& nbsp
Author: Simon Hart and Jake Hardy, partners, RPC
We want to highlight an important point for any partly unhappy part to cope with a fence in an ISDA transaction (Swaps and Derivatives Association). During the action for the parties in this position of bank litigant, we identified an apparently common practice among investment banks, by which they obtain a short -term directional bet on the market to the potential detriment of the faulty counterpart . This leads to the inflation of the amounts requested in the closure if the bank loses money on these trades.
Imagine the fictitious scene. You are counterparted by a derivative contract with “Banque A.” The market has opposed you and trade is underwater. Maybe you have received margin calls that you could not meet. Whatever reason, “Bank A” has issued a defect event notice in which he informs you of the date of early termination. As a non -defective party, the “bank A” will determine the closing amount due to termination on this future date. Proximity protocols vary a little between the master agreements of 1992 and 2002, but for current purposes, they can be treated as identical. According to one or the other, the date of early termination must be at least 20 days after the service of the default event notice.
Usually, the “bank A” has covered the risk of your transaction when it entered it with you. The “bank A” should be largely protected by this coverage against market risk in the period between the defect declaration and the closure. Indeed, the master’s agreements provide that the non -defective part may include cover costs in the assessment closure. Nothing controversial there.
Now imagine that you are a little luck because your market position improves somewhat in the period before the termination (but not enough to heal the position). When the early termination date arrives, this is reflected in a better closing assessment for your profession, which would have been the case on the date on which the defect notice was served. However, the “bank A” includes greater complaints than expected for the cost of the evaluation costs. It is, as always, unrealistic to wait for great transparency. The details of the trades and prices can be absent or thin, and it is unlikely that the support materials will be voluntary.
Near chicanery
But, with the courage of a sensitive failure part (and tenacious advisers), you are probing “Bank A” on the evaluation. You press for the detailed calculations behind the title figures and for the evidence supporting them. The skills and persistence finally discover that the important sums are requested for the losses suffered on the new “covered” transactions concluded towards the date of notice service (therefore approximately three weeks before the evaluation).
We expect any loss to be claimed as roofing costs
What are these transactions? Well, they turn out to be the bank of new trades, a “bank” concluded in the same direction as it sees your profession, therefore in the direction opposed to its hedge of origin. Just as you have made gains in relation since the default notice was served, these professions have lost money against “Bank A.” Consequently, the “bank A” indicates that it has the right to claim losses on the new trades in adjusting its coverage.
There are two questions that arise. The first is legal-the costs of these “counterattops” are borned by the service of the event notice of the fault costs which may be legally claimed from the defaulting part of the closing amount due in the ISDA framework? After a legal analysis considered, I think they are not.
The second question is practical. Why “would he” banish one “would conclude these new” counters “, especially when they canceled the previous coverage what was his protection against market risk? One of the reasons could be that it receives credit risk on your trade leg, although, in our opinion, which does not provide the basis of a legal complaint under the ISDA assessment mechanism.
The more cynical opinion is that if there is a expectation that losses can be claimed as roofing costs, there is no reason not to place a directional bet. According to our experience of the functioning of relatives, “Bank A” is unlikely to be sufficiently irrational on the economic level to volunteer to give credit to such a trade which has made money – they would simply become unconnected enriching trades.
In reality, this is not a fictitious scenario. I have witnessed a number of investment banks performing this strategy in fences where they tried to demand very significant losses on such “counterattacks” under the coat of widespread “coverage costs” .