The Jolly Contrarian on ISDA

This is a free preview of a paid episode. To hear more, visit jollycontrarian.substack.comBy now I hope the netting problem is clear: regulations require each dealer to obtain lengthy legal opinions for every master agreement in its portfolio. A full service broker dealer may have hundreds of thousands, across scores of jurisdictions. Swap, stock lending, repo, and prime services master agreements each have different closeout mechanisms. Each requires its own legal opinion.Across those jurisdictions there are, literally, thousands of legal entity types, the netting requirements for each of which will, subtly, differ. Those entity types may have similarities across borders — there are corporations, partnerships and trust-like things in many jurisdictions, and they fulfil similar functions — but they are by no means standardised. There are private corporations, public corporations, joint stock corporations and special purpose vehicles. There are protected cell companies and segregated cell companies. There are unlimited partnerships, limited partnerships and limited liability partnerships. Trusts, foundations, stichtings and fiduciaries. Some have legal personality, some don’t. And the rules and resolution protocols for even simple corporate entities will differ between jurisdictions. An Austrian GmbH is not subject to the same rules as a German one.Thanks for reading! This post is public so feel free to share it.Close-out mechanisms in standard agreements like the ISDA are designed, as far as possible, to work universally, but this is an imperfect science. In some jurisdictions automatic early termination ensures netting works, in others it invalidates the agreement altogether. Additional clauses covering local peculiarities may be needed.There is a bit of regulatory conflict here. This is blue-on-blue action. By and large these local regulations, and their peculiarities, were originally designed to promote fairness between all a bankrupt’s creditors, rather than to vouchsafing a given dealer’s capital framework. You would think that all jurisdictions would want to ensure maximum capital efficiency to give local businesses optimal access for international capital markets. But that is not how the regulations are necessarily framed. That said, should there ever be latent conflict between insolvency and capital rules, local regulators are strongly incentivised to fix them pronto. The consequence of not doing so is to shut themselves out of international capital markets. That is a bit like sanctioning yourself. So, we saw in 2016, when a German court decision threatened to undermine the effectiveness of close-out netting, the German government quickly intervened to change the law.Hence the need for constantly-updated netting opinions. However long and however erudite, a netting opinion must, for each of the hundreds of thousands master agreements in the firm’s contract portfolio must be boiled down to a single question: Will close out netting work, yes or no?That determination will set a “netting flag” in the firm’s risk systems for each agreement. That, in turn, will determine how much capital the bank must hold against that exposure under that agreement.Long, windy academic tracts about aleatory contracts and the anti-deprivation rule established in Whitmore v Mason (1861) 2 J&H 204 are not well suited to answering that simple question. There is thus a collision between the airy, theoretical world of regulation and a dealer’s greasy operational reality. It has to answer “yes” or “no” — realistically, “yes”—the consequence of “no” is almost always “we cannot trade with this entity” for every contract it enters into. Yes, opinions are required to be “written and reasoned”. But they should also be practical.Mechanically, setting netting flags involves three interacting “systems” inside a dealer’s greasy operational reality: its risk engine, its agreement database, and the diffuse activity of gathering, reviewing and approving netting opinions. These three systems are quite different. The risk system has to work. The agreement database has to feed the risk system. Netting opinion review is a manual, offline human activity that no-one wants to do because it is so boring.Risk engineFirstly, the risk engine: this will almost certainly be a industrial-grade computer system. It must be, and will be, built like a tank. It ingests trade data and market valuations for every transaction and every collateral position, aggregates them and matches each to a single master agreement record. From this it calculates the following day’s margin calls, manages risk limits and credit headroom for the client and the capital consumption for the agreement in question. This exercise is fiddly enough: for those calculations to be possible, each swap needs to map to a single ISDA, each stock loan to a GMSLA, each repo to a GMRA and so on. Should the same counterparty have two ISDAs or side-by-side collateral arrangements—unusual, but not impossible—the risk engine’s logic needs to map swap trades and their exposures to different ISDAs and CSAs. Failing to get this right can be an existential risk, so this system should be bulletproof.Master agreement databaseSecond, the Master agreement database: this is where all master agreements go once negotiations have concluded and the agreement is executed. Key terms of master agreements and collateral arrangements will be recorded in the master agreement database. This will have a solid functional core—it provides necessary master agreement data to the risk engine—but the system it is built on is quite likely to be old, heavily patched and a lot of its data, especially relating to older agreements, will be quite ropey.At the dawn of the age of swaps, there was little formality around the negotiation of master agreements. That has changed over forty years in response to the manifest crises and shocks of history, but the content of these systems will still be uneven. What once was a bespoke negotiation handled by learned counsel and magic circle law firms has long since been industrialised: modern contract negotiation is outsourced, offshored, juniorised and heavily constrained by policy and approval workflows which provide the negotiation data record for each master agreement. However, contract documentation is far from standardised. There is no good reason for that these days: it is a commoditised product, and the terms and exigencies of a master agreement are well understood and boil down to a handful of simple credit points, but master agreement negotiation remains a cottage industry that keeps a lot of busyworkers gainfully employed.If I had to guess I would say AI will not change this.In any case, the master agreement database inevitably contains less data than is embedded in the master agreements themselves, after all that earnest pettifoggery, and on occasion misrepresents it. In any case, part of an agreement’s data record—specifically the “netting flag”—must somehow get from the agreement database to the risk engine. But first it needs to get to the agreement database, and this is where the netting opinion review process comes in.Netting opinion review processThe last of those three systems is the netting opinion review process. To populate a netting flag in the agreement database, one must know what the relevant netting opinion says. This is handled by what we will call the “netting opinion system”. This implies something grander the loosely-governed, resented, syndicated human activity it is likely to be. The netting opinion system will be a disparate collection of typed forms and spreadsheets stored on a folder in a Y: drive somewhere, or an underspecified SharePoint site or access database built in 1994 and now maintained, reluctantly, by a team in Gdansk. It may include a shared inbox, a subscription to online reporting services or an arrangement with a local law firm to provide summaries. This process is a monster. Some poor sod in the legal department will have to syndicate the job out amongst the bank’s derivatives lawyers, who between them must review, construe and approve the netting opinions. That poor sod, in one institution, once upon a time, was me, readers. You can call that role something high-faluting, like “netting opinion compliance lead” but it is a thankless task. You must assign each jurisdiction that your firm trades against to a fellow lawyer: usually, each one gets three of four each. They will not thank you for it. They then must keep their allotted jurisdictions, and all the opinions for them, up-to-date. They must check with credit what risks the firm has on, against what kinds of counterparties, under what agreements in that jurisdiction. They must compare that against the industry opinions – there will likely be several, which will not necessarily be consistent — to ensure everything is covered. Where there are gaps—usually, there will be—they must commission bilateral opinions to fill them.They must populate “netting review sheets” explaining clearly which counterparties are covered, what products are in scope and what departures are required from the legal standard to ensure close-out will work as intended. Once these are approved—there is of course a governance process—these must be then filed somewhere the negotiation team can find them: they will need them to set netting flags when onboarding and negotiating with new customers. This is all laborious, time consuming, hard to effectively govern or supervise, and expensive.Regular subscribers leave us now — but next time we will pick up by looking at a solution. Premium subscribers come along as we look at:Industry opinionsHow industry opinions work, and form the core of the netting effortBurning down the houseHow, sometimes, starting again is not the worst ideaThere must be a better wayWhat if, what if, what if… What if someone built this?This Substack is reader-supported. To receive new posts and support my work, consider becoming a free or paid subscriber.

This is a free preview of a paid episode. To hear more, visit jollycontrarian.substack.comLittle Swap-a-ThingMama said, “Now, Eggfried dear:I must go out and leave you here.But mind now, Eggie, what I say:Don’t swap your things while I’m away.The fearsome cherry-picker swingsFor little boys who swap their things.And ’ere they dream what he’s aboutHe’ll take his great big plucker outAnd swipe their cherries clean awayNo matter what they do or say.”As soon as Mama turned her backYoung Eggfried swapped. Alack! Alack!He paid away a floating rate, andIn came cherries, by the plate!But scarcely could he take a biteWhen who should give the lad a fright?The door flew open, in there ranThe great long-fingered cherry-man!Oh! children, see! The plucker’s here!He’s grabbed our little Swappie’s ear!Pluck! Swipe! Snatch! The Plucker goes.Eggfried cries, “Oh, no! No! No!”Pluck! Swipe! Snatch! They go so quick!Every single cherry picked!There’s nothing left in Eggfried’s bowlTo fill the chasm of his soul.Then Mama’s home; poor Eggfried stands,His hanging head! His empty hands!“See?” says Mama, “The woe he bringsTo naughty little Swap-a-Thing!”—Otto Büchstein, Little Swap-a-Thing, from Cruwwelpeter, (1874)History proceeds one disaster at a time and regulatory capital is no exception. It was forged out of existential crisis.Today, we go back in history and look at the existential crisis from which the requirements of modern capital regulation flowed: a small and apparently inconsequential skirmish in the death throes of the battle of Bretton Woods that rather got out of hand. It involves, as these things tend to, a small town in Germany.This Substack is reader-supported. To receive new posts and support my work, consider becoming a free or paid subscriber.A long time ago in a small town in GermanyBankhaus Herstatt was a Cologne small private bank. Following the collapse of the Bretton Woods system in August 1971,[1] Herstatt had made a series of massive bets that the U.S. dollar, which had been hammered by speculators, would recover. It didn’t. By 1974, most European currencies were freely floating and Bankhaus Herstatt was nursing losses ten times the size of its capital base. This could not carry on indefinitely, and didn’t.Late one afternoon in June, regulators arrived at Herstatt’s headquarters while it was settling the day’s FX transactions and shut the bank down. All hell broke loose. It is fair to say regulators were not expecting this.Under its FX positions Herstatt was paying away U.S. dollars and receiving deutschmarks.[2] Being late in the afternoon, its European counterparties had already settled their deutschmarks, but by the time the regulators arrived it was still early in the New York morning and Herstatt’s U.S. dollar correspondent banks[3] had not yet released their payments. When they found out about of Herstatt’s failure, they cancelled them. Herstatt never satisfied its dollar obligations, leaving its European counterparties out of pocket.Sorting this ought to have been straightforward: return the deutschmarks, close out hedges and the counterparties could settle, or prove in and solvency, for the difference in value. But Herstatt’s liquidators didn’t see it that way. They refused to return the deutschmarks.German insolvency law allowed them to treat the deutschmarks as having settled. They were therefore an asset in Herstatt’s bankruptcy estate. Its dollar obligations hadn’t settled. They were a pending liability. Since they could not legally be set off against the incoming payments. The liquidators kept them. They “cherry-picked” the deutschmarks.Cue utter mayhem as the global currency markets froze, and banks refused to make any payments where they weren’t totally sure their counterparties were able to pay. This failure to remit currencies meant banks couldn’t satisfy their debts in those currencies, prompting a chain reaction that nearly brought down the international banking system: banks stopped trusting each other to complete transactions across different time zones.The system was tightly coupled then: what with the advent of computerisation, it is even more tightly coupled now. Regulators around the world decided they needed to do something.What they did was to form the Basel Committee on Banking Supervision. It has no direct power to make law, but its members do, in their individual jurisdictions. The committee’s work — the Basel Accords — are enshrined in prudential regulation around the world.Things were sorted out, after a fashion, and the situation returned to normal. Herstatt might have been a crisis averted, but as the information revolution gathered pace and the financial system increased its rate of stroke — and as new fangled financial instruments like swaps emerged blinking into the light promising, alongside precise risk allocation the outside chance of utter financial destruction, the Basel Committee’s rank-and-file membership began to worry. That old fairy story about Little Swap-a-Thing haunted them. Weren’t these new-fangled “swap” instruments just like that?Yet swap dealers were not obliged to hold capital against their positions as ordinary lenders were: there was no loan of principal under a swap. Without capital charges, dealer derivatives books were quickly growing.[4] Regulators feared credit risks might be accumulating out of sight and “off balance sheet” where they would not be protected by bank capital ratios should there be another Herstatt-style disaster.The 1988 Basel Accord required swap dealers to hold capital against their gross “in-the-money” swap values. Not the whole “notional” amount of the swap: only its mark-to-market exposure — its replacement cost, essentially — if owed to the dealer. That was an unsecured debt claim. Amounts the dealers owed to their counterparties under other transactions could not be used to offset the dealer’s claims.The new rules treated dealer swap exposures as if insolvency cherry-picking was a certainty: dealers could not offset their out-of-the-money positions. This dramatically choked the demand for swaps.But where regulators saw horror, dealers saw opportunity lost. The new asset class offered fluid risk management that, they felt, should not be buried by punitive rules. The dealers, through their industry association ISDA, set about fixing the problem. They overhauled the half-hearted close-out provisions of the 1987 ISDA Interest Rate and Currency Exchange Agreement, which the regulators felt was vulnerable to cherry-picking, and in 1992 published an updated version. It had much more robust netting provisions.The regulators weren’t immediately persuaded, but by 1995 they had come round to the idea. They would recognise “netting” under this contract, but on a couple of conditions.[5]Firstly, the dealers must have in place a suitable netting contract:...which creates a single legal obligation, covering all included transactions, such that, in the event of a counterparty’s failure to perform due to default, bankruptcy or liquidation, the bank would have a claim or obligation, respectively, to receive or pay only the net value of the sum of unrealised gains and losses on included transactions...The 1992 ISDA ticked that box.Secondly, dealers must obtain, under all relevant laws — their own, the counterparty’s and those governing the netting contracts:... written and reasoned legal opinions that, in the event of a legal challenge, the relevant courts and administrative authorities would find the bank’s exposure to be such a net amountAnd so was born the regulatory requirement for lengthy, verbose netting opinions: you must have confirmation from qualified legal advisor in the relevant jurisdiction, in detail, that, even if it wanted to, a bankruptcy official could not cherry pick in-the-money transactions. You needed opinions for each contract type, each counterparty type, and each relevant jurisdiction. That is a lot of jurisdictions: the insolvency rules relating to a a société anonyme in Belgium are different from those relating to a société anonyme in France. [6] A decent-sized bank might trade, variously, in 90 jurisdictions, against dozens of different legal entity types in each, and under six or seven different master netting agreement types.That is a lot of opinions.Shoulda coulda wouldaNow, a couple of things to say about those netting opinions. Firstly, they must be to a standard of certainty known in the trade as “would-level”. This is pretty definitive: “beyond reasonable doubt” and not “balance of probabilities” territory. It won’t do to say that netting should be enforceable, or is likely to work. The opinion must be as categorical as one can be about a hypothetical situation: the agreement would, not should, be enforceable.In a part of the law as strewn with discretions, equity, best efforts, little old ladies and Welsh hoteliers as is bankruptcy, getting a “would-level” opinion is a hard threshold to cross. Just saying, “well, once a company is in formal bankruptcy an official receiver has a wide general discretion to enforce or repudiate open contracts — to “cherry-pick” — in the best interests of the company’s unsecured creditors” has the potential to blow a netting agreement out of the water. The “single agreement” has some defences against that, as we will see, but still: simple, apparently reasonable, discretions, put there by national regulators to make sure bankruptcies are orderly and everyone gets a fair shake, are potentially problematic. This is a “blue on blue” problem: one set of domestic regulations make life harder under another set of universal regulations, even though both are targeting the same outcome: financial stability.Secondly — for this very reason: insolvency considerations are subtle, nuanced and tricky — the opinion has to be “written and reasoned”. This too, has acquired its own gruesome meaning over the decades, and the closest colloquial translation to a layperson is “utterly unintelligible”.A written and reasoned opinion cannot be a quick chat with your lawyer on a Friday evening over a beer. It must be on headed paper, and it must show the working. Your lawyer must put her back into it. She has to say why she has concluded that netting is enforceable, in detail. With receipts. Few lawyers will pass up an opportunity to drone on at length, and experts in the resolution of aleatory contracts are no exception.For compensation for legal services is generally calculated by reference to the higher of the value added and the time spent[7] — thought leaders can bellyache all they like about this, but it is true, has always been true, and always will be true — so to instruct a lawyer to perorate on a topic that is not wildly controversial is to ask the proverbial silly question. Lawyers like nothing better than giving silly answers. They will come in a 300-page sheaf, accompanied with a commensurate bill, and will say things like:It occurs that, mainly because of the applicable limitations on asset allocation (spreading of risk) and also because the Investmentfondsgesetz contains specific provisions on the redemption of the Investment Fund’s units (and certain limitations/precautions in case redemption should lead to a liquidity problem), the Investmentfondsgesetz is based on the assumption that an Investment Fund may not become overindebted in terms of Austrian insolvency law (insolvenzrechtlich überschuldet) or illiquid (zahlungsunfähig). Accordingly, save for provisions that relate to an Investment Fund’s liquidation (Abwicklung) (e.g, in case the Investment Fund’s assets decrease below EUR 1,150,000 and the Investment Fund Management Company opts to no longer manage that Investment Fund and no substitute Investment Fund Management Company is appointed in accordance with the Investmentfondsgesetz), applicable law is silent in this regard. In our opinion this (historic) view somewhat neglects to take into account the risks that may be incurred by the Investment Fund Management Company, e.g. in relation to derivatives transactions that are entered into by the Investment Fund Management Company in its name and for the account of the holders of units in the Investment Fund (Anteilinhaber) in respect of a specific Investment Fund.[8]Now, we know lawyers resile from being categorical about anything if they can possibly avoid it. That includes even simple things, like “how contracts are enforced upon insolvency”. Your lawyer will take the instruction to “show her working” as an invitation to bury the actual conclusion. The opinion will be written and reasoned at the cost of being clear.The rest, dear readers will be for the premium subscribers.