The gruesome tale of Little Swap-a-Thing

Fixing the netting problem

This is a free preview of a paid episode. To hear more, visit jollycontrarian.substack.com [https://jollycontrarian.substack.com?utm_medium=podcast&utm_campaign=CTA_7] By 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 engine Firstly, 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 database Second, 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 process The 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 opinions How industry opinions work, and form the core of the netting effort Burning down the house How, sometimes, starting again is not the worst idea There must be a better way What 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.

The gruesome tale of Little Swap-a-Thing

This is a free preview of a paid episode. To hear more, visit jollycontrarian.substack.com [https://jollycontrarian.substack.com?utm_medium=podcast&utm_campaign=CTA_7] Little Swap-a-Thing Mama said, “Now, Eggfried [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/Cherry-picker]!Oh! children, see! The plucker’s here!He’s grabbed our little Swappie’s ear! Pluck! Swipe! Snatch! The Plucker goes.Eggfried [https://jollycontrarian.com/index.php/Eggfried] cries, “Oh, no! No! No!”Pluck! Swipe! Snatch! They go so quick!Every single cherry picked!There’s nothing left in Eggfried [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/Otto_B%C3%BCchstein], 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 [https://jollycontrarian.com/index.php/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 Germany Bankhaus Herstatt was a Cologne small private bank. Following the collapse of the Bretton Woods [https://jollycontrarian.com/index.php/Bretton_Woods] system in August 1971,[1] [https://jollycontrarian.com/index.php/The_tale_of_little_Swap-a-Thing#cite_note-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] [https://jollycontrarian.com/index.php/The_tale_of_little_Swap-a-Thing#cite_note-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] [https://jollycontrarian.com/index.php/The_tale_of_little_Swap-a-Thing#cite_note-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 [https://jollycontrarian.com/index.php/Germany] 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 [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/Sw-%C3%A6p] emerged blinking into the light promising, alongside precise risk allocation the outside chance of utter financial destruction [https://jollycontrarian.com/index.php/Financial_weapons_of_mass_destruction], the Basel Committee’s rank-and-file membership began to worry. That old fairy story about Little Swap-a-Thing [https://jollycontrarian.com/index.php?title=Little_Swap-a-Thing&action=edit&redlink=1] 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] [https://jollycontrarian.com/index.php/The_tale_of_little_Swap-a-Thing#cite_note-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 [https://jollycontrarian.com/index.php/Basel_Accords] required swap dealers [https://jollycontrarian.com/index.php/Swap_dealer] to hold capital against their gross “in-the-money” swap values. Not the whole “notional” amount of the swap: only its mark-to-market [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/ISDA], set about fixing the problem. They overhauled the half-hearted close-out provisions of the 1987 ISDA Interest Rate and Currency Exchange Agreement [https://jollycontrarian.com/index.php/1987_ISDA_Interest_Rate_and_Currency_Exchange_Agreement], which the regulators felt was vulnerable to cherry-picking [https://jollycontrarian.com/index.php/Cherry-picking], and in 1992 published an updated version [https://jollycontrarian.com/index.php/1992_ISDA_Master_Agreement]. 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] [https://jollycontrarian.com/index.php/The_tale_of_little_Swap-a-Thing#cite_note-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 [https://jollycontrarian.com/index.php/1992_ISDA_Master_Agreement] 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 amount And so was born the regulatory requirement for lengthy, verbose netting opinions [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/Cherry-pick] in-the-money [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/Soci%C3%A9t%C3%A9_anonyme] in Belgium are different from those relating to a société anonyme [https://jollycontrarian.com/index.php/Soci%C3%A9t%C3%A9_anonyme] in France. [6] [https://jollycontrarian.com/index.php/The_tale_of_little_Swap-a-Thing#cite_note-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 woulda Now, 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 [https://jollycontrarian.com/index.php/Would-level_opinion]”. 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 [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/Little_old_ladies] and Welsh hoteliers [https://jollycontrarian.com/index.php/Welsh_hoteliers] as is bankruptcy [https://jollycontrarian.com/index.php/Bankruptcy], getting a “would-level [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/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 [https://jollycontrarian.com/index.php/Aleatory_contract] 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] [https://jollycontrarian.com/index.php/The_tale_of_little_Swap-a-Thing#cite_note-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] [https://jollycontrarian.com/index.php/The_tale_of_little_Swap-a-Thing#cite_note-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.

The boy and his shadow

Banca Valle del SiliconeNon era Lorenzo MediciIo ho cedole fissateTu le hai variateVogliamo la coperturaFissiamo la procedura —Otto Büchstein [https://jollycontrarian.com/index.php/Otto_B%C3%BCchstein], Eggfried [https://jollycontrarian.com/index.php/Eggfried] When we left off last time Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank] had collapsed. It burned through its “available for sale” portfolio of financial assets — mainly long dated U.S. treasury notes — to meet the surge in withdrawals it suffered when, in early 2023, the U.S. Federal Reserve — the central bankers’ central bank — hiked interest rates to tame inflation, and that caused the cheap money venture capitalists had been hosing at anyone with a pitchbook, a turtleneck and a compelling blockchain story, to suddenly dried up. Suddenly all the bank’s customers needed their deposits at the same time. That’s the deal with deposits: if customers want their money back, you must give it to them. If you don’t have cash on hand, you must liquidate assets. Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank] had ploughed its deposits into safe, long-dated, government-guaranteed bonds — good — but paying what were now uncomfortably low fixed interest rates — bad. It could only sell them at a significant loss. A fixed rate bond’s “discount” to its redemption value is a function of two things: how far its coupon sits below current rates, and how long remains to maturity. The bank’s portfolio was well below market rates and, on average, very long-dated. This added up to a whopping “discount”. You might have questions about that. For one, seeing as “borrowing short and lending long” has been the basic risk of banking since the Medicis, aren’t there tools for managing that risk? Couldn’t Silicon Valley Bank have, like, hedged themselves somehow, to avoid falling down this manhole? Secondly, war stories are all well and good, but what do they have to do with close-out netting [https://jollycontrarian.com/index.php/Close-out_netting] on an ISDA? Silicon Valley Bank was just a normal commercial bank, wasn’t it? Did it even have a swap portfolio? Those are good questions and they are related. Duration risk is something the Medicis would have understood and dealt with. It is the ultimate “known unknown [https://jollycontrarian.com/index.php/Known_unknown]”. And there are things you can do to manage it. In fact, until 2022, Silicon Valley Bank did them: it hedged with “over-the-counter” contracts under which it would pay sums broadly equal to its fixed rate bond coupons, and receive floating rate coupons back. The bank announced its strategy in 2021, expecting rate rises from the Federal Reserve. As the market priced in rate rises, those contracts became more profitable. This Substack is reader-supported. To receive new posts and support my work, consider becoming a free or paid subscriber. These hedging contracts were, of course, swaps. So, Silicon Valley Bank did have a swap portfolio. A big one. By the end of 2021, it was $15.2 billion in notional amount. But over the course of 2022, Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank] risk managers believed rates had peaked. They systematically unwound almost all their interest rate swaps to realise mark-to-market profits. This locked in one-off gains, but left the bond portfolio exposed to further rate rises. If, as the bank expected them to, rates eased the bank would realise even more profit. But if they rose further, the bank would be in a jam. It is easy to be wise in hindsight. In Q2 2022, the Fed was only getting started with its rate rises. You can see the timing of SVB’s hedge unwinds below. It is the region in red. So swaps did not cause Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank]’s downfall. To the contrary, the lack of swaps contributed by removing the main buffer that could have absorbed the coming rate shock. You could say the lack of swaps was the proverbial “curious incident in the night time”. Hedging interest rates: the boy and his shadow She returned to the nursery, and found Nana with something in her mouth, which proved to be the boy’s shadow. As he leapt at the window Nana had closed it quickly, too late to catch him, but his shadow had not had time to get out; slam went the window and snapped it off. You may be sure Mrs. Darling examined the shadow carefully, but it was quite the ordinary kind. — J.M. Barrie, Peter and Wendy (1904) This may sound trite, but it is still profound: interest is a consequence of lending. Interest doesn’t — until recently, couldn’t — exist without a corresponding disposition of principal from a lender to a borrower. Interest is to a loan as a shadow is to a boy: term loans cast one sort of shadow —fixed — and deposits cast another — floating — but both depend fundamentally on indebtedness. No Peter, no shadow. No loan, no interest. Duration risk is the problem of trying to match fixed assets that throw one kind of shadow with callable liabilities that throw another. If you could sell a fixed rate shadow, and buy a floating rate shadow, you would be covered. But how do you trade rates without borrowing and lending the principal sums they are derived from? You might, if you lent fixed and borrowed floating over identical terms and for identical principal amounts to and from the same person: then the principal payments would offset perfectly. On the same day you borrow $15.2bn on a fixed rate, you lend $15.2bn on a floating rate, on terms that they will both be repayable simultaneously. No money needs to change hands. This is an excellent solution: principal liabilities wash out to zero: the parties are paying and repaying identical amounts to each other on the same date — leaving only the residual interest rate exposures. The shadows remain; the boys cancel out. But, alas, banks were left with a formal problem, occasioned by the way defaulting companies’ assets and liabilities are usually resolved in bankruptcy: it there were two standalone loan contracts one borrowed, one lent, each supported by valuable consideration and standing on its own as a sensible economic transaction entered at arms’-length, they would be treated for all practical purposes as distinct: one would be an asset and the other a liability, and they would sit on opposite sides of the balance sheet. An insolvency administrator would naturally regard them as different things, having different consequences on the defaulting party’s bankruptcy. A bankrupt’s liabilities are, of course, subject to recovery and resolution contingencies of the bankruptcy process. A creditor might get some or all of its money back; but it might not. A bankrupt’s assets, on the other hand — its claims against its own debtors — are not. They are undiminished. Indeed, the more the bankrupt recovers from its debtors, the more it will have to repay its creditors. So the insolvency process — which is there to protect creditors — would naturally prise apart loans owed by the bankrupt from those owed to it, even if certain pairs of loans were entered together and with a unitary purpose. An offsetting lender/borrower would have to repay one, but file a creditors’ claim in bankruptcy for the other. This rather mucks up the clever idea of cancelling out the two “boys” and being left with their offsetting “shadows”. A bank counterparty would have to hold regulatory capital against its whole loan asset. It would not getting any relief for the value of its offsetting loan liability. In 1981, bankers at Salomon Brothers — who have since passed into JC mythology as the First Men [https://jollycontrarian.com/index.php/First_Men] — had two clients, IBM and the World Bank with exactly this problem, only in the converse to each other. The First Men had a bright idea. They called it the “swap [https://jollycontrarian.com/index.php/Swap]”. Swaps “I wonder,” Mr. Darling said thoughtfully, “I wonder.” It was an opportunity, his wife felt, for telling him about the boy. At first he pooh-poohed the story, but he became thoughtful when she showed him the shadow. “It is nobody I know,” he said, examining it carefully, “but he does look a scoundrel.” — J.M. Barrie, Peter and Wendy (1904) Swaps are a really neat idea. They solve that duration risk — the one that has been with us since Lorenzo Medici — in a novel way without blowing up the balance sheet the way offsetting loans would. The essential insight of a swap is twofold: first, find a single counterparty who has the opposite duration problem to you, and secondly, remove the principal exchange altogether. Now you can both hedge your position. Neither of you needs to needlessly inflate your balance sheet. Economically, an interest rate swap is identical to offsetting loans with the same person. The difference is a formal, but important, legal description: rather than the principal exchange being resolved by set-off, it is removed altogether. A swap is in no sense two inverse transactions: it is a single unified Transaction [https://jollycontrarian.com/index.php/Transaction_-_ISDA_Provision] with no principal exchange at all. There is therefore no claim for an insolvency practitioner to make for a “return of principal”. The “boys” are gone. We are left with only their “shadows”. The present value [https://jollycontrarian.com/index.php/Present_value] of the offsetting payment streams — the shadows — will fluctuate, but they will always offset each other. So, is this where we talk, finally, about netting, of those offsetting rate flows, and implied exchanges of principal? Is that why we need close-out netting opinions? To reinforce the argument, somehow, that a swap should not be recharacterised [https://jollycontrarian.com/index.php/Recharacterise] as a pair of disguised, offsetting loans? No. That bit is settled: as there is no principal exchange inside a swap, there is nothing for insolvency administrators to claim. Unlike the “offsetting loans” structure, the individual “legs” of a swap do not make economic sense by themselves. You cannot view them in isolation. Rather, the fixed leg is consideration for the floating one, and vice versa. You don’t need enforceability opinions at this level, because here there are no cherries to pick. The “cherry-picking” problem arises only when we try to boil down exposures between different swap Transactions between the same parties under the same ISDA. The Single Agreement In most financial instruments, the interest is pinned permanently to a disposal of principal. It is therefore always clear who is the creditor and who is the debtor, and they don’t change. Loans, for a bank, are always assets: once drawn, the bank is always creditor and the borrower always debtor. There are no circumstances — not even negative interest rates — in which a loan asset could turn into a debt liability. In the same way, a bank deposit is always a bank liability. A depositor, as depositor, never owes the bank. Swaps are genuinely bi-directional: they can be either assets or liabilities. You cannot predict who will owe whom at any point in the future. If rates fall, the floating rate payer will be “in-the-money”. If they rise, the fixed rate payer will. This presents a challenge, or an opportunity, when it comes to aggregating swap exposures under an agreement. Some will be positive, and some will be negative. Ideally, the counterparties should want them to offset. And now, finally, we can talk about close-out netting opinions. This is the offset they address. In its day the ISDA Master Agreement [https://jollycontrarian.com/index.php/ISDA_Master_Agreement] was a revolution. The printed form has all kinds of arcane and clever tricks but the “single agreement” concept, set out in elegant and simple language in Section 1(c) [https://jollycontrarian.com/index.php/1(c)_-_ISDA_Provision], is its masterstroke. (c) [https://jollycontrarian.com/index.php/1(c)_-_ISDA_Provision] Single Agreement [https://jollycontrarian.com/index.php/Single_Agreement_-_ISDA_Provision]. All Transactions [https://jollycontrarian.com/index.php/Transactions_-_ISDA_Provision] are entered into in reliance on the fact that this Master Agreement [https://jollycontrarian.com/index.php/Master_Agreement_-_ISDA_Provision] and all Confirmations [https://jollycontrarian.com/index.php/Confirmations_-_ISDA_Provision] form a single agreement between the parties (collectively referred to as this Agreement [https://jollycontrarian.com/index.php/Agreement_-_ISDA_Provision]), and the parties would not otherwise enter into any Transactions [https://jollycontrarian.com/index.php/Transactions_-_ISDA_Provision]. What this does is to claim the same status for all Transactions as the “swap” concept did for offsetting loans: to say that each of these Transaction “Exposures” is not an independent asset or liability, but is entered into in reliance on the agreement that all Transactions are to be summed down to a greater whole, being the total aggregate exposure under the whole ISDA. There is to be no “cherry picking”. If this was as far as it went, it might be a bit lame: this does not, of itself, remove a “central offset” to render the separate Transactions co-dependent, the way cancelling the principal exchange converted two offsetting loans into a single swap. It just says, hey, we go into this on the understanding cherry-picking is not allowed, okay? Insolvency laws have a habit of overriding inconvenient contractual provisions. Bankruptcy is an alternative universe: normal rules to not apply. See “Bankruptcy is a phase transition [https://jollycontrarian.com/index.php/Bankruptcy_as_a_phase_transition]”. But the ISDA has a second trick that goes some way to achieving that effect. It is buried in Section 6(c)(ii) [https://jollycontrarian.com/index.php/6(c)(ii)_-_ISDA_Provision]: (ii) Upon the occurrence or effective designation of an Early Termination Date [https://jollycontrarian.com/index.php/Early_Termination_Date_-_ISDA_Provision], no further payments or deliveries under Section 2(a)(i) [https://jollycontrarian.com/index.php/2(a)(i)_-_ISDA_Provision] or 9(h)(i) [https://jollycontrarian.com/index.php/9(h)(i)_-_ISDA_Provision] in respect of the Terminated Transactions [https://jollycontrarian.com/index.php/Terminated_Transactions_-_ISDA_Provision] will be required to be made, but without prejudice to the other provisions of this Agreement [https://jollycontrarian.com/index.php/Agreement_-_ISDA_Provision]. The amount, if any, payable in respect of an Early Termination Date [https://jollycontrarian.com/index.php/Early_Termination_Date_-_ISDA_Provision] will be determined pursuant to Sections 6(e) [https://jollycontrarian.com/index.php/6(e)_-_ISDA_Provision] and 9(h)(ii) [https://jollycontrarian.com/index.php/9(h)(ii)_-_ISDA_Provision]. See what’s happening there? Can you see the magic? Kind of buried, right? What is is saying is that upon close-out, the Terminated Transactions [https://jollycontrarian.com/index.php/Terminated_Transactions_-_ISDA_Provision] are just terminated and nothing is required to be paid under them. The Transactions just vanish in a puff of smoke. The Close-out Amounts are mystically conveyed somehow to the main Master Agreement, where they are determined not as final amounts due under the Transactions — by this stage, the Transactions have vanished, remember — but as calculation inputs to an amount due under the ISDA Master Agreement itself. The intention here is to defeat arguments that, “for this set of out-of-the-money [https://jollycontrarian.com/index.php/Out-of-the-money] exposures, you are an unsecured creditor in the queue, but for this set of in-the-money [https://jollycontrarian.com/index.php/In-the-money] exposures, you must pay up right here, right now.” Instead, all those amounts are treated simply as inputs to a single termination calculation for the whole agreement due under the “architectural” Master Agreement, not the individual Transaction. This, by the way, is why you cannot unilaterally terminate a Master Agreement — you need it, at all times, for this purpose. That is where we leave off this episode — we will return next week to look at the mechanics of netting. Thanks for reading! This post is public so feel free to share it. This is a public episode. 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Borrowing short and lending long

This is the first chapter in a new series about close-out netting [https://jollycontrarian.com/index.php/Close-out_netting], and the tiresome, hideous problem of close-out netting [https://jollycontrarian.com/index.php/Netting_opinion]opinions [https://jollycontrarian.com/index.php/Netting_opinion]. If you haven’t already, you might want to check out the introductory prologue, already released. It is here [https://jollycontrarian.com/index.php/The_Netting_Problem]. This is chapter one: we are still in scene-setting mode. Before we get started with the really boring stuff it is worth getting down to brass tacks and asking some really basic questions about how why we even have netting, why regulators care so much about it, what difference netting opinions make and why are they so long? If you thought this was fun, or interesting, please pass it on to someone who you think might like it. But before getting to that we need to go right down into the elephants and turtles of what banking is all about. For to understand why we need close-out netting opinions we must understand what close-out netting does. To understand what close-out netting does, we must understand the point— the importance — of capital adequacy [https://jollycontrarian.com/index.php?title=Capital_adequacy&action=edit&redlink=1]. To understand the imperative of capital adequacy, we must have our heads around the profound structural problem faced by every credit institution: “borrowing short and lending long”. Fundamental intermediation To understand that problem we need to understand the basic function every bank plays in the economy, of taking — with permission, of course — money from those who have more than they need, and giving it — for a fee — to those who don’t have enough. This fundamental business of banking is intermediation. Depositors — those with too much money — lend it to the bank, in return for deposit interest. The bank then lends that money — or, at least, a sum equal to most of it, to borrowers — those of its customers who don’t quite have enough. The bank lends to them, also, in return for interest. I don’t imagine this will come as a great surprise to anyone. As long as the borrowers are as good as their word and pay back what they owe, all is mostly well. If the borrowers can’t pay their money back, then the bank will have a harder time repaying its depositors. That much is obvious. But even if they can, the banks face an embedded structural problem. Generally, banks take in deposits “on call”. They are repayable to depositors on demand: Just stick your card in the ATM and you have have your savings back. But when banks lend money to their customers, they tend to do so on term loans: they can’t ask for their money back when ever they want it. They must wait until the end of the term. This can present banks with a cashflow problem, especially if they happen to field a large amount of withdrawal requests from depositors at the same time. Usually, this doesn’t happen: a bank’s deposit base tends to be fairly stable, and across the bank inflows and outflows on a given day are more or less balanced. But occasionally circumstances can contrive to change that, and things can get pretty spicy, fast. We can best explore this by the sad tale of Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank]. Interlude: The sad tale of Silicon Valley Bank SVB committed one of the most elementary errors in banking: borrowing money in the short term and investing in the long term. —Larry H Summers [https://x.com/LHSummers/status/1635443481106866176], 14 March 2023. There are any number of ways to measure the size of a bank: by number of customers, depositors or employees; by branches, by geographic spread or by aggregate value of customer deposits — but the conventional one is total asset value — the aggregate value of all the investments the bank has made — much of it with those deposits. By that measure, in March 2023 Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank], though founded only 40 years earlier, was the 16th largest bank in the U.S. If you measured Silicon Valley Bank by its number of depositors, it wasn’t nearly as big. Whereas JPMorgan has something like 90 million customers, Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank] had about 40 thousand. And whereas the average customer balance at JPMorgan, across business and retail accounts is about $20,000, the average customer deposit balance at Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank] was a shade under $4,000,000. I can save you a bit of maths here: Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank] was a tenth of JPMorgan’s size, but had one thousandth as many customers. And those customers were not diverse. They were not, like JPMorgan’s customers, a scattered distribution of miscellaneous butchers, bakers and candlestick makers: Silicon Valley Bank’s customers were all techbros. They all knew each other. They were all directionally positioned the same way. They all had lots and lots of spare cash. If you are JPMorgan, the beauty of your retail banking portfolio is that it is not at all concentrated. There are millions of butchers, bakers and candlestick makers, and they all deposit and withdraw their tiny amounts over the month, based on their own unique needs and circumstances. Because they are, for the most part, independent of each other, the overall effect is to smooth out all the volatility in your overall balances. Your “deposit base” is stable. It’s predictable. Silicon Valley Bank was very different. It had thousands, and not millions, of customers, and each one deposited a lot. Their deposit balances ran to millions. It was a really concentrated little bank. What was special about SVB? What was special about its customers? What kind of freak keeps millions of dollars in a checking account? Well, the clue is in the name. Silicon Valley Bank was founded in 1983 by a couple of Bank of America executives who spotted an opportunity to provide banking services to the then nascent “technology industry”. At the time, “Silicon Valley” was a fun name for a rabble of dope-freaks, dropouts and hippies mucking around with soldering irons and BASIC in Cupertino garages. These cats struggled to get accounts at Wells Fargo and JPMorgan. The new bank met their needs. Roll forward 40 years and it’s a different story. Silicon Valley Bank is the go-to bank for the VC crowd. Anyone who was anyone banked there. An SVB card was as much a part of the techbro clobber as the black turtlenecks, immortality vitamins, slap-head anarcho-libertarian ideology, sack-hopping altruism [https://jollycontrarian.com/index.php/Effective_altruism] and the simulation hypothesis [https://jollycontrarian.com/index.php/Simulation_hypothesis]. But only techbros banked there. Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank] didn’t collect deposits from many butchers, bakers or candlestick makers. It didn’t really want them: when you have queues of unicorn techbros queueing up to stash their cash with you, who has time to onboard the little guys? As time passed, Silicon Valley Bank steadily “lent in” to its niche: it provided startup advice. It made introductions. It had great VC contacts. It did off-the-cuff in consulting. It was part of the valley ecosystem. Some venture capitalists made banking there a condition of funding. Techbros are joiner-inner types at the best of times: this was a network effect [https://jollycontrarian.com/index.php/Network_effect:_why_distant_networks_aren%E2%80%99t_better_than_local_ones] on steroids. By 2020 software was eating the world, just like the VC snapperheads said it would, and money was abundant. There was the metaverse, crypto and nascent AI: as long as you had an account at SVB, VCs did not discriminate. They threw money at WeWork, WireCard and Theranos and it was fine. They would happily throw money at you. All you needed was a pitchbook [https://jollycontrarian.com/index.php/Deck], a hoodie and a compelling story about blockchain [https://jollycontrarian.com/index.php/Blockchain_as_a_service]. The name of the game was “first-mover advantage”: move fast and break things. Scale. Lever. Dominate the your space. Build a moat. Cash burn was a badge of honour. If you ran out, you just raised more. So Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank]’s main customers, the techbros, had lots of cash. Like, lots. In the U.S., retail bank deposits up to $250,000 are government insured against bank failure by the Federal Deposit Insurance Corporation. For regular banks, most of their deposits are FDIC-protected: only 20% of retail deposits exceed the quarter of a million dollar threshold. You’d expect that: who puts quarter of a mill in a savings account? SVB’s customers, that’s who. Ninety percent of SVB’s deposits were over the $250,000 FDIC threshold. There are two things to take from this: firstly, SVB deposits were stupefyingly big and secondly, they were at risk if SVB should get into trouble. There would be no government bailout. Everyone at Silicon Valley Bank was depositing cash. Almost no-one was borrowing. This is not normal for a bank. Borrowing and lending tend to balance out. When money is cheap, people feel good. They borrow to buy stuff, and pay the borrowing costs out of their income. They put things on the credit card. They buy houses this way. Cars. They put things on hire purchase. They put capital into their businesses. For this, they go to the bank. That’s what a bank does: matches depositors and borrowers. Yin and Yang. But techbros aren’t like normal people. They don’t get money from banks: they get it from venture capitalists. Techbros are — were — structural lenders, not borrowers. So, Silicon Valley Bank had an odd problem: what to do with all these excess deposits? Between March 2021 and March 2022 — in a single year, in the middle of the Pandemic — SVB’s deposit base doubled. It was being given deposit cash in a near-zero interest rate environment. Its interest costs were low, sure, but it had some, and overheads. Without borrowers, it had to find somewhere to park that cash and some income to pay its bills, return a profit, and yet be able to meet deposits if customers suddenly wanted their money back en masse. Usually, customers don’t do that — retail banking is a boring business — but SVB was special. If there could be a secular inflow in, there could be a secular inflow out. SVB had a credible answer. It would invest the deposit cash in U.S. government bonds and highly-rated mortgage-backed securities. These were, it thought, a better bet than mortgages and business loans anyway. The gig for normal banks is to lend that deposit cash to home buyers and businesses. These investments carry credit risk. Businesses can fail. If you’ve lent out on a mortgage, you run the risk your borrower can’t pay you back, and the property collapses in value. Even if it doesn’t, they are long-term commitments. You can’t get your money back until the term expires. And that term might be as long as 30 years. By contrast, U.S. Treasuries are safe. They are as safe as it gets: Uncle Sam don’t go bust. They are reliable: they pay fixed, regular coupons [https://jollycontrarian.com/index.php/Coupon]. They are liquid [https://jollycontrarian.com/index.php/Liquid]: you can sell them in a day [https://jollycontrarian.com/index.php/Standard_settlement_cycle] and get your money back. For a commercial bank without borrowers, they looked like a sensible hedge. I dare say the managers and executives at Silicon Valley Bank congratulated themselves on their prudence. Still, short-dated government bonds in a low interest rate environment don’t pay much interest. This is not the place to talk about yield curves in detail, but to generalise outrageously, the longer you are prepared to invest your money, the higher your interest rate tends to be. The “yield curve” usually slopes up and to the right. Silicon Valley Bank put all its deposit cash in 10-year U.S. treasury notes. All seemed in order. There was one extra little funny. Silicon Valley Bank was big — but not colossal. It was not a systemically important financial institution [https://jollycontrarian.com/index.php/Systemically_important_financial_institution], or “Stiffy”. U.S. regulators did not think it was big enough to present a real threat to the financial system. This meant it avoided certain capital regulations that applied to bigger banks. One was the “liquidity coverage ratio [https://jollycontrarian.com/index.php?title=Liquidity_coverage_ratio&action=edit&redlink=1]”. This requires a bank to keep a certain portion of its deposit obligations in “high-quality liquid assets” on hand at all times — cash or cash like instruments, which doesn’t include long-dated treasuries – to meet unexpected withdrawal requests. If market conditions suddenly change and customers suddenly all want their money, a bank can use its “liquidity buffer” to ride out the storm. In 2019, Silicon Valley Bank had lobbied for an exemption from these coverage ratios for banks with less than $250bn in assets. For reasons that, no doubt, U.S. bank regulators would come to regret, they granted it that exemption. As a result, SVB kept very little liquid cash on hand. It ploughed it all into ten-year Treasury notes and highly rated mortgage-backed securities. Then came COVID. At first it seemed a good thinrg. SVB’s deposits tripled—from $61 billion in early 2020 to $189 billion by 2022. It doubled down on its strategy. The inflation rate that didn’t bark in the night-time “Is there any other point to which you would wish to draw my attention?”“To the curious incident of the dog in the night-time.”“The dog did nothing in the night-time.”“That was the curious incident,” remarked Holmes. — Sir Arthur Conan Doyle, The Adventure of Silver Blaze All good things must end and the pandemic turned out to be the final straw that broke the zero inflation madness. Ever since the global financial crisis [https://jollycontrarian.com/index.php/Global_financial_crisis] in 2008 governments everywhere had been helicoptering cash onto their bin-fire economies with, seemingly, no adverse inflationary effects. The idea that low interest rates cause inflation seems baffling for a moment, but makes sense when you think about it. Inflation is prices going up. Prices tend to rise when demand outstrips supply. Demand rises when people spend. People spend when money is cheap. Money is cheap when interest rates are low. Low interest rates tend to push inflation up. And yet for fifteen years money was cheap. With every new crisis, central banks firehosed their economies with it, but inflation barely moved. No-one had a good explanation. Over time there was a kind of tacit assumption that, somehow the link between cheap money and big inflation was broken. So when the economic world ground to a juddering halt, once again, in March 2020, central bankers knew the drill. They went to their printing presses as usual. But this time inflation shot up. This took central banks by surprise. Central bankers have one basic lever to control inflation: interest rates. Just as cheap money boosts inflation, expensive money kills it. Around the world central bankers hiked interest rates. Fast. Duration mismatch: the fundamental risk of banking Borrowing short and lending long is not — despite what the former secretary to the U.S. Treasury had to say about it on Twitter — an elementary error, but the very fundamental premise of banking. Banks cannot avoid it. That is what they do. By its fundamental nature, it is that exact risk — “duration mismatch” — that the service of “banking” presents to those who engage in it. To see why we need to go one layer of turtles deeper, readers. Banking is the business of reallocating capital. Banks borrow money from those in the community who don’t need it and lend it to those who do. A bank hoovers up all those for-now-unneeded deposits, loafing around in savings and cheque accounts, consolidates then and then lends them out, usually in sizeable slugs and for sizeable terms, to those who need investment. In their most simplistic terms, banks intermediate between lenders — “depositors” — and borrowers. The priorities of depositors are different to those of borrowers. Depositors give up comparatively small balances they don’t need right now in return for interest, but on condition that they can have the money back whenever they want it. Monthly wage packets come in and then get salted away over the month. Generally speaking, a bank is obliged to return deposits on demand, and a failure to do so is a payment default. In the normal run of things, banks are quite good at predicting when and how much money their depositors, en masse, will need to withdraw. Their “deposit base” tends to be stable over a long period. This means that banks can, with reasonable confidence, use a large portion of their deposit base to make long-term investments. Which is just as well, because “long term money” is what bank borrowers want. They want to lock up the money they borrow. They want committed bank facilities to buy property and invest in working capital. These projects have a much longer term: mortgages may be twenty or thirty year arrangements. Borrowers need to know the money they borrow, and the price they have to pay for it, is committed. So: banks borrow from depositors “short” — overnight, or on call — and lend to their customers “long” — for pre-agreed terms. This creates what lawyers call “duration risk”. If all the depositors suddenly ask for their money back at once, and it is tied up for twenty years, the bank is “cashflow insolvent [https://jollycontrarian.com/index.php/Cashflow_insolvent]”. In the ordinary course, banks manages these risks by diversifying: they have millions of depositors and tens of thousands of borrowers, and the behaviours and repayment schedules of both are predictable enough for the bank to manage its cashflows notwithstanding the duration mismatch, as long as it maintains a sensible “liquidity buffer” of free cash to cater for unexpected spikes in withdrawals. If it’s that easy, then how does anyone get it wrong? Every now and then, banks do. Silicon Valley Bank [https://jollycontrarian.com/index.php/Silicon_Valley_Bank] did, badly. On time being money Hey, Rick? Time is money, right? I know “standing on the landing” may be a great song title, to me it’s just a tax loss. —Mike, The Young Ones, 1984. The general ideal of banking is to earn more interest on loans that you pay on deposits. This is, in essence, how banks make money. Deposits usually pay an interest calculated on an overnight rate [https://jollycontrarian.com/index.php/Floating_rate]. Bank loans are usually fixed for much longer periods. While this creates “duration risk”, as we’ve seen, we’ve also seen that in ordinary times it can be managed: banks run a “bid/offer spread” between lending and borrowing rates for one thing, and for another, at any time long-term interest rates, at which they lend, tend to be higher than short term ones, at which they tae deposits. The interest rate “yield curve” at any time usually slopes up and to the right. Therefore, structurally, they should be profitable most of the time. This not always true. And the whole yield curve can move upwards. Today’s overnight rate could be higher than last month’s ten year rate. This could create a problem: a bank could be stuck with a portfolio of low-interest investments which it has to fund with high-interest deposits. If the overnight deposit rate unexpectedly spikes, a bank will have to raise its deposit rates, to stop its borrowers shopping around for a better rate, but will be stuck with its lending rates as they are. This can create, at least in the short run, a problem for the bank, unless it has enough cash on hand to meet the interest shortfall until is sorts itself out. Things would be even worse if the interest rate spike was accompanied by a surge in withdrawal requests. At this point let’s go back to Silicon Valley Bank. It is March 2023. Second interlude: the sad demise of Silicon Valley Bank Meanwhile, in Silicon Valley Meanwhile, in Silicon Valley, that weird low-inflation, low-interest-rate, cheap-money environment — which for a decade had prompted cone-headed VCs to swamp money at anyone with a pitchbook and a turtle-neck — ground to the same juddering halt. The funding dried up. No more Series D rounds. Everything still might have been okay for Silicon Valley Bank had it been able to sit on its low-yielding treasury securities, as it intended to, until they matured, riding out the temporary blip in interest rates. But that depended on depositors being cool with leaving their money in the bank. That, too, might have happened, had it been JPMorgan and its customers a widely distributed, unconnected bunch of butchers and bakers with chump change in their checking accounts. But Silicon Valley Bank’s customers were not like that: they were homogenous, tightly interconnected and weird — as in “western, educated, industrialised, rich, and democratic” weird, but also as in “freaky tech-bro taking pills to be immortal” weird — and all of them had unfeasibly large balances that weren’t covered by FDIC insurance. Techbros suddenly found they needed to raid their bank accounts to make payroll. And they wanted their money, in any case somewhere a bit safer. Silicon Valley Bank started shipping lots of withdrawal requests. It had lots of liquid US Treasuries it could sell, if it needed to, to fund withdrawals. No great panic, except for one thing: being long-dated fixed rate bonds, their stated interest rate was low. Their “present value [https://jollycontrarian.com/index.php/Present_value]” was also significantly under water. To fund the withdrawals Silicon Valley Bank had to sell part of its U.S. government bond portfolio at a $1.8BN loss. It announced plans to raise capital in the market to shore up its balance sheet and reassure investors — but that announcement had exactly the opposite effect. All hell broke loose. All those techbros scrambled to pull their money out. On 9 March 2023 Silicon Valley Bank suffered a bank run. The next day regulators shut it down. Coda: call me “Lucky” As I sit, staring into this liquid amberRipples move out to the edge of the glass.Is that, really, your reflection in there?I just want to jump into the warm depthsAnd be there with youOne more time.Oh, alright.Hit it, boys — —Blondie, Here’s Looking At You (1981) Silicon Valley Bank’s sudden collapse is illustration enough of the non-linear [https://jollycontrarian.com/index.php/Non-linear], hard-to-predict, tightly-coupled [https://jollycontrarian.com/index.php/Tightly-coupled] nature of complex financial markets [https://jollycontrarian.com/index.php/Complex_system]. But it wasn’t done. Ten days later, half a world away, there would a final twist. Ripples were moving out to the edge of the glass. On the 12th of March, Signature Bank — another darling of the tech crowd, with a surprisingly similar idiosyncrasy — also failed. Fear spread. The credit market had some kind of acid flashback to 2008. Was this the start of another banking crisis? Eyes fell on the weaker banks around the world. Attention fell on one. The old warhorse Credit Suisse [https://jollycontrarian.com/index.php/Credit_Suisse] — battle-scarred, woozy, punch-drunk and unsteady on its feet after repeated drubbings — finally hit the canvas. Granite-chinned old “Lucky” had taken a beating in pretty much every catastrophe of the prior decade: Archegos [https://jollycontrarian.com/index.php/Archegos], WireCard, 1MDB, Mozambique Tuna bonds, Greensill, Abraaj, Madoff [https://jollycontrarian.com/index.php/Madoff], to name a few and got up every time. This time, for once, the blame lay elsewhere. But this time, the old dog wouldn’t get up. The social contagion problem Hamlet: Why, then, ’tis none to you, for there isnothing either good or bad but thinking makes itso. To me, it is a prison. —Hamlet, II, ii Fulfilling the important community role that they do, banks are vulnerable to social contagion. If depositors form the opinion that they might not repay their deposits, they are likely to withdraw them. Depositors — even unweird ones — talk. They listen to the radio and read the newspaper. They are on Twitter. Word can spread quickly. Very soon there can be a line of depositors queuing up outside the bank. This is inevitably a bad thing, not just for the bank, but also the depositors. No-one wins out of a bank run. For the longest time, bank regulators have required banks to organise their balance sheets to reduce the risk of duration mismatches — and reduce the risk of customers being worried there might be a duration mismatch, which is just as important. As long as they aren’t worried about duration mismatch the “ordinary” balance of loans and deposits will tend to be fairly stable. A very simple way which banks, and bank regulators, can reduce this risk is by requiring banks to hold a certain amount of cash in reserve. If a bank keeps some of that deposit cash “on its balance sheet” to cover for unexpected outflows when horrible things happen. One horrible thing that can happen is the failure of a derivative counterparty. Counterparties can have surprisingly large “exposures” to single swap counterparties — see the series on Archegos — so they need to have money on hand to cover that contingency. But how much? How would you calculate it? It is one thing to be owed money by a bankrupt counterparty — that’s the oldest problem in banking — but what if you say your counterparty owes you, but its insolvency administrator looks through your “single agreement” to all the transactions, and tells you that you you owe the bankrupt counterparty? That would be bad, right? And what if it said it added up all your “out of the money” transactions, and you owed it twenty times what you were claiming from it? This is the risk that close-out netting addresses. We will look it closer in the next instalment. The music The audio version of this piece makes lots of extra in-jokes (if you enjoyed this please do listen to it — it took ages to edit!) and to do that borrows some of JC’s favourite tracks. So you can listen to them properly, and the artists are suitably remunerated (thanks guys!) I have put a playlist together. Here it is: This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit jollycontrarian.substack.com/subscribe [https://jollycontrarian.substack.com/subscribe?utm_medium=podcast&utm_campaign=CTA_2]

The Netting Problem

You’re all here for eternity which, I hardly need tell you, is a heck of a long time. —Rowan Atkinson, Welcome to Hell Every now and then I field an unsolicited offer from someone to help me with “search engine optimisation”. This person says something along the following lines: “In the competitition for attention on the world wide web, getting to the top of the google search results is more important than ever. I can help boost your site in search algorithms, so you rise above your competitors.” Smugly, I always tell these people the same thing: “Look, chump: I write weak satire about financial derivatives. I don’t have any competitors. No-one else is that stupid.” The JC’s basic gig is to investigate the background context about things that are usually taken for granted — or ignored — to shed light on the business, economics and rationale of capital markets activity. It is all pretty arcane, dry stuff. By design, I tend to think: the dense thicket of bumferous tedium is an imposing barrier to entry — “moat” is the latest buzzword [https://jollycontrarian.com/index.php/Buzzword]. It keeps insiders at an advantage. My own attention-span is short so, while I was scaling that barrier, to keep myself interested, I resolved to make it fun to write — and therefore fun to re-read. There’s a mnemonic quality to it too: the more colourful you can make it, the easier it is to remember. So the JC presents material in an off-beat way. Since industry is populated, largely, by “on-beat” people — the financial services industry doesn’t exactly encourage loose cannons — I often wonder who my audience is. The answer I usually settle on is, “me”. But there is a small band of fellow travellers out there. The loose cannons. The inquisitive. The easily bored. I know it. You keep your cards close, but you know who you are. So I box on. In any case The Jالی Contrarian™ started as a handy, non-linear way for this low-trajectory loose cannon to store “tacit” knowledge as he went along: crib notes, good practice, bad practice, old wives tales, wry observations and functional know-how about who does what, why, and the practical ins and outs and theoretical background to these mad legal contracts. And here, fifteen or so years later, we are. The thing about tacit knowledge is that it is tacit: forty or more years of people doing, but not writing down, this stuff means there tend to be large holes in the record, here and there, where institutional memory has disappeared altogether. Here I have feely made stuff up, a series of “just so” stories to put this into some kind of context, even if it is a false one. I have recently completed a long series about collateral that was like that. It is not easy to write entertainingly about swaps. Rib-ticklers do not exactly leap off the page: there are no star-cross’d lovers, dark and handsome strangers, boy wizards or bunny-boiling sociopaths. Actually, I am not sure about this last one: there is something of the Hannibal Lecter about those prepared to write tomes about aleatory contracts [https://jollycontrarian.com/index.php/Aleatory_contract], a topic we will shortly get to. But even so, there are levels of dullery. Variation margin [https://jollycontrarian.com/index.php/Variation_margin] is one thing: you can crowbar in Jimi Hendrix anecdotes and Monkey! references into that. But close-out netting [https://jollycontrarian.com/index.php/Close-out_netting]? We are on a different level here, readers: it isn’t just arcane and technical: it is, at a fundamental level that even the most ardent ninja will feel to her marrow, stupefyingly dull. So we will try to liven it up with a little Kabuki theatre for you all, from the pen of that finest exponent of finance fiction [https://jollycontrarian.com/index.php/Finance_fiction], Hunter Barkley [https://jollycontrarian.com/index.php/Hunter_Barkley]. This is from his forthcoming novella Close-out! Close-out! Close-out! [https://jollycontrarian.com/index.php/Close-out!_Close-out!_Close-out!]. The warehouse was dark. Condensation dripped. Water pooled. Steam hissed. Algy led. Boone stayed close. They ran silent: matched strides. Tracked footprints. They moved like feral cats. They went room to room. Algy cleared left and right. He cleared out the corners. He waved them through. They made it to the central chamber. It was dark. They went in. A solitary downlight picked out the Hackthorn goon: Cass Mälstrom [https://jollycontrarian.com/index.php/Cass_M%C3%A4lstrom], C.O.O. He sat at a card table in the middle of the floor. He had game. He was ex-McKinsey. A real thought-leader [https://jollycontrarian.com/index.php/Thought-leader]. He sat tight. He didn’t move. Boone coughed. Mälstrom looked up. “Is that you, Boone?” “Yes, Cass, it’s me.” “You alone?” “Look, I just want to sort this out. I didn’t want this — none of us did — but you gave us no choice. Why didn’t you pick up the phone, Cass?” “I — I been busy, Opco.” Mälstrom seemed edgy. He clocked Algy. “Who—hey, who’s that? I said come alone! I said no fuzz, Boone.” “Algy’s not a copper, Cass! He’s my bagman. He’s got what you want, if you’ve got what we want.” Boone nodded at Algy. “Show him, Al.” Algy opened the kimono. He flashed his trench. He dangled his wares. MTMs glittered from the lining on either side. Mälstrom whistled. “Pretty.” “So, we got ours, Cass. Now, how’s about you?” Mälstrom swallowed. Beads pricked on his pink forehead. “It’s — it’s a—all here.” Mälstrom seemed suddenly nervous. He motioned at a calico sack on the desk, next to a fruitbowl. Algy muttered, “What’s with the summer fruit, Opco? I don’t like it. Something ain’t right.” Boone held up a finger. “We showed you ours, now you show us yours. Just let us see what you have, Cass, and we can be on our way. We just want what’s owed to us. We don’t want any trouble.” Another voice came out of the dark. Urgent. Malicious. “Who said anything about trouble?” A loud click. Boone knew at once: it was the sound of a bump-stock OSLA [https://jollycontrarian.com/index.php/1995_Overseas_Securities_Lender%E2%80%99s_Agreement] being cocked. “Wh—?” “Not so fast, Mr. Boone.” Boone said, “I say, who is this?” “Your worst nightmare.” A long glinting copper barrel moved into the spotlight throw and pressed against Mälstrom’s temple. Mälstrom squeaked. “Just do what she says, Opco. Just do it. Sh — she’ll kill me! I’ve seen what she can do! She’s not kidding around!” A tall woman in black chiffon moved into the light. “I don’t believe we’ve met, Mr Boone. I’m Emsworth [https://jollycontrarian.com/index.php?title=M._T._Emsworth&action=edit&redlink=1], of the O. A.” “A banko!” hissed Algy. “Yes, Mr. Farquhar, a “banko”. A liquidator. A receiver with a mandate to resolve. Hackthorn Capital Partners [https://jollycontrarian.com/index.php/Hackthorn_Capital_Partners] L.L.P. is my baby now. My baby, and your problem. Now, let’s have your MTMs [https://jollycontrarian.com/index.php/MTM], Mr. Boone. Nice and slow. Come along.” Emsworth reclicked the OSLA and shoved it against the hedgie’s temple. Mälstrom re-squeaked. “Do it, Boone!” “Put down your money, Mr. Boone.” Boone nodded to Algernon. Carefully, Algy placed the MTMs down, one at a time. “I did all the calculations just like you said I should, Opco, under Section 6(d). I gots all the statements.” “Ok, Al, count them off.” Algy busied himself around the table, placing bags in a row. “Here’s our forty five for you. For this next one, you have to put down twenty six for us. We put twenty two for you. You put eighty five down for us.” It took fifteen minutes. Algy stood back, proud of his work. Emsworth smiled. “Goooood. I like it when people are sensible.” “All right, Ms. Emsworth. You’ve had your fun,” said Boone. “Now it’s your turn.” Algy nodded. “Right. So now you gots to put down your OTMs too. The ones for us.” Emsworth chuckled. “I don’t think so.” She swept Algy’s piles into a black Samsonite and snapped the lock. “Hey!” squeaked Algy. Boone took a step forward. Emsworth re-cocked the OSLA. “Easy, now: let’s not do something we’ll any of us come to regret, Mr. Boone.” Boone stopped. “All right, all right: but this is not how it’s supposed to work, Ms. Emsworth. That’s not the deal. We settle down. We net, positives against negatives. Tell him, Cass.” Mälstrom whimpered. Emsworth twisted her face into a long, deep, cruel laugh. “Oh, Mr. Boone. You poor deluded fool. This is Guatemala. You’re not in Kansas any more.” She reached over to the fruitbowl, plucked a cherry and raised it slowly to her thin lips. “Jeepers, Boone, look out! I think she’s — cherry-picking [https://jollycontrarian.com/index.php?title=Cherry-picking&action=edit&redlink=1]!” cried Algy. Emsworth smiled and bit. The fruit burst. Crimson juice ran down her chin. “I say, Mr. Boone, your little monkey is perceptive. I am “cherry-picking [https://jollycontrarian.com/index.php?title=Cherry-picking&action=edit&redlink=1]” — just as I am entitled to do.” Opco said, “Now look here. This is a single agreement [https://jollycontrarian.com/index.php/Single_agreement]! We square up. That is the deal! What about your OTMs? What about the money you owe us?” “But, Mr. Boone: we are through the looking glass now. We hav emade the phase transition [https://jollycontrarian.com/index.php/Bankruptcy_as_a_phase_transition] from the normal world into bankruptcy [https://jollycontrarian.com/index.php/Bankruptcy_and_insolvency]. The normal rules do not apply. Now, if you’ll excuse me, I have what I need, and I have a plane to catch.” “What about my money, Emsworth?” Emsworth yanked a circuit breaker and another downlight glared. “If you want your OTMs you shall have to wait for them. And fight for them.” The spot revealed a rusted metal cage. A dozen big cats paced inside: leopards. Tigers. They growled. “What the hell is this”? “Can’t you read, Mr. Boone?” There was a stencilled sign above the cage: “CREDITORS”. “Mr. Mälstrom’s creditors. You are welcome to join them. They are all looking a bit peckish, don’t you think, Mr. Boone? Shall we feed them?” Emsworth dangled the MTMs. “Stop this! Tie them up!” “Tie them up? Oh, no, Mr. Boone. That would never do. They are unsecured. If you want your money, you’ll have to scrap them for it.” Emsworth lobbed the calico sack into the cage. The big fat cats fell upon them in a threnody of gnashing maws. “All yours, Mr. Boone! Good day!” Official Assignee, First Class M. T. Emsworth [https://jollycontrarian.com/index.php?title=M._T._Emsworth&action=edit&redlink=1] threw the circuit breaker. The room went black to the reverberating sound of her calculating [https://jollycontrarian.com/index.php/Calculated] laughter. “Nein!” Ogfried sat bolt upright, drenched in sweat. A light clicked on. He blinked. The Gräfin stirred, rolled over, pushed up her sleeping mask and regarding her husband painedly. “Vot is eet, darlink?” Herr Ogfried Schümli Pflümli ranking workstream lead [https://jollycontrarian.com/index.php/Workstream_lead] of the Basel Committee’s special execution disaster planning taskforce, grunted. The dripping warehouse was gone. The lions were gone. The calculating Guatemalan receiver, M. T. Emsworth, was gone. He was in his bed, a comfortable four-poster in his favourite suite at The Meadows. A gossamer curtain billowed by an open window. Outside, the forbidding crests of the Jungfrau were bathed in starlight. The Gräfin said, “Ach —you hef a nightmare, sweetheart.” Schümli Pflümli [https://jollycontrarian.com/index.php/Sch%C3%BCmli_Pfl%C3%BCmli] blinked again. His suite was still there. No lions. But — it seemed so real. So urgent. So dangerous. So — plausible. Was it really — could it have been — just a dream? “Nein,” he said to himself, out loud. “Zis could really happen. We must do something.” It is Schümli Pflümli [https://jollycontrarian.com/index.php/Sch%C3%BCmli_Pfl%C3%BCmli], in Barkley’s telling of it, that we have to thank for the current, grisly state of the world. The poor man saw the risk that bankruptcy administrators posed to the financial universe, and made it his life’s mission to stop that catastrophe ever happening, by requiring comprehensive legal opinions on the effectiveness of the Single Agreement [https://jollycontrarian.com/index.php/Single_agreement] for every counterparty in every jurisdiction, for every master agreement. By one measure this has been the most successful regulatory innovation in the history of finance: as far as I know, not a single master agreement has had its integrity challenged in insolvency by any liquidator anywhere in the world. But on the other hand, some people say that, as a disguise, elephants paint the soles of their feet yellow and hide upside down in custard. As far as I know, no-one has ever seen an elephant hiding upside down in custard, either. For all that, though, netting and capital adequacy is a very useful lens to understanding how the market works, and why it takes the shape it does. The whole palaver is also, in my view, badly in need of fixing. Today we start to confront, in all its majestic, horrifying glory, the problem of close-out netting [https://jollycontrarian.com/index.php/Close-out_netting]. The netting problem This topic — “the capital treatment of close-out netting [https://jollycontrarian.com/index.php/Close-out_netting], what is wrong with it and how to fix it,” has been flapping around my head like a wounded pigeon for a decade. All in-house sales & trading lawyers will know the problem well, for it is their problem. Our problem: to identify, gather, read, analyse and summarise “written and reasoned” close-out netting opinions covering every master netting agreement [https://jollycontrarian.com/index.php/Master_netting_agreement] in the bank’s portfolio. These opinions might be anything from thirty to three hundred pages long. Each. Now, no-one wants to read a netting opinion. No-one. Given the lengths their authors go to spin the blessèd things out it might seem improbable, but I don’t believe anyone wants to write a netting opinion, either. But they do. By the boatload. In the year of our Lord 2026, a good-sized trading broker-dealer is likely to have hundreds of thousands of master agreements. Each of them must be covered. A given firm may need several hundred permanently-updated opinions. The sheer drudgery of this exercise defies simple description. You have to start reading just one of these opinions to understand it. So, actually, let’s do just that. To make the point. Here is sample paragraph, from page 26 of a 107-page opinion: 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. And that is just one opinion, for just one agreement type, in just one jurisdiction. Capital regulations require banks to have up-to-date opinions like this for every jurisdiction in which they trade, for every type of counterparty, and every type of master agreement. Having, like many of you, lived with this exact problem for years, and having, for a sales & trading lawyer, an unusually low boredom threshold — I am “constructively [https://jollycontrarian.com/index.php/Constructive] lazy” — In my tours of duty I spent a lot of time trying to work out how to make this job less of an imposition. This isn’t simply a problem of tedium. It is a real and present problem of cost. The world-wide collective enterprise devoted to gathering, wrangling, interpreting and applying these netting opinions [https://jollycontrarian.com/index.php/Netting_opinion] is a full-blown military-industrial complex. Its total annual cost to the industry is hard to measure but surely runs to hundreds of millions, if not billions. That does not account for the psychological toll it takes on the thousands of well-meaning lawyers, treasury analysts, technologists and contract negotiators who are drawn into its slavering maw. Now the financial markets owns some of the brightest and most creative structuring brains around. So why this problem hasn’t been solved before now? That question has puzzled me. My own view is that there are myriad interlocking reasons. To suffer is divine For one thing, lawyers are a Calvinist bunch. There is nothing they like better than whipping themselves with cold spaghetti. There is a school of thought, widely held, that to suffer is divine: that if it isn’t painful, fiddly, counter-intuitive and complicated, it somehow can’t be any good for you. There is nothing more redolent of a devotional flogging than settling down with A Memorandum of Law on the Validity and Enforceability of Close-Out Netting under the ISDA Master Agreements under Italian law. Amongst sales & trading lawyers this translates to the weary resignation that wading through pages and pages of an academic Belgian peroration on aleatory contracts [https://jollycontrarian.com/index.php/Aleatory_contract] is some how cleansing, noble, good and necessary. To suggest there might be a better way is seen as indicating weakness: a want of moral fibre or intellectual rigour. Netting opinions are an inhouse lawyer’s cold-water swimming regime, therefore. As hateful as they may find them, it just isn’t done to complain. Somebody else’s problem For another, a bank’s “netting problem” is dispersed laterally across a number of back-office and risk management siloes: treasury owns the capital adequacy calculation. Trading [https://jollycontrarian.com/index.php/Trading] pays for its balance sheet usage. Credit [https://jollycontrarian.com/index.php/Credit_officer] sets lines against individual counterparties. The documentation unit [https://jollycontrarian.com/index.php/Documentation_unit] negotiates the contracts that give effect to the credit department’s policies. The legal department [https://jollycontrarian.com/index.php/Legal_department] reviews and interprets the opinions [https://jollycontrarian.com/index.php/Netting_opinion]. Each of them will see the overall problem — the “netting problem” writ large — as somebody else’s. A “Somebody Else’s Problem” field, or ““S.E.P.”, is a cheap, easy, and staggeringly useful way of safely protecting something from unwanted eyes. It can run almost indefinitely on a torch battery, because it utilises a person’s natural tendency to ignore things they don’t easily accept. Any object around which an S.E.P. is applied will cease to be noticed, because any problems one may have understanding it (and therefore accepting its existence) become somebody else’s. An object becomes not so much invisible as unnoticed.” The internal costs of the netting problem are similarly spread: industry association [https://jollycontrarian.com/index.php/Industry_association] memberships are managed centrally and at an unfeasibly senior level. The portion of membership dues that goes on accessing industry association [https://jollycontrarian.com/index.php/Industry_association] opinions is not broken out. Subscription to netting analytics services may be paid for by legal or credit but recharged to the business. Bespoke opinions are often paid for, somewhat arbitrarily, by the desks that first require them. The human [https://jollycontrarian.com/index.php/Personnel] capital [https://jollycontrarian.com/index.php/Personnel] cost of all this busywork — making sure these layers of immortal & invisible protection are in place — is dispersed across various back-office risk teams and recharged to multiple front office [https://jollycontrarian.com/index.php/Front_office] trading desks. The netting problem has no single owner. It is a classic “somebody else’s problem [https://jollycontrarian.com/index.php?title=Somebody_else%E2%80%99s_problem&action=edit&redlink=1]”. Is it a problem? The oddest thing about the netting problem is that, in practical fact, it doesn’t seem to be a problem. In the forty-five years since IBM and the World Bank executed that first ever swap, there has not been a well-known case of a receiver in a major financial centre challenging a close-out netting provision, let alone successfully. To be sure, there have been near misses — famously, a German federal court narrowly construed the scope of contractual close-out in 2016, as chicken lickens [https://jollycontrarian.com/index.php/Chicken_licken] like to remind everyone — but even that only threatened to limit and not strike down the single agreement [https://jollycontrarian.com/index.php/Single_agreement] concept. It did not happen. Germany’s regulators immediately amended the insolvency code to validate netting. Given the catastrophic effect such a ruling would have on a country’s own derivatives market, not to mention the stability of the wider financial system, the prospect of such an outcome happening in any other developed jurisdiction and being allowed to stand without corrective geopolitical action is, these days, unthinkable. Close-out netting is not a private commercial preference between counterparties. It is a systemic assumption of stable capital markets. Naysayers might pick up that I said “developed” jurisdictions. “Aha,” they say, “but what about undeveloped jurisdictions?” This is not the place to talk in detail about that yet: we’ll get into how banks can practically control that risk later — but note: the effect of designating a jurisdiction “no-net”, as much of sub-Saharan Africa and the Middle East is, is not just to allay the fanciful paranoias of the world’s bank regulators, but it is also to exclude a significant part of the the developing world from the international capital markets. And the international capital markets are exactly the sort of thing that could help them, well, develop. Still, the received opinion seems to be that Basel rules requiring netting opinions are the very thing that has, single-handedly, spared the global financial system from the mendacious interventions of hostile receivers in far-flung places. Since you can’t presently trade swaps in Eritrea, we have been spared a live-fire experiment in the damage its insolvency regime could to the the banking system. That is why no-one has seen an Eritrean receiver pulling apart a master netting agreement. Maybe. But by the same token, no-one has ever seen elephants hiding upside-down in custard [https://jollycontrarian.com/index.php/Elephant], either. In the meantime, social justice warriors: if you really want to change the world, here is something to lobby about right away. Not glamorous, not interesting, not half as fun as painting yourself orange and gluing yourself to the floor, but it is important. Campaign against netting opinions! Solving the problem Q: How many therapists does it take the change a light-bulb? The wounded pigeon flapping about in JC’s head was a technological solution to this sorry state of affairs. It is still somewhat complicated, and still involves lots of legal opinions, and it is true there are several even easier solutions — such as just doing away with the regulatory requirement altogether, or having the Basel Committee centralise and promulgate the netting requirements themselves, since they are the ones insisting on the requirement — but since none of these solutions are likely to happen in my lifetime, I invoke serenity’s prayer and present my one, that might. The concept behind it is simple, but it requires three things to come together. First, some fairly sophisticated — but not, in 2026, particularly revolutionary or even difficult — technology. Second, a good understanding of how close-out netting [https://jollycontrarian.com/index.php/Close-out_netting] works, the capital adequacy issue it addresses, how rogue insolvency administrators might upset it, what regulators expect to prevent that, how banks practically address that issue, how lawyers think about that issue, why the two don’t very well match, and how, with more thoughtful deployment of technology and a bit more assertiveness with the lawyers, the network might solve some of these problems. This bit I thought I could work my way through. Third, people in the industry — financial institutions, industry associations, law firms, and their respective decision-makers and operations staff — would have to buy into this new way of doing things. They would have to be prepared to look differently at the world to see the opportunity presented by fixing this problem. The industry “light-bulb” — and all its little siloes, fiefdoms and power bases — would really have to want to change. Experience tells me that, as a rule, those commanding prevailing siloes, fiefdoms and power bases do not want anything to change. Why would they? The key, I think, is to find some participants in the system who do not have siloes, fiefdoms or power bases, but who would perhaps quite like them, and give those participants an opportunity to change. If those people embrace change, they can put the rest of the system into such a discombobulated funk that the rest of its citizens — including those with siloes, fiefdoms or power bases — might feel no choice but to change too. In that case, to hell with the fiefdoms. Getting to work In 2026, the first step is manageable. So is the second. As with all complex systems [https://jollycontrarian.com/index.php/Complex_systems], the third one’s the charm. If those in the “netting industry” even see it as a problem, rather that just a consequence of their professional calling, they see it as an insoluble one, that will occupy them profitably, if not excitingly, for the rest of their career. To be a successful financial markets professional you must have an unusually high boredom threshold, so we should not be surprised about this. This situational tolerance for pain explains how the present arrangement has settled down the way it has. Not because it best suits the regulatory goal — it doesn’t — but because it suits the interests of those embedded in the current melée. Principally, lawyers. (JC has a theory that the financial markets in their entirety can be seen as a kind of extended phenotype [https://jollycontrarian.com/index.php/The_domestication_of_law] for big law [https://jollycontrarian.com/index.php/Big_law], but that is a topic for another day). I want to talk about how we might induce the lightbulb to want to change a bit later on: for now, let’s carry on with the overview. It brings together many of JC’s favourite subjects: systems theory, financial engineering, market history and mythology and legal practice management. I’ve had a bash at writing this as a conventional newsletter, but it just wasn’t working. I missed a couple of deadlines trying to make it work, so I’m going to try to make this into a customised podcast designed from the ground up as an immersive audio experience. That way I can give full flight to my whims for pastiche, fantasy and outright fabrication — if this makes it more fun for me, it should make it more fun for you — and tell the story in multiple parts. This introductory episode is designed to set the scene, and outline the forthcoming episodes, culminating in the JC’s own live-fire experiment in trying to disrupt this great military industrial complex, an experiment that is doomed to fail. If it fails, let it at least be an entertaining calamity. If it succeeds, so much the better, and we can save the world, emancipate the enslavèd hordes of inhouse lawyers around the planet and conclude this podcast from my new superyacht in the Mediterranean. I hear it’s nice of the north coast of Sicily at this time of year. This Substack is reader-supported. For an assurance that there will be new posts, and for access to the next-level content in the Premium JC [https://jollycontrarian.com/secure/index.php/Main_Page] please consider a paid subscription. And even if you don’t — even if you do, come to think of it — if you enjoyed this post please tell your friends. If you didn’t, tell someone you want to annoy. This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit jollycontrarian.substack.com/subscribe [https://jollycontrarian.substack.com/subscribe?utm_medium=podcast&utm_campaign=CTA_2]