Agents and Parties - Equity Derivatives Provision
2002 ISDA Equity Derivatives Definitions
Section Calculation Agent, Determining Party and Hedging Party in a Nutshell™
Full text of Section Calculation Agent, Determining Party and Hedging Party
Content and comparisons
Between them, the definitions of Calculation Agent, Determining Party and Hedging Party rich fodder for buy-side legal eagles to make a nuisance of themselves arguing the toss over plainly fatuous “potential” risks. This is good for the healthy revenues that flow into that cottage industry of master agreement negotiations, but an appalling waste of time on any other axis.
The Calculation Agent is the person appointed to calculate all the values that need calculation during the ordinary course of the Transaction. These include the Final Price, on each Valuation Date, the prevailing Floating Rate and so on.
The Determining Party has the more limited role, and only comes into its own should the physical market have gone Pete Tong and the Transaction has been fully or partially cancelled. At this point, the Determining Party must work out the Cancellation Amount. This is meant to reflect the actual price that the Hedging Party was able to terminate its hedge, so it should come as no surprise to you that the Hedging Party is the Determining Party. This does seem to surprise some people who ought to know better, partly because ISDA’s crack drafting squad™, in its usual quest to cater for every logically possible eventuality, and not just ones that make practical sense, spent a paragraph or two ruminating about what should happen where there are two Determining Parties.
The Hedging Party is, as the name suggests, the one who is actually doing the hedging — in the case of an equity derivative, that means buying or selling a physical security. This is usually the dealer, and if it is not will be one of the dealer’s affiliates with market access in the relevant market, and who may transfer its risk back to the dealer some other way.
Now buy-side legal eagles do not like to hear this, but it is true. The swap dealer — often your prime broker — is the one you go to because of its market access, back-office systems and attractive financing rates. You place, or give up, your orders to the swap dealer; the swap dealer executes them for its own book, and provides you the return of your synthetic investment through a delta-one equity swap. The swap dealer does not come to you looking for exposure to equity derivatives.
Therefore: (i) it (or its affiliates) will be the one that is hedging; (ii) it will be the one having to make the determinations required of a Determination Agent should there be some kind of Market Disruption, and (iii) it will be the one executing the opening and closing orders, using best execution, that are determined by the Calculation Agent.
If you want to control the price at which you trade, you can do that via a give-up (in the European market, anyway), or by placing an upper or lower limit on your order (at which point you risk your order being unfilled. Your remedy, should you not like the price you get, is to give your order to another broker next time.
Why “Agent” here, and “Party” there?
Calculation Agent; There is a sense that an “agent” is one who acts on the behalf of others — both counterparties, in the case of a derivative contract — and should not consider its own interests. The Calculation Agent in any swap will generally be one of the counterparties — most usually the swap dealer — and in equity derivatives definitely so. The “agent” tag is meant to remind us that when acting as Calculation Agent one acts by reference to the distilled abstract qualities of the market, meditating on the golden mean, as it were, and not by reference to one’s own sordid axes and grubby financial interests.
All the same we dimly apprehend that a Calculation Agent who also happens to be one of the counterparties has some kind of conflict of interest — buy-side legal eagles definitely apprehend that — but in equity derivatives the conflict is more one of form than substance: the swap dealer hedges itself delta-one and has nothing to gain, in the abstract, by valuing a Transaction artifically high or low. Its revenue, remember, comes from its commissions and its financing efficiency, not through the price of the underlier.
Hedging Party and Determining Party: The Determining Party and Hedging Party are, by contrast, parties (not necessarily counterparties to the actual Transaction, though usually) overtly acting with regard to their own position, being the hedge transaction, not the equity swap itself — though in every case, required to do so in good faith and using commercially reasonable procedures.
“Good faith and commercial reasonableness” standard
At first blush it looks like only the Calculation Agent is subject to the “in good faith and a commercially reasonable manner” standard, but this is really just the way ISDA’s crack drafting squad™ decided to express themselves. Whereas the performance standard is baked into the definition of Calculation Agent in Section 1.40, for Determining Party it is set out separately in Section 12.8(b), and 12.8(e) and 12.8(g): “Any Cancellation Amount will be determined by the Determining Party (or its agent), which will act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result.”
Likewise for the Hedging Party, which Section 12.9(a)(v) requires to have made commercially reasonable efforts to hedge before declaring there has been a Hedging Disruption, as does Section 12.9(a)(vii) for Loss of Stock Borrow and Section 12.9(a)(xi) when sourcing a Lending Party.
- “Exotic”, to finance professionals, means the same thing as “courageous” to civil servants.