Myths and legends of the market
The JC’s guide to the foundational mythology of the markets.™
One of the great foundational myths of the financial market is that, in times of trouble, a council of expert market professionals will rally around a stricken colleague and provide wise, equable and firm prices on complicated derivative positions that underly the dealer’s structured products business. It is enshrined in the canonical texts of the financial services faith: the ISDA Master Agreement, the run of standard ICMA bond terms and conditions.
The fact that such a council of reference dealers has never once been reliably witnessed in the history of the derivatives markets, yea even unto the First Men, troubles no-one.
The quaint notion that a dealer poll would, at the point when needed, actually do anything was laid to rest in the 2023 case of Lehman Brothers International (Europe) v AG Financial Products, Inc. which involved the closeout and valuation of a 1992 ISDA following Lehman’s collapse.
This case is an object less on for many unacknowledged facts about derivatives trading — such as that cases involving seemingly tried and tested aspects of close-out methodology get litigated at all, let alone that they take 15 years to get to judgment — but the standout point is the forlorn pointlessness of convening dealer polls.
From Crane J’s factual summary:
In accordance with its responsibilities under the ISDA Master Agreement, following its declaration of an event of default, Assured engaged the assistance of Henderson Global Investors, Ltd. (Henderson), to conduct an auction so that it could satisfy the ISDA Market Quotation process. Henderson contacted 11 potential bidders in advance of the auction that took place on September 16, 2009. Not one bid was received.
LBIE did manage to get some indicative bids that were, expert witnesses thought “indicative market data of where these transactions, these underlyings would be trading at that stage on termination date”. But not one of them was prepared to make a binding offer, and the most fulsome indicative bid was disclaimed up the wazoo:
“This is not investment advice of any kind and we do not purport any degree of accuracy in these levels.”
Useless, you would think, as an input in determining a fair market level. Indeed, internal LBIE emails — kids, if you learn one sodding lesson from the history of financial market disaster let it be “don’t put your darkest thoughts in emails to your buddies” — suggested they only wanted indicative bids to encourage other banks (many may have had similar trades on their books as LBIE), to make any bid, so that LBIE could then argue there was a market price:
“any color is good color to us and [JP Morgan employee] is lobbying for [JP Morgan’s US trading team] to at least put a number on it even if it is zero”.
Crane J notes, somewhat drily: “This raises the concern that LBIE’s goal, with respect to the indicative bids, was to make these trades seem as worthless as possible to then be able to collect the most from Assured in a lawsuit.”
So here are some things to bear in mind before reaching for a dealer poll to unblock a negotiation that is stuck on valuation:
Firstly, at the point you are likely to be arguing about it, everyone’s hair — yours, the counterparty’s and the rest of the market’s — hair will be on fire. Prices will be yoyoing around and most people will be focussed on their own book and won’t care about yours. Imagine your reference dealer is sitting on one of those mechanical bucking broncos. At the moment you ask for a firm bid on your portfolio — that, by the way, you don’t intend to hit — someone switched the bronco on full.
Secondly, since it has nothing to gain from providing a price — you want “price discovery”, not an actual trade, remember — no dealer in its right mind will give you one. Best case scenario it is distracted from managing its own book while bronco machine is on max. Less edifying ones are that it could get called as a witness in the litigation that is bound to follow or, God forbid, joined as a defendant in it. All your incautious bloomies are suddenly discoverable before an unsympathetic court.
- Reference Market-maker (1992 ISDA)
- Market Quotation (1992 ISDA)
- Close-out Amount (2002 ISDA)
- Reference Dealer (2010 GMSLA)
- ↑ Emphasis in original.