands on water: something we want, but hope we never need.

We are loss-averse: we tend to spend far more time and resources than is rational preparing for apocalyptic risks.

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 such things.

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 wear it. In this way, capital optimisation is own credit 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. They are inherently levered, and therefore extremely volatile. They have large notional values, but, usually, much lower mark-to-market values. An “at-market” swap starts with zero exposure, either way, and thereafter can fluctuate 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. There is no scenario in which the lender owes the borrower. The loan covenants reflect this. 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 — 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.

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 it. (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 market’s, your management’s and yours. The more the firm stands 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 the market, and quite possibly the geopolitical situation too. All kinds of people will be doing inexplicable things. Your customers will be AWOL. Bank chief executives won't be answering each other’s calls. Prime ministers will be ordering overseas embassies to max out their credit cards. The central bank will be ordering people to lowball LIBOR.

We do not imagine that, when they crafted its close out mechanics, the ’squad had the wider general ambiance in which the ISDA’s s last-resort rights would be exercised. They can't have. We suppose they contemplated the close out urge coming upon the responsible credit officer, in isolation, at a time of beatific placidity. That there would be time and space to consider and quietly contemplate what must be done, perhaps with a frisson of regret for the poor customer whom one is letting down.

Rest assured, it will not be like that. There will be multiple counterparty failures at once. All kinds of things will be stretching your attention, and your management's. Even among those who had them in the first place, patience and a sense of humour will be in short supply. People — many, many people — will want short, clipped answers to different questions they are all shouting at you at once. If you even understand the question, the last thing anyone wants to hear by way of answer is, “it’s complicated ” or God forbid, “the contract is not clear.”

This, we think — and we applied to say the JC seems to be on his own are about this one — recommends short, clear, plane, and blunt termination events addressing only generally catastrophic circumstances. The reality is that most of these are embedded in the pre-printed form of the isd master agreement itself. Do not mess around with these, and try to resist the temptation to unnecessarily augment them.