Template:M intro isda ISDA purpose: Difference between revisions

Expected events tend to be particularised, delimited and finely detailed. They need to be: they directly affect what you pay or receive under the Transaction, so their articulation must be exact and important. Interestingly, documentation is generally left to trading and operations staff, not legal staff. Their drafting conventions have been tested to destruction over thirty years. The rate of outright dispute on the meaning of trade terms in confirmations is generally low, and their resolution is typically quick and pragmatic. Lessons are learned: trade terms winnow themselves down to the genuinely critical over time.  

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.  

We are loss-averse: we tend to be prepared to spend far more time and resources than is rational preparing for apocalyptic risks. Thus, the [[negotiation]] [[military-industrial complex]] spends comparatively little time documenting the economics of swap {{isdaprov|Confirmations}} — these days a lot of that is done by computerised [[document assembly]] — but an awful lot negotiating point-to-point [[NAV trigger|net asset value trigger]]s that are almost certain never to be invoked.  

The dividend of all this conceptual haggling, if done well, is a mythical contractual utopia, beloved of senior [[credit officer|credit officers]] but poorly understood by anyone else, of “[[strong docs]]”. Anyway, I digress.

Thirdly, the ISDA Master is carefully designed to yield a specific regulatory capital treatment for those financial institutions who are sensitive to their [[leverage ratio]].  

Ninja point: it may look like it, but ''capital optimisation is not the same as credit risk management''. As a matter of fact, it is the ''converse'': capital management addresses the period until a counterparty credit loss actually happens, defining the minimum capital a dealer must hold to ride out the credit loss following a counterparty default.

Whereas credit mitigation comes into play when a counterparty has defaulted, capital optimisation works during the period beforehand. Once a counterparty has defaulted, your capital calculation is of no further use: you just hope it was enough. It makes no difference to the size of your loss; only your ability to weart the loss without failing. In this way, capital optimisation is more like ''own'' credit risk management and counterparty risk management: it ensures that ''when'' your counterparty blows up, it doesn’t take your arms and legs with it.  

Capital management is, therefore, also an expected event  a tool for managing “expected events” and not “tails events” as such because it has a daily direct impact on the bank’s risk weighting calculations, and therefore how much capital the bank is allowed to put at risk. It is a cost management tool, not a risk management tool, that is to say.

Derivatives are odd contracts because they are inherently levered, and therefore extremely volatile. They have large notional values, but lower mark-to-market values. An “at-market” swap<ref>Almost all swaps start off as at-market. Starting your swap off the market implies a one-way initial payment under the transaction, by way of premium, to the party who starts “out-of-the-money”. Otherwise, it would be economically irrational to enter into the Transaction.</ref> starts with zero exposure, either way, and thereafter can fluctuate wildly in either direction. Compare this with a traditional loan, where the transaction starts with an exposure equal to its notional amount — lender goes “in the money”, borrower “out-of-the-money” — and the value of the loan to the lender then fluctuates narrowly around that notional amount (to account for accrued interest, changing interest rates, and the borrower’s changing credit profile) until it is all repaid, in one go, at maturity. The exposure profile of a swap is very different. The raw market exposure of a portfolio of swap transactions can, thus, be huge compared with the original capital committed (i.e. zero): the total of all your [[out-of-the-money]] positions, which you can assume you must perform, versus all collateral you hold, which you should assume you will be required to return.

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).