The bilaterality, or not, of the ISDA
2002 ISDA Master Agreement
The Jolly Contrarian holds forth™
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In this episode of the JC’s series of unfeasibly deep explorations of superficially odd things in the ISDA metaverse, consider the bilateral nature of the ISDA Master Agreement and its curious designators: “Party A” and “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).
Why? Well, we learn it from our first encounter of an ISDA Schedule. bilaterality.
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.
“A swap contract,” they intoned, “is an exchange among peers. It is an equal-opportunity sort of thing; Biblically righteous in that, under its awnings, one be neither lender nor borrower, but an honest rival for the favour of the Lady Fortune, however capricious may she be.
“We are equals. Rivals. Counterparties”. Covenants, privileges of credit support and so on may flow either way. They may flow both ways. In our time of regulatory margin, they usually do.
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 (“out-of-the-money”) or be owed (“in-the-money”). And swaps, too, are professional instruments. Moms and pops, Belgian dentists and the like may buy bonds, but they din’t, and never have, entered ISDA Master Agreements.
Now the ISDA Master Agreement itself never uses the terms “Party A” or “Party B”. Being genuinely bilateral, it never has to. The labels are arbitrary assignations that apply at trade level. Thus, they only appear in the Schedule and in Confirmations, 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 ISDA Master Agreement assumes you already know who is who, having agreed it in the Schedule.
So we agree: for this relationship we will call you “Party B”, and me “Party A”.
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 dealers on occasion are minded to do. 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 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, negotiators 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 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.
Is it bilateral though?
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 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”.
You could analyse an interest rate swap as off-setting fixed rate and floating rate loans. Seeing as the same amount of principal in the same currency flows in both directions at the same time, the principal flows cancel each other out — they “net” to zero.
“Aha, JC: quite so. But this implies, does it not, that the parties are not lending to each other?”
The difference is in how the two sides manage their respective positions.
We should not let ourselves forget: beyond the cramped star system of inter-dealer relationships, there is a boundless universe where one party is a “dealer” and the other a “customer”. This is the great majority of all ISDA arrangements.
The roles of customer and dealer are different. The difference does not depend on who is “long” and who “short”, nor on who pays the fixed rate and who pays the floating. Hence, the expressions “sell-side” — the dealers, who sell exposure — and “buy-side” — their customers, who buy it.
For the customer the object of transacting is to change its market exposure: to get into a positions it did not have before, or get out of one it did. This sounds obvious. But, being a bilateral contract, you might think it follows that the dealer is changing its position, too. But it is not. A dealer is there to provide exposure without taking any itself, and thereby to earn a commission. The dealer intends to say flat.
Now, a swap is a principal obligation, so entering into one necessarily does changes the dealer’s exposure — but the dealer must then “delta hedge” its position away, executing an offsetting position somewhere else. It might do this by buying the underlying asset, of futures, or entering into a offsetting swap by which matches off its “long” exposure against another “short” exposure with another counterparty.
There are plenty of ways to delta hedge, but the basic economic principle is that the dealer has not changed its market position. It has not, over all, made an investment. It has not borrowed anything.
Provided the dealer knows what it is about, its main risk in running a swap portfolio is not therefore market risk — it should not really have any — but customer credit risk. Should a customer fail, the dealer’s book is no longer matched: its hedge is now an outright position.
Hence, having adequate collateral from each customer, to cover the risk that it fails, is very important.
Swaps are usually synthetic loans
But how does this make a swap into a “synthetic loan”? Compare a swap with an actual loan:
Hackthorn Capital Partners owns USD10m of AUM. It wishes to buy USD10m of Cryptöagle. It can either: sell its existing AUM and use the proceeds to buy Cryptöagle, or keep its existing portfolio and borrow USD10m.
If it sells its existing portfolio outright, the position is as follows:
- Sold: USD10m.
- Borrowed: Zero.
- Amount owed: Zero.
- Bought: 10m Cryptöagle @ USD1 per share.
- Amount due: total return on 10m Cryptöagle.
If it keeps its existing portfolio and borrows, the position is as follows:
- Sold: Zero.
- Borrowed: USD10m.
- Amount owed: floating rate on USD10m.
- Bought 10m of Cryptöagle @ USD1 per share.
- Amount due: total return on 10m existing portfolio and 10m Cryptöagle.
Note the cashflows in the loan scenario:
During the loan, Hackthorn pays a floating rate on USD10m and is exposed to the market price of Cryptöagle.
On termination, Hackthorn sells Cryptöagle to repay the loan. If sale proceeds exceed the loan repayment, Hackthorn keeps the difference. If they don’t, Hackthorn must fund the shortfall from its portfolio and book a loss.
Hackthorn’s net exposure is therefore: USD10m - Cryptöagle spot price.
These are the same cash flows you would expect under a delta-one equity derivative:
During swap, Hackthorn pays floating rate on USD10m and dealer pays total return on Cryptöagle. On termination, if the swap termination amount is negative, Hackthorn pays it to dealer. If it is positive, dealer pays Hackthorn.
The swap termination payment is USD10m - Cryptöagle spot price.
Like a loan, the equity swap gives Hackthorn exposure to Cryptöagle whilst keeping its existing portfolio, which Hackthorn uses to fund cashflows on its new capital asset. This is a form of leverage. The floating rate Hackthorn pays is implied funding. The dealer will only accept this if it is satisfied Hackthorn has enough capital to finance its swap payments and settle any differences at termination. This is the same risk calculation a bank lender would make.
But, hang on: this is a bilateral arrangement, so isn’t the converse true of the dealer?
Isn’t the dealer paying the cashflow of the asset to get exposure to the floating rate in the same way? Isn’t it, in a sense, “borrowing” by paying a total return? Or look at it this way: is not a “short” swap position, for a dealer, exactly the same as a “long” swap position for a customer?
Generally not, because in providing these swap exposures to its customers, the dealer is not changing its own market position. It delta-hedges. At the same moment it puts on a swap, it executes an offsetting hedge. The dealer’s net position on its derivative book will generally be flat. You don’t need to borrow money to take no position.
On the case for one-way margin
In recent years — ironically, just as the “dealer” vs “customer” dynamic has become more pronounced — the global regulatory-industrial complex, still fighting last decade’s war, has forged rules which overlook this. Notably, the coordinated worldwide approach to bilateral regulatory margin. As swap positions move in and out of the market, counterparties must post each other the cash value of the net market movements each day. This is a little like closing positions out at the end of each day and settling up, with a key difference: you don’t close out your positions. The valuations at which the parties exchange margin are guestimated. The parties stay on risk.
Well — one of them does — the customer: the one who initiated the trade, to put itself into a market position of some sort. The other party, remember, is delta-hedged. It didn’t initiate the trade, but accommodated it, on the precise grounds that its market position would not change, and its credit position, against the customer, would be satisfactory.
Requiring margin — even guestimated margin —from a customer who is net out-of-the-money makes sense: if the customer fails, the dealer’s corresponding hedges are defeated. It will be left with an open market exposure to all of the customer’s positions. From a systemic risk position, this is the last thing anyone wants: a dealer whose customer positions are all effectively hedged can’t go bust. So, daily variation margin to the dealer mitigates the dealer’s market risk to date; initial margin covers it for the forward market risk should it have to close out its hedge portfolio against the defaulting client.
As long as the dealer is covered, market disruption is minimised, and the dealer’s own solvency — the deterioration of which, due to its interconnectedness with the rest of the market, may well present a systemic risk — is not threatened.
But requiring a dealer to post margin to its customer to cover the customer’s net in-the-money positions makes no sense whatsoever:
First, customers — and here I mean buy-side market participants who do not themselves post systemic riskCite error: Closing
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<ref> tag They are putting themselves in harm’s way. Part of the thrill of taking on risk is that you have risk.
Dealers are delta-hedged against every customer. They are not “the other side of the trade”. A dealer’s “position” against a given client being “under water” in itself does not change the dealer’s risk of insolvency. Of course, dealers do present a risk of insolvency, and customers will tolerate so much exposure to that risk, but the customer has other levers to manage it. They can close out their position, take profits and re-establish the position at the new level, or with another dealer, for one thing. That enables the dealer to close out its hedge, pass on the hedge gains and reset hedges and initial margin at the higher level. This is not the same as paying out the mark-to-market of a unrealised swap.
To be sure, customers might not like doing this — realising a taxable gain and having to stump up more initial margin when re-establishing positions blows, for sure — but none of these are good reasons for anyone but the customer concerned. Withholding variation margin on profitable positions gives customers the choice: you can either keep your position open, but your money with the dealer, avoid tax and live with the “dealer risk”, or book your gain and get your money back and start again — encourages prudent behaviour. If nothing else it incentivises customers to diversify their risk. And it does not automatically lever up the customer’s portfolio. For what do we think the customer will do with all that free cash VM its dealer keeps sending it? If it was planning to just sit on it, wouldn’t just — leave it at the bank?
Secondly, dealers and banks are already capitalised and regulated for systemic risk. There are already constraints on how they must operate, and how much capital they must hold against the contingency of portfolio losses. It holds this capital, in large part, to protect against the risks presented to it by its customers. Customers like thinly capitalised, highly-levered investment funds.
That risk is amplified if dealers must pay away their own cash to reflecting their clients’ unrealised gains on a derivative portfolio already 70% financed by the dealer. It's just mad: “Hi. You owe me 70pc of the value of the stock you bought largely with my money, and you want me to pay you margin if the stock goes up?”
This is all the more mad where the dealer is hedging with a physical asset. No-one pays variation margin on gains on a physical asset.
Now you might make the case that this capital regulation has been a bit of disaster, and some have but one lot of crappy regulations is not a prescription for more crappy regulations. Even if, as in this case, the new regulations were also proposed by the Basel committee too.<ref><ref> Especially not when they undermine the first lot.
And this is exactly what bilateral variation margin does. Capital is the measure of “unallocated cash” available to meet the claims of general creditors. Cash being fungible, any cash on the balance sheet counts towards the capital ratio. A counterparty with an uncollateralised paper gain of $100m against a dealer still has a claim to that $100m: it can close out at any time, and even if the dealer fails first it still has a claim on that amount from the dealer’s capital reserves. It is just lining up with other creditors who also have claims.
No-one of this stops the dealer recognising the “equity” in a customer’s unrealised mark-to-market gains and extending credit — increasing lines — against it. This is what margin lenders and cash prime brokers do every day of the week.
But this lending is discretionary, and dealers can apply the haircuts, credit terms and diversification criteria as they see fit. The dealer can decide where and when to draw its lines.
Imagine if lending banks were forced to pay mortgage customers the value of unrealised gains on their house prices. Imagine how much worse the global financial crisis would have been then.
“But, but, but, JC: there is a difference. Where a house is concerned, the customer owns the house. It has no credit exposure to the bank for the house. If the bank fails, the customer keeps its house. With a swap, the customer would lose everything. All this is true. But, equally the customer’s personal capital outlays for that house — its real investment — is 20% (at the time of the GFC it might have been closer to 0%). This is a levered play.
The same is true of a derivative exposure. It is an implied loan. The customer puts down its initial margin — economically equivalent to a deposit — and gets the return of the whole asset. The bank’s interest is to optimise its funding and to earn a commission on the opening and closing of the trade. It agrees to lend 70 percent of the starting value of the asset. If the customer wants to isolate its credit exposure from the dealer, it can take out a margin loan against a physical asset, just like a mortgage. Or it can take its profit, close out its trade and find out the terms on which the dealer will reset.
For several reasons:
Banks are Banks are not losing value on the customer positions: as per the above, they are delta-hedged. Banks have no market exposure unless their clients go bust.
Banks generally go bust because their clients go bust. They don’t go bust by themselves—I know, I know, Silicon Valley Bank did, but it is an honourable exception that proves the rule.
If we are worried about bank solvency, then forcing the bank to cash settle unrealised gains on derivatives portfolios is a bad idea.
“settling to market” every day with an important distinction: you don
Banks are independently capital regulated for solvency.
Swap counterparties are sophisticated professionals with the tools and resources to monitor credit exposure to their dealers and brokers. (We take it that understanding the financial weapons of mass destruction that these sophisticates truck in require more ninja wizardry than does weighing up the creditworthiness of a regulated financial institution).
It is a much better discipline for sophisticated counterparts to manage their credit exposure — spread it around, so to speak, than to require their banks to send hard cash out the door as collateral to clients with outsized exposures.
Every dollar these banks pay away reduces the capital buffer the bank has available for everyone else. It also provides the customer with free money on an unrealised mark-to-market position. This is like paying out while the roulette wheel is still spinning, in the expectation of where the ball might land. That is a loan: if the customer doubles down and loses, you don’t get your money back.
Daily mark to market moves are mainly noise. Yet this is what parties must collateralise against. A great deal of the back-and-forth of variation margin is accomodating noise . The signal emerges over a prolonged duration. Over the short run posted collateral can, as we know a system effect: if I double down on an illiquid position, it will tend to rise, and I will get more margin, and — this is the story of Archegos.
The increased systemic exposure of banks failing — which is what the margin regs were designed to address — is not caused by the banks themselves, but by their client exposures. Client exposures in turn are a function of client failures, which are in turn a function of leverage
Their failure shouldn't, typically, be a systemic risk unless their unusually size, interconnectedness or unintended system effects make them systematically important, in which case they should be regulated if they are systemically important, and made to hold capital, and (b) they have the market position and bargaining power to negotiate margin terms.
- BINO — bilateral in name only
- The real distinction: dealer and customer
- Has this emphasis on bilaterality has led the regulatory dance into the wrong corner of the dancefloor?
- Lender and borrower: when an ISDA really is a lending contract
- They may enter contracts for difference and spread bets from brokers, but these are standardised, smaller contracts.
- They are not.
- To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.
- The dealer may need to borrow money to fund its hedge, but this is exactly what the customer’s floating rate pays for. This is “borrowing on the customer’s behalf”.
- After the GFC, bank proprietary trading fell away to almost nothing.
- This label is not just sardonic: there really is a cottage industry of of “regulatory change management professionals”, in-house and out, who owe their last decade’s livelihood to accommodating quixotic regulatory initiatives like this. They are a powerful lobby with a direct interest in maintaining the rate of regulatory churn.
- A grave factor in Credit Suisse’s losses on Archegos was “margin erosion” caused by massive appreciation on its swap positions. While Credit Suisse was unusual in not using “dynamic margining” (which solves the “margin erosion” problem) to its synthetic equity derivatives book, “static” initial margin is the rule for other asset classes, and for regulatory IM.
- Broker/dealers that are not deposit-taking banks are more lightly capitalised. But nor — for that very reason — can they hold customer assets and cash on their balance sheet, but must hold it on trust for customers with a client money bank that is capital regulated.
- Dealers can, and do, manage this by financing their physical portfolios. They would do this anyway, but variation margin requirements more or less oblige then to.
- Notably Gerd Gigerenzer, who has tracked the expansion in length of the Basel accords against the persistent rate of bank failure.