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

{{smallcaps|[[Party A and Party B - ISDA Provision|In this episode]]}} of the JC’s series of deep explorations of superficial things in the [[ISDA]] metaverse, we consider the “bilateral” nature of the {{isdama}} and its curious designators: “{{isdaprov|Party A}}” and “{{isdaprov|Party B}}”, and that curious descriptor of both of them: “[[counterparty]]”.  

These set the ISDA apart; give it a sort of otherworldly aloofness; a sense almost of social justice. Other banking and broking transactions use labels which help you orient who, in the [[power structure]], is who: a loan has a “Lender” (always the bank) and “Borrower” always the punter. A brokerage has “Broker” (master) and “Customer” (servant).  

But not the {{isdama}}. From the outside its framers — the [[First Men]] — opted for the more gnomic, interchangeable “{{isdaprov|Party A}}” and “{{isdaprov|Party B}}”.

Why? Well, we learn it from our first encounter of an ISDA Schedule. ''[[The bilaterality, or not, of the ISDA|Bilaterality]]''.

{{smallcaps|A belief in}} even-handedness gripped the ones whose [[deep magic]] forged the runes from which the [[First Swap]] was born.  

For most finance contracts imply some sort of dominance and subservience: a large institutional “have” indulging a small commercial “have-not” with debt finance for the privilege of which the larger “have” extracts excruciating covenants and enjoys a preferred place in the queue for repayment among the have-not’s many scrapping creditors.

 

 

 

 

Now the {{isdama}} ''itself'' never uses the terms “Party A” or “Party B”. Being genuinely bilateral, it never has to. Being arbitrary assignations at trade level the labels only get a mention once the symmetry breaks down in the {{isdaprov|Schedule}} and in {{isdaprov|Confirmation}}s, to be clear who is who on a given trade: who is paying the fixed rate and who the floating; which thresholds, maxima, minima, covenants, details, agents and terms apply to which counterparty. This much is necessarily different. Nothing beyond: the {{isdama}} assumes you already know who is who, having agreed it in the {{isdaprov|Schedule}}.

 

 

These colourless and generic terms hark from a time where, we presume, the idea of “find and replace all” in an electronic document seemed some kind of devilish black magic. Some kind of [[Tipp-Ex]]-denying subterfuge.

 

But anyway. These generic labels still lead to practical difficulties. A [[dealer]] with ten thousand counterparties in its portfolio wants to be “Party A” every time, just for peace of mind and literary continuity when perusing its collection of Schedules, as we know [[dealer]]s on occasion are minded to do.<ref>They are not.</ref> If, here and there, a dealer must be “Party B”, this can lead to anxious moments should one misread such a Schedule and infer its infinite [[IM]] {{csaprov|Threshold}} applies to the other guy, when really, as it ought, it applies to you. Frights like this are, in their way, quite energising.

You quickly get over them when you realise it is your error of construal, not the negotiator’s of articulation.

 

Less energising are actual errors: as a group, [[negotiator]]s are redoubtable, admirable creatures but, like all of us fallible and prone to oversight: they may, by lowly force of habit, forget to invert the “Party” labels when inserting the boilerplate {{isdaprov|PPF Event}} rider for that one time in a thousand when the firm is not “Party A”. It is easily done, and just the sort of thing a [[four-eyes check]] will also miss: If it does, no-one will never know — ''unless and until it is too late''.

 

But there is a better objection: for all our automatic protestations to the contrary, the ISDA is not ''really'' a bilateral contract, and it ''is'' often a financing contract, in economic effect even if not in formal structure. Where there is a customer gaining exposure to a risk and a dealer providing delta-hedged exposure to that risk, a swap is a sort of “synthetic loan”.

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====

{{smallcaps|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''.

{{smallcaps|Beyond that 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>

{{smallcaps|What is in}} a name?

This may be to draw a long bow, but you could argue that emphasising bilaterality has led the regulatory dance into the wrong corner of the dancefloor. The JC does.

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?