Equity derivatives dispute rights

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You will, frequently encounter buyside counsel who are fixated on calculation agent dispute rights. Equity derivatives are no exception. It makes no more sense here than anywhere else.

Valuation signals for equity derivatives — traded prices on execution venues — are generally liquid, independent, and observable. Equity derivatives are an access product: the dealer provides its clients with exposure, and hedges it delta-one: the dealer does not take a naked proprietary position one way or another (thanks to Volcker and equivalent rules, it is not allowed to).

The dealer is therefore earns its keep not by “ripping its client’s face off”, but by the more sedate means of (i) a fee for executing the trade, and then later terminating it (these are exact equivalents of broker commissions on purchase and sale), and (ii) managing the spread between the financing cost it charges and the net funding cost of its hedging activity. The cost model is as for cash brokerage: commission, and financing. Equity derivatives dealers do not take proprietary positions.

Thus, broadly a dealer determines the prices of your swap exactly as it would were it handing a cash equity brokerage order: by buying or selling actual shares in the market. The dealer trades on real prices: only for its hedge, not for its client’s account directly. Just as a client wouldn’t get to dispute right a cash trade — well, good luck telling a stock broker, “I have another leading independent dealer telling me it could have got a better price on that stock” — nor should you on a synthetic. The whole theory of the game is that it is a liquid market and the dealer has better access to that market than you do. If you can get better prices elsewhere, go elsewhere.

This isn’t some abstract model the dealer has dreamed up: the dealer has actually traded at that price, forked out its own money, and that price was the best one it could get. It is obliged by regulation to get the best price — best execution, right? — and by the commercial imperative. Why on earth would a dealer lowball its client? It doesn’t have a dog in the fight.

Distressed markets

Now in distressed markets — where market disruption events prevent a dealer effectively hedging so the dealer wants to forcibly exit the position — it is true the market isn’t liquid and there might not be observable prices — or any prices. But, again, that is the client’s risk, not the dealer’s: dealers don’t provide warranties of market liquidity, much less as to (lack of) volatility or market price. That’s not the deal: that is the exact risk that client is taking by investing in equities.

The dealer, like the client, wants to get the best price it can, to keep the client happy. But market disruption bad enough to to force dealers out of positions is not common. Hedging disruption is unusual. It is also where the dealer earns its keep, by managing its client relationship. It will get on the phone. It will seek to build consensus on what to do in the circumstances, which seem plain in hindsight, but were impossible to predict in advance.

If the client has a source of liquidity the dealer will be all ears — but considering that the reason they formed their relationship was on account of the dealer’s superior market connectivity and access to liquidity, how likely is it that suddenly the client has all the best market intel? In any case, what the dealer and its client do not want to do in a time of stress — and more to the point, will not do — is start poring over their docs to investigate their precise legal obligations. A market disruption is nobody’s fault. They are smart people — subject matter experts, indeed — in possession of all available information relevant to the situation to figure out the best way through it, in a way that ISDA negotiating legal eagles, lobbing hypotheticals at each other years before aqny of these events happen, simply are not.

The parties will figure it out.

Do not, therefore, piss around with Determining Party dispute right fallbacks.

See also

• Co-calculation agent
• Commercial imperative