Payment upon Certain Extraordinary Events - Equity Derivatives Provision
2002 ISDA Equity Derivatives Definitions
Section 12.7 in a Nutshell™
Use at your own risk, campers!
Full text of Section 12.7
Content and comparisons
Not to be confused with Cancellation and Payment as they appear in section 11.1(b) relating to Adjustments and Modifications, and Partial Cancellation and Payment as it relates to Merger Events in section 12.2(f).
- Significant events relating to the Issuer or its Shares (Merger Events, Tender Offers, Nationalization, Insolvency and Delisting etc); or
- Additional Disruption Events affecting the market under section 12.9 such as Change in Law, Hedging Disruption, Increased Cost of Hedging, Loss of Stock Borrow or Increased Cost of Stock Borrow, all of which were relate to the Hedging Party’s Hedge Positions rather than the underlying Issuer.
What happens upon Cancellation following Extraordinary Events depends on whether your Transaction is an Option Transaction — in which case Section 12.7(b) applies and there is all kinds of fun with Agreed Models or Calculation Agent Determination — or a Forward Transaction or Equity Swap Transaction, in which case the shorter Section 12.7(c) will apply, and unless you’ve been unwise enough to agree there should be two Determining Parties, the Hedging Party (in its guise as Determining Party) will close out its hedge and present the bill.
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.”
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.
Section 12.7(c) and the curious question of the multiple Determination Agents
Now, here is a funny thing.
In its ever-unquenched thirst to cater for every conceivable eventuality, however inconceivable, the ’squad devoted themselves in Section 12.7(c)(ii) to the contingency that there might be two Determining Parties appointed to hash out the Cancellation Amount that applies for a Transaction. This, we think, imagines some kind of collective co-calculation agent regime where the parties each have their own Man In Havana making independent calculations with the intention of split whatever difference there may be.
But alas, having had the energy to contemplate this vanishingly remote scenario, our ninja friends didn’t have the diligence left to write out what should happen properly, and as a result, what Section 12.7(c)(ii) tells the co-Determining Parties to do doesn’t make any sense.
In fairness, simply having co-Determining Parties doesn’t make any sense, but that won’t do as an excuse: if you insist on contemplating something unnecessary, you should at least work it through properly, so negotiators who fall into the trap of thinking you knew what you were doing when you drafted the option, and who therefore select it, don’t get themselves into bother later, which we regret to say they will, if they select two Determining Parties. Not many do, but it is not unheard of.
But first things first.
Why it makes no sense to have two Determining Parties
Cast your mind back to the reason we have a Determining Party, and not just the Calculation Agent, in the first place. It is specifically for calculating Cancellation Amounts when nixing a trade that has suffered a catastrophic Additional Disruption Event:
...determination of a Cancellation Amount is inextricably related to the hedge and — especially where there is a disrupted market – this is best to be calculated by the one whose problem it is to unwind that hedge: namely, the Hedging Party. In theory (though almost never in practice) the Hedging Party might not be the Calculation Agent.
Now, remember what is going on here: we have a client, going long or short some Equity underlier without actually having to buy it, and a swap dealer, providing that exposure by using its deep connections into the world’s equities and futures markets. Customer, that is to say, and service-provider. The swap dealer has no skin in the game: it has no stake in the performance of the underlier. It will be hedging delta-one, usually by buying (or short-selling) the underlier outright. Other than to the extent that price keeps its customer happy and returning for more business, it is indifferent to the price of the underlier, as long as it can pass it on to its client. It has every incentive to get the best price it can: that is the commercial imperative.
Now, if the Transaction has been disrupted so badly it is to be cancelled, this means is hard to get a price in the underlier, That, in turn, means it is hard to liquidate the hedge. Whose problem is that? The Hedging Party’s. It went out and bought the hedge, in fair times, and now it has to sell it, while times are foul.
To be clear this is no idle intellectual speculation: liquidating a hedge is not simply looking at some fantastical model dreamt up by the most delusional quant on the trading floor, arriving at some mad price that will ruin the client for nothing. No. The Hedging Party is actually long the risk. It will have to crystallise real liability, using money from its own pocket to flatten out that risk. The amount it pays away is exactly what it will expect its client to suffer. That is the deal.
Running a synthetic equity business is mainly boring, often fraught, and on the odd occasion terrifying job. Calculating Cancellation Amounts upon market disruption counts, at least, as fraught. If the Hedging Party can’t match its hedge executions with its client pricing, it will lose money. It occasionally escapes the buyside community, but this is not the idea. The dealer is does not expect to profit, or lose, from movements in the underlier: the point is to pass those onto the client, who has specifically signed up for them.
The dealer will, tersely, say, “I am sure you have a great relationship with Wickliffe Hampton and everything, but I could not care a row of buttons where they see the notional value of my hedge. They don’t have to sell it. I do. The price I see is X. Now, if your buddies at Wickliffe Hampton are prepared to make me a firm bid at Y to buy my actual hedge, from me, then I am listening. Otherwise, the price I see is X.”
But it is Determining Party, not Hedging Party
The truly stubborn buy-side agitant will persist: “if this is really about who is the actual Hedging Party, why doesn’t it just say “Hedging Party”? Why do we need a new definition of Determining Party? It isn’t used for anything else. Your beloved ’squad doesn’t make these things up for the sake of it, after all.”
The galling fact is that we cannot explain this. Our best guess is yet more unnecessary over-elaboration on ISDA’s crack drafting squad™’s part — it may not have made a difference (and might have avoided this very article) had the ’squad not created an extra label, but we are where we are. It is possible, we suppose that the dealer hedges with a swap, and the actual price discovery happens away from the Hedging Party along a chain somewhere). But that isn’t a very satisfactory answer.
Why, if you must insist on having two Determining Parties, this clause doesn’t work
This is the clincher. the co-Determining Party language doesn’t work. Say we have, with heavy heart, acquiesced, and agreed two Determining Parties. Let’s further say there has been an Extraordinary Event, such that a Cancellation Amount is required. We reach for Section 12.7(c). Each Determining Party does its thing: the swap dealer’s sees a price of 102, and the client’s agent sees 104.
Logic should say the number we are after is 103, yes? The average. But, thought easily could have said that, that is not what Section 12.7(c) does say.
“...an amount will be payable equal to one-half of the difference between the Cancellation Amount of the party with the higher Cancellation Amount (“X”) and the Cancellation Amount of the party with the lower Cancellation Amount (“Y”) and Y shall pay it to X.”
The difference between X and Y (104 - 102) is two. Half of that difference is one. If it is meant to yield a consensus single Cancellation Amount, this, to put not too fine a point on it, is wildly, obviously, and patently wrong.
“Equity vs Equity” swaps, maybe? Don’t think so.
What could be going on? One thought we had — and it is a feeble, half-thought, so pay it little mind other than to dismiss it — is that this is meant to address a Transaction where both parties are hedging separate equity risks: rather than the usual equity swap, which pays an Equity Amount return against a Floating Amount return, the Transaction is structured as two offsetting Equity Amounts. This would at least justify there being two Determining Parties, and it would also justify them using the difference between the values, rather than their average — but not half the difference between the values.
And even here, the concept doesn’t work: a Cancellation Amount is crafted as the total termination amount for the whole Transaction, not just a valuation of the Equity Amount leg. Nor are such swaps otherwise contemplated in the 2002 ISDA Equity Derivatives Definitions, seeing as there is a much easier way of achieving long exposure to one underlier and short exposure to another: just enter two vanilla Transactions, one long and one short.
Ok, how about the User’s Guide to the 2002 Equity Derivatives Definitions?
Perhaps, you might thing, the User Guide sheds some light? Well, perhaps indeed. But alack: the little it has to say on the subject sheds light on one question only: that whoever wrote the User’s Guide has no better clue to what is meant to be going on that anyone else. For it opines:
“If there are two Determining Parties, each party will determine a Cancellation Amount and one half of the total of the Cancellation Amounts is payable.”
This is, of course, not what Section 12.7(c) says at all. As we have noted, it says, “... an amount will be payable equal to one-half of the difference between the Cancellation Amount of the party with the higher Cancellation Amount (“X”) and the Cancellation Amount of the party with the lower Cancellation Amount (“Y”) ... ”
- 12.7(a) (Cancellation and Payment; Partial Cancellation and Payment)
- 12.7(b) (Effect of Extraordinary Events on Option Transactions)
- 12.7(c) (Effect of Extraordinary Events on Forward Transactions and Equity Swap Transactions)
- I know, I know.
- Yes, that is the JC quoting itself. Bite me — if you can’t be bothered seeing what else you can find on this topic on the Google, that is.
- Yes it is true that derivatives counterparties don’t, legally, have to hedge, but please, ladies and gentlemen: that is the academic theory. In practice, they absolutely do. The disconnect between a swap dealer’s hedge and the price of their derivative is a matter of interest for stamp-duty specialists only.
- Is it just me who finds the idea that ISDA contemplates just a solitary reader of its “User’s Guide”? And that that solitary reader is the JC? Mind you, it could be worse: the 2011 Equity Derivatives Definitions have no users!