Template:M intro isda Party A and Party B: Difference between revisions

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 This thought grew and grew and now there is a [[A swap as a loan|whole new article about it]].
+====“BINO” — bilateral in name only====
+But except for that a class of [[Inter-dealer|inter-dealer]] swap relationships, {{isdama}}s are “bilateral” only really in ''name'': one party — the [[swap dealer]], provides exposures to another, the customer, who consumes them. The customer provides the impulse to trade; the customer elects when to exercise options and terminate positions. The [[dealer]] hedges, calculates values and is burdened with additional [[regulatory capital]] charges if it doesn’t get its [[close-out netting]] right.
+This has led to two kinds of bother: first, a bit of a squabble as to who gets to be Party A and who Party B; since [[swap dealer]]s set up their templates to assume ''they'' will be Party A and their customers Party B, when immovable object meets irresistible force it can spark an unseemly dispute from which the dealer will inevitably have to back down. At least one swap dealer solved this problem by deciding to be “Party B” as standard. This only confused clients who were unused to being “Party A”.
+Furthermore, when labouring over some neatly [[iatrogenic]] [[co-calculation agent]] fallback dispute mechanism — and be assured, you will spend far more time doing this than can ever be justified by your reward, in heaven or on earth, for doing so — it is easy to get your “[[Party A]]s” and “[[Party B]]s” mixed up. Doing so buries, deep in the [[fossil record]], a technical deficiency that may go entirely unrecognised for ''decades''.
+Roll forward eighteen years. The world is again on the brink of financial [[Apocalypse]]. The customer is now a [[systemically important financial institution|systemically-important]] leviathan, largely thanks to years of optimistically lax credit sanctioning. But suddenly, it is teetering. The [[Credit officer|chief credit officer]] runs about with her hair on fire and for the first time, ''everyone is staring forensically at the docs''. Suddenly that co-calculation agent fallback dispute mechanism is all that stands between the firm and a three billion dollar abyss. And guess what? ''Some clot transposed Party A and Party B''.
+====The real distinction: [[dealer]] and [[customer]]====
+Beyond the small class of [[inter-dealer]] swap contracts that make up a dealer’s funding and hedging programme — there ''is'' a material distinction between the parties to an swap contract. The asymmetry comes not from whether one is [[long]] or [[short]], or buyer or seller, but from who is ''customer'' and who is ''dealer''.
+A customer or “[[end user]]” uses the {{isdama}} to ''change'' its absolute exposure to a given risk or underlier. To take, or lay off, a risk.
+A [[dealer]] uses the {{isdama}} to earn a [[commission]]. It does this, yes, by providing its customers a changed absolute exposure, but at the same time carefully hedges that exposure so that, but for those fees, the dealer is market ''flat''. Now, it is the nature of the beast that a dealer can’t always ''stay'' market flat: it is too dependent upon the performance of its customers, counterparties and models for that — but this is not for want of trying. The {{isdama}} is as much a borrower/lender arrangement as most other banking arrangements. See [[a swap as a loan|the JC’s long-form essay]] about this.
+In any case, almost all {{isdama}}s will be between a ''customer'' and a ''dealer''. A few will be [[inter-dealer]]. Almost ''none'' will be inter-customer.<ref>I know, I know: the first ever swap was, though, right?</ref>
+====Why does it matter?====
+What is in a name?
+This may be to draw a long bow, but the JC says that emphasising the ISDA’s bilaterality has led the regulatory dance into the wrong corner of the dancefloor.
+The logic is this: this is a contract of equals. Each poses an equal, but offsetting, risk to the other. Therefore credit concern cuts both ways, so any regulatory impositions should — ''must'' — also apply both ways.
+And so we have seen: [[swap dealer]]s have to post [[Regulatory initial margin|regulatory initial]] and [[Variation margin|variation margin]] to their customers, just the same way their customers must post it to them.
+''But this is nuts''. Swap dealers are regulated financial institutions providing a service for a fixed commission. When dealing they don’t take on outright market positions. They must hold [[regulatory capital]] against their dealing activity. That this means of managing systemic risk hasn’t always ''worked'' fabulously well is not the point: the principle is sensible: ensure financial institutions are sound by obliging them to ''hold on'' to money, rather than making them give it away.
+And a customer who frets about its outsized exposure to a dealer has a ready solution: ''move its business away''. Diversifying the portfolio encourages competition in the market and introduces a healthy redundancy.<ref>In “[[Normal Accidents: Living with High-Risk Technologies|normal accidents]]” terminology financial markets are [[Tight coupling|tightly-coupled]], [[Complexity|non-linear]] systems where “slack” loosens that coupling and reduces the risk of catastrophic failure.</ref> Overall, encouraging customers to limit their outright exposure to dealers enhances the market’s overall resilience.
+Obliging dealers to [[Variation margin|cash-collateralise]] customers’ open positions creates the ''opposite'' incentives. Customers are encouraged not to diversify their risk, but to concentrate it, with the [[dealer]]s offering the most aggressive margin rates. And the dealer market is competitive to the point of being paranoid, as we learned from [[Archegos]]. Dealers will cut their required margins to the bone, thereby increasing their risk of loss.
+By contrast, [[end user]]s are not regulated. They are often thinly capitalised funds, trading with leverage on someone else’s money: guess who? ''The dealer''.
+The real source of systemic [[dealer]] risk, is the [[Second-order derivative|second-order risk]] presented by the dealer’s ''customers'' blowing up.
+This is a situation a dealer is more likely to get itself into if it has to pay away wodges of regulatory margin to collateralise un-realised customer gains, giving those customers, already betting with the broker’s money, even more of it. We have a separate essay on this: See ''[[when variation margin attacks]]''.
+Might the market have gravitated this way were it not for our fiction of pretending this is a bilateral relationship?