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

{{smallcaps|[[Party A and Party B - ISDA Provision|In this episode]]}} the JC considers the “bilateral” nature of the {{isdama}}, why swap participants alone amongst financial players are called “[[counterparty|counterparties]]”, and what this confusing “{{isdaprov|Party A}}” and “{{isdaprov|Party B}}” business is all about.  

The unpresumptuous way it labels the parties to a Transaction sets the ISDA apart from its fellow [[finance contract]]s. They give it a sort of otherworldly aloofness; a sense of utopian equality; social justice almost. Other [[finance contract]]s label their participants to make it clear who, in the [[power structure]], is who: a [[loan]] has a “[[Lender]]” — the [[bank]]; always the master — and a “[[Borrower]]” — the punter; always the servant. A brokerage agreement has a “[[Broker]]” (master) and “[[Customer]]” (servant). Okay, I know ''theoretically'' the master/servant dynamic is meant to be the other way around — the customer is king and everything — but come on: when it comes to finance it isn’t, is it? We are ''users'', all hooked up to the great battery grid, for the pleasure of our banking overlords and the [[The domestication of law|pan-dimensional mice]] who control them.

Why? Well, we learn it from our supervising associate, when we first encounter a [[Schedule - ISDA Provision|Schedule]]. ''[[The bilaterality, or not, of the ISDA|Bilaterality]]''.

{{smallcaps|A belief in}} even-handedness gripped the ones whose [[deep magic]] forged the runes of that ancient [[First Swap]]. Not just a two-sided structure — most private contractual arrangements have that — but a ''symmetrical'' one, lacking the relationship of dominance and subservience that traditional finance contracts imply. Unusually here there is not necessarily a large, institutional “have” indulging a small commercial “have-not” with its favours in the form of loaned money or extended credit, for which privilege the lender can extract excruciating [[covenant]]s, giving not a jot in return, and enjoy a preferred place amongst the [[customer]]’s many scrapping creditors.

But [[swaps]], as the [[First Men]] saw them, are not like that. Not ''necessarily''.

“A swap,” they decreed, “shall be an exchange among peers. It is an equal-opportunity sort of thing; righteous in that, under its auspices, one is neither lender nor borrower, but simply an honest rival for the favour of the Lady Fortune, however capricious may she be.”

“Thus, those who swap things are not master and servant, but equals. ''Rivals''. Let us call them ‘Counterparties’.”

And, to be sure, swaps ''are'' different from loans and brokerage arrangements. They start off “at market”, where all is square. Either party may be long or short, fixed or floating: at the moment the trade is struck, the world infused with glorious possibility.  

One fellow’s fortunes may rise or fall relative to the other’s and, as a result, she may ''owe'' (in the vernacular, be “[[out-of-the-money]]”) or ''be owed'' (“[[in-the-money]]”).  

Covenants, privileges of collateral, credit support and so on may, thereby, flow either way. They may flow ''both'' ways. In our time of [[regulatory margin]], they usually do.

And swaps, too, are the preserve of professional investors, who know what they are doing. Usually, they know it better than the bank employees they face, having once themselves ''been'' bank employees. Moms and pops, [[Belgian dentist]]s and the like may take loans, buy bonds, have a flutter on the share market and even trade cryptocurrencies but they don’t, and never have, entered {{isdama}}s.<ref>They may trade [[contracts for difference]] and make spread bets with brokers, but these are standardised, smaller contracts.</ref> The ISDA is for grown-ups. Equals.

That said, other than below the dotted lines where you type the counterparty names, the pre-printed part of {{isdama}} itself does not use the expressions “{{isdaprov|Party A}}” or “{{isdaprov|Party B}}”. [[2002 ISDA wikitext|Have a look, if you don’t believe me]]. Being genuinely bilateral, it never has to.  

Party-specific labels are only needed once the studied symmetry of the Master Agreement gives way to the need, articulated in in the {{isdaprov|Schedule}} and {{isdaprov|Confirmation}}s, to stipulate who is taking which side on a given trade, giving which covenant or submitting to which {{isdaprov|Additional Termination Event}}. They may be equals, but we still need to know who is going to pay the [[fixed rate]] and who the [[Floating rate|floating]]; which thresholds, maxima, minima, covenants, details, agents and terms apply to which party. This much is necessarily different. Nothing beyond: the {{isdama}} assumes you already know who is who, having agreed it in the {{isdaprov|Schedule}}.

So we agree: for this swap trading relationship we will call you “Party B”, and me “Party A”. Beyond these colourless and forgettable labels, we are equal. They are maddeningly forgettable: harking from a time where the idea of “find and replace all” in an electronic document seemed like [[Tipp-Ex]]-denying, devilish magic — it might have been easier — and saved some curial angst— had parties been able to use unique identifying labels across their agreement portfolios.  

{{Quote|It was, I am afraid, a rather sloppily drafted document. First, it described LBIE as Party A and LBF as Party B, contrary to the Schedule which gave them the opposite descriptions.

:—Briggs, J, in ''Lehman Brothers International (Europe) v. Lehman Brothers Finance S.A.'' [2012] EWHC 1072 (Ch)}}

Being ''so'' generic, the “Party A” and “Party B” labels can lead to practical difficulties: a [[dealer]] with thirty thousand counterparties 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> This is not just a matter of having to play in your change strip every now and then: if, here and there, a dealer must be “Party B” having lost the toss to a counterparty who also insists on being Party A, this can lead to anxious moments, should one have momentarily forgotten the switch during the negotiation and assigned your carefully-argued infinite [[IM]] {{csaprov|Threshold}} to the other guy.

Frights like this are, in their way, quite energising, if you pick them up during the “four eyes check” at the conclusion of [[onboarding]].<ref>You won’t.</ref> Less so when Briggs J catches them for you in a judgment from the commercial division of the High Court.<ref>He will.</ref>

{{Smallcaps|But there is}} a better objection: for all our automatic protestations to the contrary, the ISDA is not ''really'' a symmetrical contract of equals. It ''is'' often a financing contract, in economic effect, even if not in formal structure. Where one party is an [[end user|customer]] gaining exposure to a market risk and the other is a dealer providing [[Delta hedge|delta-hedged]] exposure to that risk, a swap is a sort of “[[synthetic loan]]”.

Realising this may change how you think about ISDA negotiation. This thought grew and grew and now there is a [[A swap as a loan|whole new article about it]].

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 is, economically, a principal: it provides the impulse to trade; it elects when to exercise options and terminate positions. The [[dealer]] is, economically even if not legally, an agent: it hedges, calculates values and is burdened with additional [[regulatory capital]] charges if it doesn’t get its [[close-out netting]] right.  

 

 

 

{{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.<ref>Almost all {{isdama}}s will be between a ''customer'' and a ''dealer''. A few will be [[inter-dealer]] — but there are only so many dealers. Almost ''none'' will be inter-customer. I know, I know: the first ever swap was, though, right?</ref> 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 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]]''.

 

This is a situation a [[dealer]] is more likely to get itself into if it has had to pay away wodges of [[regulatory margin]] to collateralise its customer’s un-realised 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?