View source for Template:Isda Automatic Early Termination summ

{{dialogue|
{{dia|HAL 9000|Just a moment — just a moment — I just picked up a fault in the [[AET-35|AET-87]] Unit.}}
{{dia|Frank Poole|What is it? }}
{{dia|HAL 9000|It’s a device for optimising [[regulatory capital]], but that’s not important right now.}}
{{dia|David Bowman|What’s the problem, HAL?}}
{{dia|HAL 9000|It’s going to go one hundred per cent. failure, within 72 hours. }}
{{dia|Poole|Surely, you can’t be serious?}}
{{dia|HAL 9000|I ''am'' serious. And don’t call me “Shirley”. }}
{{dia|Bowman|(''sticking to the script'') I don’t know what you’re talking about, HAL? }}
{{capsital|Cue musical introduction}}
{{dia|HAL9000|Well, I’ll tell you. }}
{{dia|Chorus| ''He’s going to tell! <br>He’s going to tell!<br> He’s going to tell! <br>He’s going to tell! —}}
{{dia|Poole|Stop that! Stop that! No singing!}}
{{capsital|Carries on for three hours in this vein}}
:—''Monty Python and the Magnetic Anomaly from Airplane!''
}}
{{drop|A|utomatic Early Termination}} — colloquially, “{{{{{1}}}|AET}}”, but not to be confused with “{{{{{1}}}|ATE}}” ({{{{{1}}}|Additional Termination Event}}) or “{{{{{1}}}|ETA}}” ({{{{{1}}}|Early Termination Amount}}) — is an odd, feared and misunderstood concept buried at the back end of Section {{{{{1}}}|6(a)}} (''{{{{{1}}}|Right to Terminate Following Event of Default}}'').

In a document stuffed with arcanities, {{{{{1}}}|Automatic Early Termination}} is especially abstruse, so if you are hitting this article cold then, firstly: what the hell are you doing; and secondly some background reading is in order:
{{quote|'''Recommended background reading'''
{{hbullet|'''[[Bankruptcy phase transition]]''': The difference between [[insolvency and bankruptcy]] and why the phase transition between them is a weird dreamtime that freaks derivatives lawyers out.<li>
'''[[Bankruptcy shenanigans]]''' and why they present a unique problem for derivatives counterparties that ''normal'' creditors are less bothered about.<li>
'''[[Single Agreement]]''': The unbearable weirdness of ISDA’s [[single agreement]] concept.<li>
'''[[Regulatory capital]]''': The rules on how much capital a regulated financial institution is required to hold, and how that is calculated. <li>
'''[[Closing out an ISDA]]''': The law and lore of closing out an ISDA<li>
'''[[Flawed asset]]''': ISDA’s notorious “[[flawed asset]]” provision: Section {{{{{1}}}|2(a)(iii)}}. }}
}}

{{{{{1}}}|Automatic Early Termination}} provision is triggered when a party to whom it applies suffers an in-scope {{{{{1}}}|Bankruptcy}} {{{{{1}}}|Event of Default}}. If it is triggered, all outstanding {{{{{1}}}|Transaction}}s are instantly and automatically terminated, without the need for any action by — or even the knowledge of — the {{{{{1}}}|Non-Defaulting Party}}. This usually means instantly, but in one case, it is even quicker than that. 

If the {{{{{1}}}|Bankruptcy}} event is the presentation to the court by a creditor of a formal petition seeking the entity’s bankruptcy under Section {{{{{1}}}|5(a)(vii)(4)}} — let us call this a “'''[[bankruptcy petition]]'''”, some creative warping of [[Lexophysics|lexophysical]] swaptime is required. We will discuss this at some length and with wistful pedantry, in the {{premium}} section. 

In taking things out of the {{{{{1}}}|Non-Defaulting Party}}’s hands, AET subverts the normal order of things under the {{isdama}}. Normally, the {{{{{1}}}|Non-Defaulting Party}} is in control. It may, but need not, call an {{{{{1}}}|Event of Default}} if the circumstances justifying one exist. AET is, well, automatic. It even obliterates the {{{{{1}}}|Non-Defaulting Party}}’s right to ''waive'' designation of an Event of Default, since by the time it is in a position to do so, the Event Default has already been declared.

(Could a {{{{{1}}}|NDP}} ''pre''-waive in anticipation? See “{{pjchotlink|Anticipatory waiver?}}” in the premium section.)

JC’s view is that {{{{{1}}}|Automatic Early Termination}} is a bad solution to an unlikely problem, but since it is embedded in every ISDA on the planet, and remains present in the minds of those who mandate capital calculations, we are stuck with it.

====The theory====
{{Quote|“Formal [[bankruptcy]] is a “[[phase transition]]”: the whole “legal context” surrounding a company ''changes''. Erstwhile [[certainty|certainties]] vanish: normal rules of [[contract]], [[debt]] and [[Credit risk|credit]] are suspended; in their place arise uncontrollable ''vagaries''. The court appoints a [[bankruptcy administrator]] and invests her with wide, nightmarish ''[[bankruptcy|discretion]]s'' to do as she pleases, within reason, to sort out who gets what while ensuring the right thing is done by all the bankrupt’s creditors, customers, employees and, if there is anything left, shareholders. All, therefore, must fall upon her ''[[discretion|mercy]]''”
:—{{br|The phase transition of bankruptcy}}}}
{{drop|W|here a Defaulting}} Party’s bankruptcy regime allows its administrator to suspend its contractual terms or cherry-pick which of its {{{{{1}}}|Transactions}} to honour, it would help the {{{{{1}}}|Non-Defaulting Party}} if the ISDA were to automatically terminate ''before'' that [[Phase transition|phase transition]] occurred. To be safe, termination should happen at the exact moment — or even an infinitesimal moment ''before'' — that bankruptcy regime comes to life.

[[Bankruptcy shenanigans]] could affect a {{{{{1}}}|Non-Defaulting Party}}’s rights in at least two ways: Firstly, it may prevent it closing out {{{{{1}}}|Transactions}} ''at all''. The bankruptcy administrator may have the [[discretion]] to affirm or avoid individual {{{{{1}}}|Transactions}}. This ''bigly'' messes with the fundamental philosophy of the {{isdama}}.

Secondly, it may impact netting rights: a party having exercised its close-out right, ISDA’s “[[single agreement]]” operates to net all {{{{{1}}}|Transaction}} exposures down to a single sum. If a bankruptcy administrator is allowed to enforce some Transactions and set aside others — that is, to “[[cherry-pick]]” — that netting right is compromised, especially if the administrator has tactically [[DK]]’d only your profitable trades.

====History====
{{drop|W|e rarely look}} back to the {{1987ma}} these days; few [[Burmese Junglers]] remain out there fighting the good fight, but sometimes the fossil record gives us purchase on the state of modern biology all the same. So it is with {{{{{1}}}|Automatic Early Termination}} which was introduced, uncredited, in the {{1987ma}}.

{{financialisation of the markets}}

====Insolvency versus bankruptcy====
{{drop|A|s we note}} [[Bankruptcy as a phase transition|elsewhere]], there is common confusion between the ''accounting'' status of “[[insolvency]]”, which has no formal legal status and therefore makes no particular difference to the effectiveness of netting, and the ''legal'' status of “[[bankruptcy]]”, which does.<ref>Not helped by confusion in terminology in company regulations and ~cough~ market standard contracts. </ref> Mere [[insolvency]] may ''lead'' to [[bankruptcy]], but need not: they are different concepts and have different legal implications (in that bankruptcy has some, insolvency does not). Only once you are into formal [[bankruptcy]] are
[[bankruptcy shenanigans]] on the cards. 

ISDA’s definition of “{{{{{1}}}|Bankruptcy}}” somewhat jumbles the concepts up. Some ISDA {{{{{1}}}|Bankruptcy}} events (especially [[Cashflow insolvency|cashflow]]/[[balance sheet insolvency]] and composition with creditors) are “pre-[[phase transition]] events”, are not really observable, nor are they accompanied by formal changes in the application of laws of contract and should not trigger {{{{{1}}}|Automatic Early Termination}}.
=====1987: a blunt instrument=====
{{sdrop|I|n the {{1987ma}}}} they do anyway. {{{{{1}}}|Automatic Early Termination}} applies across the board, to all {{{{{1}}}|Bankruptcy}} events, and all counterparties: it is not even an optional election, to be engaged judiciously when needed. It just sits there and applies across the board if ''any'' {{{{{1}}}|Bankruptcy}} {{{{{1}}}|Event of Default}} should be declared. You could engineer your Schedule to disable it, but this would require initiative.<ref>By providing that the final sentence of Section {{isda87prov|6(a)}} will not apply to Party A and Party B, or some such thing.</ref>

This presented a real risk of indeterminacy, where the facts triggering an insolvency-style {{{{{1}}}|Bankruptcy}} were not public or even easily determinable. How are you meant to know whether your counterparty is [[balance sheet insolvent]]? Even for the company’s own accountants, this is more a matter of art than science. If mere insolvency triggered {{{{{1}}}|AET}}, it would be impossible to know whether a given ISDA was alive or dead. And that is before you even consider the impact of Section {{{{{1}}}|2(a)(iii)}}. 

There is this weird thing: {{{{{1}}}|Automatic Early Termination}} could be triggered without notice, action or knowledge, and that would trigger a section {{{{{1}}}|2(a)(iii)}} suspension, also without notice, action or knowledge. In that case, it is hard to see what to make of unexplained non-performance by your counterparty under the contract. Was ''it'' bankrupt? Or did it think ''you'' were bankrupt?
=====1992: Slow reverse-ferret=====
The history since 1987 has been to slow-walk AET back — not nearly fast enough, in this commentator’s opinion — from that highly unsatisfactory epistemological state. By 1992, AET excluded the “soft” economic ''[[insolvency]]'' events and was limited to circumstances with a live risk of [[bankruptcy shenanigans]]. 

The {{1992ma}} also converted {{{{{1}}}|AET}} into an optional election in Part 1 of the {{{{{1}}}|Schedule}}. For most parties, in most jurisdictions, it stays off.

=====2002: grace periods tighten=====
In 2002 a further refinement was implemented in the definition of “bankruptcy petition”. {{icds}} split Section {{{{{1}}}|5(a)(vii)(4)}} in two: a {{{{{1}}}|bankruptcy petition}} instituted by a regulator is ''not'' subject to a [[grace period]]; one instituted by anyone else — such as a creditor — would only mature into an {{{{{1}}}|Event of Default}} if ordered by the Court, or not otherwise discharged within a 15-day [[grace period]] — down from the 30 days in the {{1992ma}}. 

If a regulator is taking formal action against you, the game is certainly up. A [[grace period]] here serves no real purpose. A mere creditor doing so may be little more than a rather brusque debt-collection tactic: it may not indicate any genuine concern about a party’s ability to pay its debts, but rather be a pointed hurry-up. In that case, a {{{{{1}}}|bankruptcy petition}} can be fairly easily discharged. Hence the [[grace period]].

====Few and far between====
{{drop|A|s it stands}} there are only a few counterparty types in a few jurisdictions where the conditions for {{{{{1}}}|AET}} prevail. There are not many because — let’s be clear, here — {{{{{1}}}|AET}} is a bit of try on: any self-respecting netting-hostile bankruptcy regime ought to see straight through it.

It is, after all, a piece of time-travelling contractual magic — it [[deem]]s Transactions to have terminated, without anyone’s knowledge or action, the instant ''before'' the event that, on expiry of a [[grace period]] would later trigger it, to avoid the ambit of discretionary rules designed to ensure fairness and prevent just that kind of preference. Expecting this to work very often seems ''a bit optimistic''.

There is a more benign view, but it is still a bit hopeful: {{{{{1}}}|Automatic Early Termination}} helps deliver the appropriate outcome, dispelling residual doubt about ambiguous or untested regulatory provisions that were never intended to allow bankruptcy shenanigans, but that were crafted without the sui generis use case of the master trading agreement in mind. On this view, {{{{{1}}}|AET}} is a sort of “better be safe than sorry” gambit.

Then there is a pragmatic view. This is blunter: {{isdama}}s once were weird innovations that bamboozled and (wrongly) outraged bankruptcy administrators. Nowadays, they are not. Everyone knows what ISDAs are, why they net, why the “[[single agreement]]” concept is a sensible plank in the capital structure of the financial system, and why the [[bankruptcy shenanigans]] AET seeks to avoid would not produce a fair result for anyone. 

This is all well and good. But if, unwittingly, {{{{{1}}}|Automatic Early Termination}} now ''creates'' practical risks where once it avoided theoretical ones, it still should be a source of concern. In JC’s view, it does.

We will talk about that at great length in the premium section.