Sustainability-linked derivatives

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The ISDA Master Agreement

The Jolly Contrarian holds forth™

Easter Islands.png
A dead metaphor, yesterday.

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Index: Click to expand:


The Varieties of ISDA Experience
Subject 2002 (wikitext) 1992 (wikitext) 1987 (wikitext)
Preamble Pre Pre Pre
Interpretation 1 1 1
Obligns/Payment 2 2 2
Representations 3 3 3
Agreements 4 4 4
EODs & Term Events 5

Events of Default
FTPDBreachCSDMisrepDUSTCross DefaultBankruptcyMWA
Termination Events
IllegalityTax EventTEUMCEUMATE


Events of Default
FTPDBreachCSDMisrepDUSTCross DefaultBankruptcyMWA
Termination Events
IllegalityTax EventTEUMCEUMATE


Events of Default
FTPDBreachCSDMisrepDUSTCross DefaultBankruptcyMWA
Termination Events
IllegalityFMTax EventTEUMCEUMATE

Early Termination 6

Early Termination
ET right on EODET right on TEEffect of DesignationCalculations


Early Termination
ET right on EODET right on TEEffect of DesignationCalculationsSet-off


Early Termination
ET right on EODET right on TEEffect of DesignationCalculationsSet-off

Transfer 7 7 7
Contractual Currency 8 8 8
Miscellaneous 9 9 9
Offices; Multibranch Parties 10 10 10
Expenses 11 11 11
Notices 12 12 12
Governing Law 13 13 13
Definitions 14 14 14
Schedule Schedule Schedule Schedule
Termination Provisions Part 1 Part 1 Part 1
Tax Representations Part 2 Part 2 Part 2
Documents for Delivery Part 3 Part 3 Part 3
Miscellaneous Part 4 Part 4 Part 4
Other Provisions Part 5 Part 5 Part 5
Index: Click to expand:

Sustainability-linked derivatives
/səsˌteɪnəˈbɪlɪti lɪŋkt dɪˈrɪvətɪvz/ (n.)

A derivative transaction with an ESG overlay, taking into account specific measures and targets in the form of Key Performance Indicators.[1]

It is said that the ancient people of Easter Island felled every tree on their island while erecting statues to their Gods and ancestors. Without these vital root systems, the island’s topsoil eroded, nutrients washed away, plants could not grow and eventually the whole ecosystem was wrecked. The island became uninhabitable, It has not recovered in 400 years.

The magnificent statues remain, but still: this was quite the disaster in the service of trying to please imaginary people.

This “ecocide” theory, popularised by Jared Diamond a generation ago,[2] is out of favour with hand-wringing snow-flakey academic types nowadays. ISDA’s council of elders may feel the same way about the JC’s corresponding “swapicide” theory,[3] in which a community of earnest toilers, bent on vouchsafing collective prosperity but caught in the throes of a voguish delusion that everything is different this time sets about demolishing every tree in sight in the pursuit of mad, hyper-complicated, illogical schemes to solve imaginary problems for non-existent investors.

No better example could there be than its initiative to introduce “sustainability-linked derivatives”. What is ISDA up to? Is It trying to stay relevant? [4] Are we watching an industry association having a midlife crisis?

There has always been something quixotic about an organisation whose avowed purpose is to promote “safe efficient, markets” but which promulgates things like credit derivatives, but — even so — this feels like a step further through the looking glass; a tumble deeper down the rabbit hole.

The ’squad’s prior follies at least tried to cater to existing demands, markets and regulatory imperatives. This new push feels like an attempt to create a new market no one is asking for out of — well — hot air.

How “SLDs” are meant to work

If its own discussion paper is anything to go by, no-one (yet!) has much of an idea what a sustainability-linked derivative would even look like. ISDA proposes that it would sort of plug-in to a normal swap, containing a ratchet that would adjust spreads on the parties’ respective payment obligations should they hit (or miss) pre-agreed ESG key performance indicators.

Now, objectively measuring environmental impact is hard,[5] and open to abuse,[6] even when you aren’t talking your own book as you do it. But the “greenwashing” risk is the least of the challenges here. Higher up the list is basic intellectual coherence.

For a start, this is not a derivative in any normally understood sense. It is more like an arbitrary penalty clause: a payment derived not from some observable third party measure, but an internal metric entirely within the counterparty’s gift to game: it knows what targets it can and cannot plausibly meet; its counterparty has — short of due diligence it will not care to do just to execute a swap (among other things, it might bugger up your marginal carbon footprint) — no idea at all.

Insofar as an SLD is a derivative, it is a self-referencing one. Regulators don’t much like those, usually. There is a reason they don’t let athletes bet on games they are playing in.

So this becomes an open invitation to systematic insider dealing on one’s own operations. And that is assuming a wily trader stays “long” her own firm’s sustainability performance at all times. But swaps are by their nature bilateral. What is to stop her shorting her own sustainability credentials, incentivising her employer’s transition towards carbon and modern slavery?

Secondly, the need for robust, measurable KPIs implies a grand, work-creating, rent-generating, carbon footprint-inflating bureaucratic infrastructure of little drones running about, setting targets, measuring them, publishing them, making determinations about them, resolving disputes about them and so on. Who is going to fund the sustainability determinations committee? And will the whole enterprise not, by wasting trees, do more environmental damage than it solves?

Thirdly. why should my trading counterparties care? What has any of this to do with them? What benefit accrues to the environment when my swaps desk pays more or less cash to theirs? Why would they make themselves hostage to my ESG compliance effort? Why should they suffer a penalty just because I have cracked my own gender pay gap? (Isn’t there reward enough in just doing that, by the way? What does it say about economic incentives that we must bribe each other to promote our own staff fairly?)

And besides, how are you supposed to hedge that? Are you allowed to hedge? Would hedging ESG penalties be somehow cheating?

Nor will these be a kind of synthetic carbon credit (and, anyway, ISDA already has a product for that). No money flows into tax coffers or environmental protection funds as a result under this proposal. It just means parties pay more money than they need to to each other. This is an odd way of vouchsafing efficiency.

Commerce does not work by gifting emoluments to virtuous strangers just because they recycle shopping bags.

Financial sustainability much?

It feels like there is a category error here. The “sustainability” a financial counterparty should really care about is solvency.

That kind of good corporate governance — and sorry, millennials, but JC is with Milton Friedman on this one: that means shareholder return — is reflected in credit spreads: how likely does the market regard my bankruptcy. Not ESG KPIs.

My brokers will not discount my credit premiums just because I care about polar bears. If they don’t get their money back, the happy knowledge that I did my bit for water scarcity will be cold (wet?) comfort. What will — should — matter a lot more is that I keep up my payments on my swaps and loans.

This is what is coded into my spreads. Spreads are set at trade date and are not then adjusted — hence, a rich lifetime of employment for credit value adjustment traders. But in any case, my incentive is to manage my business as best I can so that when I trade I achieve the tightest spreads. That is all the incentive the market has needed, until now, to promote “sustainability”.

There is force in the idea that carbon credits are derivatives not so much of greenhouse gas pollution as regulatory fashion. Sustainability-linked derivatives aren’t event that. They aren’t a derivative at all.

See also


  1. Deliciously unenlightening definition courtesy of Baker & McKenzie. If you have any idea what “an ESG overlay” to a “derivative transaction” might be, do write in. JC considered ending this article with “key performance indicator” as that neatly captures the absurdity of this asset class, but felt oddly compelled to carry on.
  2. Guns, Germs, and Steel: The Fates of Human Societies, Jared Diamond, 1997.
  3. Sunk without trace: 2011 ISDA Equity Derivatives Definitions, 2022 ISDA Securities Financing Transactions Definitions, 2023 ISDA Digital Asset Transactions Definitions. Those that did bear fruit were no great scream of exhilarating clarity: the 2014 ISDA Credit Derivatives Definitions, 2016 ISDA Regulatory VM CSAs and 2018 ISDA Regulatory IM CSA being cases in point.
  4. Recent clumsy land-grabs of ICMA/ISLA territory, and forays into crypto certainly give that impression.
  5. Readers are invited to Google it and note how many management consultancies are shilling to help you do it.
  6. Readers are invited to Google this, too.