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====The three aims of an ISDA==== | ====The three aims of an ISDA==== | ||
The {{isdama}} is a framework under which two “[[counterparties]]” can transact [[over-the-counter]] derivatives — mainly, but not only,[[swap]]s. Besides its original appeal as an [[easance]] the ISDA has three main aims: it is a [[relationship contract]]; a [[Credit risk mitigation|credit risk management tool]], and a [[capital optimisation]] tool. | The {{isdama}} is a framework under which two “[[counterparties]]” can transact [[over-the-counter]] derivatives — mainly, but not only, [[swap]]s. Besides its original appeal as an [[easance]] the ISDA has three main aims: it is a [[relationship contract]]; a [[Credit risk mitigation|credit risk management tool]], and a [[capital optimisation]] tool. | ||
===== Relationship contract ===== | ===== Relationship contract ===== | ||
[[File:Wedding.jpg|250px|thumb|right|A relationship contract, yesterday.]] | [[File:Wedding.jpg|250px|thumb|right|A relationship contract, yesterday.]] | ||
Firstly, the Master Agreement is a [[relationship contract]]: an agreement | 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, the | The Master Agreement does not itself create any obligations or liabilities. It does not commit anyone to any Transaction. Therefore, curiously, the 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 under 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.<ref>This is, indeed, the premise of [[Muriel Repartee]]’s Z-Grade [[Fi-Fi]] schlock horror [[ISDA: Dawn of the Dead]].</ref> | ||
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]]”. | 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]]”. | ||
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If the counterparties do decide to dance, they agree economic terms of a {{isdaprov|Transaction}} and sign a {{isdaprov|Confirmation}} that sets out those terms and inherits the remaining terms of their ISDA. | If the counterparties do decide to dance, they agree economic terms of a {{isdaprov|Transaction}} and sign a {{isdaprov|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 [[Credit risk management| | Secondly, once the parties ''have'' decided to dance, the ISDA is a [[Credit risk management|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 {{isdaprov|Credit Support}} and [[Close-out Amount - ISDA Provision|Close-out]] rights. | |||
{{isdaprov|Credit Support}} may take the form of margin “posted” by the counterparty itself against its own exposure and [[guarantee]]s, [[keep-well]]s and [[letters of credit]] provided by third parties on the counterparty’s behalf. | {{isdaprov|Credit Support}} may take the form of margin “posted” by the counterparty itself against its own exposure and [[guarantee]]s, [[keep-well]]s and [[letters of credit]] provided by third parties on the counterparty’s behalf. | ||
{{isdaprov|Events of Default}} and {{isdaprov|Termination Events}} | {{isdaprov|Events of Default}} and {{isdaprov|Termination Events}} entitle an compliant party to [[close out]] {{isdaprov|Transactions}} early, should its counterparty ''not'' comply with it (or its creditworthiness deteriorate in more or less oblique ways contrived by the compliant party’s credit department. | ||
Most Events of Default and Termination Events address credit deterioration, but not all: some deal with other externalities — change in law, force majeure, tax — that don’t directly affect either party’s credit position. | |||
======Expected events and tail events====== | ======Expected events and tail events====== | ||
We can, in any case, distinguish between welcome “expected events” and unwelcome “[[tail events]]”. | We can, in any case, distinguish between welcome “expected events” and unwelcome “[[tail events]]”. | ||
“Expected events” are the risks you assume by entering the | “Expected events” are the risks you assume by entering the Transaction in the first place: the economically significant things you believe may, or may not, happen to the [[underlier|underlying instruments]]. If these events do not pan out as hoped, you have no complaint: that was the bargain you struck. These events tend to be foreseeable in detailed, particularised, delimited ways. They need to be: what you pay or receive will depend on them. | ||
Articulation here is exact and important. It is therefore generally left to trading and operations staff. Drafting conventions have been tested to destruction over thirty years. | |||
In any case we can see a clear division of labour between the Master Agreement, under which you ''minimise and mitigate'' | “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 tend to be foreseeable as general categories but not in the particular, because these events are rare, unwanted, and by nature the way in which they present is unexpected. (Those that are expected are headed off): if your counterparty blows up. It It suffers sanctions. If the contract is declared illegal. If relevant tax laws suddenly change. If the Great King of Terror descends in a flaming chariot, etc.<ref>The arrival of the Great King of Terror is a ''bad'' tail event: there is nothing you can really do to mitigate it. Best not write a swap on it.</ref> | |||
Articulation if tail risks is done by legal and negotiation staff, is generic, sweeping, and infrequently tested. Where it is tested, by the courts, after times of crisis — it often turns out not to work as expected.<ref>Almost the entire international jurisprudence on section 2(a)(iii) arises from the Lehman collapse.</ref>that is to say, ''bad'' | |||
In any case we can see a clear division of labour between the Master Agreement, under which you ''minimise and mitigate'' [[tail risks]] that probably won’t happen under all {{isdaprov|Transactions}}, and the {{isdaprov|Confirmation}}, under which you precisely ''describe'' and ''allocate'' (but do not ''reduce'', as such) risks that certainly will.<ref>This not, ah, a [[Bright-line test|bright-line distinction]], but it is a good rule of thumb. You might put some asset-specific “tail risk” Termination Events in the Confirmation, but for the most part you try to get them all into the Master Agreement.</ref> | |||
So the {{Isdama}} provides a sort of “end of days” protection for the tail risks 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: something we certainly want, but sincerely hope we will never need. | So the {{Isdama}} provides a sort of “end of days” protection for the tail risks 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: something we certainly want, but sincerely hope we will never need. | ||
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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 this. (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). | 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 this. (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==== | ====Qualities of a good ISDA==== | ||