Template:Isda Automatic Early Termination summ

HAL 9000: Just a moment — just a moment — I just picked up a fault in the AET-87 Unit.

Frank Poole: What is it?

HAL 9000: It’s a device for optimising regulatory capital but that’s not important right now.

David Bowman: What’s the problem, HAL?

HAL 9000: It’s going to go 100% failure within 72 hours.

Poole: Surely you’re not serious?

HAL 9000: I am serious, and don’t call me Shirley.

Bowman: I don’t know what you're talking about, HAL?

HAL9000: Well, I’ll tell you.

Cue musical introduction:

Chorus: He’s going to tell! He’s going to tell! He’s going to tell! He’s going to tell! —

Poole: Stop that! Stop that! No singing!

—Monty Python and the Magnetic Anomaly from Airplane!

{{{{{1}}}|Automatic Early Termination}} is an odd and misunderstood concept. It sits buried at the back end of Section {{{{{1}}}|6(a)}} ({{{{{1}}}|Right to Terminate Following Event of Default}}). In essence it provides that where a party to whom {{{{{1}}}|AET}} applies suffers an in-scope {{{{{1}}}|Bankruptcy}} event, all outstanding {{{{{1}}}|Transaction}}s are instantly terminated, without the need for any action by the {{{{{1}}}|Non-Defaulting Party}}.

This inverts the normal order of things under the ISDA Master Agreement wherein the {{{{{1}}}|Non-Defaulting Party}} generally has the right, but not the obligation, to call an {{{{{1}}}|Event of Default}}. Being automatic, therefore {{{{{1}}}|AET}} even obliterates the {{{{{1}}}|Non-Defaulting Party}}’s ability to waive this event, since by the time it is in a position to do so, the event has already happened.

(Could a {{{{{1}}}|NDP}} pre-waive in anticipation? See “anticipatory waiver?” in the premium section if that is the sort of thing that keeps you up at night.)

JC’s general view is that {{{{{1}}}|Automatic Early Termination}} is a bad solution to an unlikely problem, but since it is intractably embedded in every ISDA on the planet, after thirty-five years of folly, we are pretty much stuck with it.

Others — for example the learned author of Cluley on Close-Outs — have a different view. But, look: JC has to depart ways with the cool crowd every now and then, just to maintain his membership with the Worshipful Company of Contrarians. This is one of those times.

It’s not about the window

{{{1}}}

Triago: Herewith, hereinafter and hereinbefore-confirmed:
A custom aperture. Wall-inlaid,
Well-glazed and fringed by lintel stone.
A device to shed upon us light!

Regolamento: Oh, a window?

Triago: Good heavens, No! Not that!
(Whispering) There are ways and means of saying ’t, ser —
Prithee, gird thy verbiage about with care
Lest th’Exchequer’s like for “levies upon transparency”
Untimely drains th’excess from our meagre chancelry—
Catcheth thou the drift?

Regolamento: It is not a window, then? These sound like solid facts?

Nuncle: ’Tis not so much a window
As a means of dodging tax.

—Büchstein, Talentdämmerung

{{{{{1}}}|Automatic Early Termination}} is as much to do with managing regulatory capital — in particular, vouching safe close-out netting — as it is about substantive credit risk mitigation.

Banks — those who calculate regulatory capital in banks, or are obliged to read netting opinions on their behalf at any rate, care a lot about it.

Other market counterparties, perhaps less so. Given that its potential effect is likely to be “iatrogenic” — worse than the risk it addresses — a non-bank counterparty could be forgiven for being a little blasé.

The theory

Where a {{{{{1}}}|Defaulting Party}}’s insolvency 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 the administrator had a chance to do any such thing. To be safe, termination should happen at the exact moment — or even an infinitesimal moment before — that insolvency regime kicks in.

There are two things such a suspension could affect:

1. Discretionary termination right: Firstly, insolvency rules may operate to prevent the {{{{{1}}}|Non-Defaulting Party}} closing out {{{{{1}}}|Transactions}} under the ISDA at all. They may give the insolvency administrator a discretion to affirm or avoid individual {{{{{1}}}|Transactions}}. This bigly messes with the fundamental philosophy of the ISDA Master Agreement:

   A swap counterparty to a portfolio of swap transactions scheduled to mature over the next five years may have no present obligation to pay any cash under those {{{{{1}}}|Transaction}}s even if, from a mark-to-market perspective, the net present value of that portfolio is significantly negative. Who knows? Things may come right.

   All those hopes and dreams would be crushed if the ISDA Master Agreement were terminated on grounds of {{{{{1}}}|Bankruptcy}}. The {{{{{1}}}|Defaulting Party}} would immediately be liable to pay that full mark-to-market value in cash. A bankruptcy suspension right prevents the {{{{{1}}}|Non-Defaulting Party}} from crushing the bankrupt party’s dreams. Well, its other unsecured creditors’ dreams, at any rate.
2. Netting right: Beyond that, having exercised its early termination right the contractual provisions of the single agreement operate to net all transaction exposures down to a single sum. Since a bankruptcy administrator may have a right to enforce some contracts and set aside others that netting right is prejudiced.

{{{{{1}}}|AET}} It was introduced in the 1987 ISDA, but was not labelled “{{{{{1}}}|Automatic Early Termination}}” in that agreement, possibly because it was not conceived as an optional election to be used with caution where needed: it just sat there and applied across the board.

{{{{{1}}}|AET}} is thus only triggered by certain events under the {{{{{1}}}|Bankruptcy}} event of default — formal bankruptcy procedures — and not by economic events that tend to indicate insolvency (such as an inability to pay debts as they fall due, technical insolvency or a creditor’s mere exercise of default rights or enforcement of security. Though, interestingly, those events (captured in limbs (2) and (7) of the {{{{{1}}}|Bankruptcy}} definition) did trigger automatic early termination in the 1987 ISDA. This is just one more reason not to use that edition, if there are any Burmese Junglers out there looking for one.

{{{{{1}}}|AET}} does not apply to other {{{{{1}}}|Events of Default}}.

It is now an election

Though the 1987 ISDA triggered automatic termination upon any type of {{{{{1}}}|Bankruptcy}} event for any counterparty in any jurisdiction, it has since turned out that the mischief against which {{{{{1}}}|AET}} guards does not really arise in most jurisdictions: only those a history of Teutonic jurisprudence.

In those (e.g., Germany, Austria, Switzerland and Japan) immediately upon commencement of formal bankruptcy proceedings a bankruptcy administrator would be entitled “cherry-pick” those {{{{{1}}}|Transaction}}s it wishes to honour (typically, those that are in-the-money to the {{{{{1}}}|Defaulting Party}} whose estate it is administering) and those it wished would just conveniently vanish from the financial record (namely those where the {{{{{1}}}|Defaulting Party}} is out-of-the-money).

Since the whole point of the {{{{{1}}}|Single Agreement}} and the close-out netting concept is to get to a market exposure as close as possible to zero before launching any recovery actions, this kind of cherry-picking would completely demolish the entire capital theory on which the ISDA Master Agreement is founded. Hence, Automatic Early Termination!

In any case, since the 1992 ISDA {{{{{1}}}|AET}} has been an election that you toggle on or off for each counterparty in Part 1 of the {{{{{1}}}|Schedule}}.

It only has limited use

{{{{{1}}}|AET}} is only really useful:

(1) to a regulated financial institution, which
(2) would incur a capital charge if it doesn’t have a netting opinion, and
(3) where it wouldn’t get that netting opinion for a particular counterparty without {{{{{1}}}|AET}} being switched on in its ISDA Master Agreement.

There are only a few counterparty types where these conditions prevail: the German and Swiss corporates mentioned above, for example. There may be others, but not many, because {{{{{1}}}|AET}} is a good-old-days, regulators-really-are-dopey-if-they-fall-for-this kind of tactic. It only really survives these days because it is so part of the furniture no-one has the chutzpah to question it, despite the trail of destruction and confusion it has left across the commercial courts of the US an the UK.

I mean, really? Deeming your ISDA to have magically terminated, without anyone’s knowledge or action, the instant before that termination would become problematic as a result of your insolvency? Come on. Is any sophisticated insolvency regime going to buy that kind of magical thinking? (No slight meant on Germany or Switzerland here: the “Teutonic” {{{{{1}}}|AET}} does not deliver netting where unequivocally it would otherwise be forbidden, but rather buttresses residual doubt about the effectiveness of netting during insolvency as a result of looseness in insolvency regulations that aren’t categorical that you can net. The view is generally it should be okay in insolvency, but there are just some freaky discretions that may make life awkward if used maliciously. This is not legal advice.)

Why not just switch it on, to be on the safe side?

Master trading agreements are unusual in that upon an {{{{{1}}}|Event of Default}}, there is no guarantee a given portfolio of {{{{{1}}}|Transactions}} will be in-the-money to the {{{{{1}}}|Non-Defaulting Party}}.

The last thing an {{{{{1}}}|NDP}} will want to do is accelerate {{{{{1}}}|Transaction}}s under ISDA if that means it winds up realising mark-to-market losses. Indeed, the “flawed asset” provisions of the ISDA Master Agreement are designed precisely to allow a {{{{{1}}}|Non-Defaulting Party}} to suspend its own performance — therefore not make its position any worse — without crystallising its {{{{{1}}}|Transaction}} exposures.

Having {{{{{1}}}|Transaction}}s automatically accelerate is undesirable: one would only choose that if the alternative was catastrophically worse.

In the minds of those who framed the early ISDAs, mendacious application of discretions by foreign bankruptcy administrators was just such a catastrophic worseness.

But —time having passed, water flowed under the bridge and tempers mellowed with age and wisdom — JC wonders whether there are not better things the world’s risk officers to be fretting about instead of the capital implications of general rules of governance that apply to local corporations.

There is an extended rant on the close-out netting page.