The subject matter of a derivatives contract is risk. Risk is in the future, and in consequence the entire value of the performance remains uncertain until the due date. But of course the value resides in the uncertainty. Such a contract only has a value up until the point when the risk-laden event supervenes. The value of the contract is precisely that, the value of this indeterminacy.


This has two consequences.


First, the contract’s value only persists as long as the risk remains supported by what is not at risk. What is not at risk – the support outside the risk – is provided by the parties. Both must remain good for the risk as long as the contract is live. If this ceases to be the case, the contract no longer has any purpose and must be terminated. In a risk contract, the monetary equivalent of the risk, and the ability of the parties to pay, constitutes the entire value and is of the essence.


This is not true of normal commercial contracts, where the risk of non-performance by either party is incidental. In a contract of sale, for example, parties may agree that property only passes when payment is made. If the buyer’s credit collapses prior to performance, the seller still has the goods. Creditworthiness of the parties is only a significant issue at the margins, for example when performance is staggered.


The characteristic of risk contracts that they remain “live” until the moment when the risk has passed, and that the continuing capacity of the parties to support that risk is essential, is reflected in various elements. Apart from the Definitions (s 14), the first of the two long operative sections of the 2002 ISDA Master Agreement is taken up with provisions for Default by one of the parties. Default in this context includes not only failure to pay, but a variety of other sins raising doubt as to the party’s creditworthiness (s 5). In retail derivatives deals, the customer’s continuing creditworthiness is secured, where necessary, by margin calls on a daily basis.


Second, a risk contract only has a trade value as long as the risk persists. Once the uncertain event has passed, the contract no longer has a value. Its value is concentrated on the period prior to the uncertain event. For this reason, trading the contract before maturity is not, as it would be with a normal commercial contract, a sign that one of the parties has had second thoughts. Rather, it is what the contract is about. The value of the risk at any particular moment is the subject of the trade. For this reason, the second of the major operative provisions of the Master Agreement details the arrangements for Early Termination and “Close-Out Netting” (s 6).


Although also described as “Termination” in the Master Agreement, the “close-out” provisions effectively reconstitute the contract anew on the basis of the current value of the risk. The process of establishing that current value, accordingly, is provided for in detail in s 6 (e) of the MA. Whether or not the parties may actually transfer their interest under the contract is subject to individual negotiation. Under the MA, only the party currently on the right side of the risk, and entitled to payment on the basis of the counterparty’s default, may transfer its interest to another entity (s 7 (b)). In practice, however, transfer – i.e. actually getting out of the contract by transferring one’s rights and liabilities to another entity – is not a substantive concern. This is because the same thing can be achieved by concluding a derivative with reversed risks to the original one. That will neutralise the risk, and it will cost the same as “terminating” the original contract. In all cases, of course, an agreed course of valuation is crucial (see MA 2002, s 14, “Close-out amount”).



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