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===Technical nuts and bolts===
{{quote|
Leaving for a few moments when in this day and age you would ever need or even want to invoke {{{{{1}}}|2(a)(iii)}} other than in the strangest of days, let’s consider the mechanics. You will notice there ''are none''. Section {{{{{1}}}|2(a)(iii)}} just ''sits'' there, and has effect, without anyone’s particular by-or-leave. No notice is required: no-one need look out for envelopes being delivered to the physical address the firm occupied seventeen years ago when someone filled out Part IV of the schedule. Section {{{{{1}}}|2(a)(iii)}}doesn’t even say an {{{{{1}}}|Innocent Party}} is ''entitled'' to withhold payment: rather the conditions are not met and ''payment is not therefore due''. It just happens.
{{Script|Herculio}}: I have a thought. This meagre tract: not ninety words <br>
Wrapp’d about with preliminal nicety and <br>
Stamp’d as for affixation to a [[boilerplate|servic’d boiler]] —<br>
Conceals a clever trick. <br>
{{script|Ser Jaramey}}: What kind of onion’d witchery is this? <br>
:—{{otto}}, {{br|Ser Jaramey Slizzard}}}}
=== Assets, and flawed assets ===
What is the big deal about this, then? Well, it turns your ISDA into a “flawed asset”.
{{quote|{{d|Flawed asset|/flɔːd ˈæsɛt/|n|}}


This poses some rather intriguing questions:
A financial asset that looks good, but thanks to a carefully buried [[conditions precedent]], is not there when you, and more importantly, your insolvency administrator, most wants it.}}


Firstly a conceptual one: at what point do we know — when even do ''I'' know  — whether I have “suspended” my payment and not just simply ''failed'' on it? Is there a difference? The payment arrangements under a modern ISDA are a blizzard of electronic impulses, across multiple booking systems, product silos and other arrangements. The various operatives will have no idea of the status of other payments — sometimes these things fail for explainable reasons. So if, for some reason {{{{{1}}}|2(a)(iii)}} applies, the conditions precedent do not exist, but I make my payment anyway, then what? Is that a mistaken payment? Is it supported by [[consideration]]? Is there a potential claim for [[money had and received]]?
{{drop|I|n the language}} of financial obligations, the right to future payments under a contract is an ''asset''. The creditor owns that right and, all other things being equal, can ''deal'' with it — that is, sell or raise money against it — the same way it can sell or mortgage a house, car, a portfolio of equities, or some [[Bitcoin|decentralised cryptographic tokens representing abstract capital]].


What, for the purpose of close-out valuations, is the status of payments that ''were'' made, but that were not ''required'' to be made? Are these some kind of negative energy in the close-out spacetime; dark matter, a kind of inverted {{isdaprov|Unpaid Amount}}?<ref>Okay I am having a bit of fun with you here I confess.</ref>
Assets have certain “[[ontological]]” properties, such as ''continuity'' ''in time and space.'' They might rust, depreciate, go out of fashion or stop working properly but they are nevertheless, existentially, still ''there''. While you own them they therefore have some value to you, however parlous the state of your affairs might otherwise be.


The other one is practical. In times of market dislocation all kinds of things can go wrong. People suddenly instigate to manual processes stopping and frisking money on its way out the door. For all you know ''your correspondent bank may be doing this without your knowledge''<ref>This is not nearly as unlikely as it seems: in a widespread market dislocation, or where sanctions are involved (hello Ukraine conflict!) expect everyone to be terrified of getting anything wrong. ''Everything'' will slow down.</ref>  Counterparties make oral arrangements to check payments in before sending anything out — there is all klnds of paranoia, fear & loathing. It’s great. Sometimes payments — going on either direction — can get hung up, stuck, blocked, sanctioned, or — who knows? — waived, or suspended by mutual consent, or even suspended by ''implication'': let’s say the parties agree (or ''think'' they agree) to manually net settlement of payments usually made gross.  
Should your stars line up so that some official comes to be drawing up a closing account of your earthly financial existence — should you become [[Insolvency|''bankrupt'']], heaven forfend — your assets can reliably be popped onto the “plus” side of the ledger. The difficulty subsists in working out what they are worth, but at least they are there.


It is not always certain whether payments have, in fact, been missed. This kind of uncertainty becomes most likely ''exactly at a time of stress''. What effect do these actions have?
This continuity is important to the administration of failing enterprises wherever they are based. It is a rude shock to find the assets you thought were there have without good explanation, gone. Many countries have rules preventing company managers from selling or giving away assets at an undervalue or otherwise granting unfair preferences as impending disaster looms. And nor can they enter contracts, even in times of fair weather, which would have the effect of granting unfair preferences, or depriving other creditors, should the clouds roll in.


This can lead to some unfortunate surprises: the counterparty who files a notice of {{{{{1}}}|Failure to Pay or Deliver}}, only to find that, last week some clot in Collateral Ops mis-keyed a small yen payment, meaning that none of the payments it now sees as failing were even due in the first place.
An asset that doesn’t have that quality of continuity: that suddenly isn’t there, or that has the unnerving quality of winking in and out of sight at inopportune moments — is thus somehow imperfect: “flawed”.  


===...These days?===
Section {{{{{1}}}|2(a)(iii)}} seems to have that effect on a {{{{{1}}}|Defaulting Party}}’s claims under an ISDA  —  its asset. Just when the {{{{{1}}}|Defaulting Party}} goes insolvent or fails to perform, the {{{{{1}}}|Non-defaulting Party}} is entitled to suspend the performance of its obligations without terminating the {{{{{1}}}|Transaction}}. Not entitled, even — as we will see, it just happens.
The overriding mischief that a [[flawed asset]] provision addresses arises when a solvent swap counterparty with a long-dated [[out-of-the-money]] portfolio, finds its counterparty has, against the run of play, gone bust. If I am in the hole to you to the tune of $50 million, but that liability isn’t due to mature for ten years, in which time it might well come right and even go positive, I don’t want to crystallise it now, at the darkest point, just because ''you'' sir have gone tits-up.  


Answer: insert a flawed asset provision. This lets me suspend my performance on your default, ''without'' closing you out, until you have got your house in order and paid all the transaction flows you owe me. So the portfolio goes into suspended animation. Like Han Solo in ''The Empire Strikes Back''.  
Should the {{{{{1}}}|Defaulting Party}} then cure the default, the {{{{{1}}}|Transaction}} resumes and the {{{{{1}}}|Non-defaulting Party}} must resume all its obligations, including the suspended ones. But for so long as the default is not cured, the {{{{{1}}}|Non-defaulting Party}} does not have to do anything. The {{{{{1}}}|Defaulting Party}} is left hanging there, with this “flawed asset”.


Now if, heaven forfend, you ''can’t'' thereafter get your house in order — if what was once your house is presently a smoking crater —then the game is up anyway, isn’t it? You will be wandering around outside your building in a daze clutching an [[Iron Mountain]] box cycling hurriedly through the stages of grief, wondering where it all went so wrong, wishing you had pursued that music career after all, but in any case casting scant thoughts for your firm’s unrealising mark-to-market position on that derivative portfolio with me.  
=== Insolvency regimes: not keen. ===
{{drop|T|he United States}} [[Bankruptcy Code]] renders unenforceable terms terminating or modifying a contract that are triggered by the simple fact of insolvency proceedings. These are known as “[[ipso facto]]” clauses, because the simple ''fact'' of bankruptcy “in itself” triggers the clause.


This seems cavalier in these enlightened times, but in the old days people did think like this. But, with the gruesome goings-on of 2008, those are largely bygone days, though older [[legal eagle]]s may wistfully look into the middle distance and reminiscing about these kinder, happier times. Those who didn’t wind up desperately rekindling their music careers in 2009, anyway.
If Section {{{{{1}}}|2(a)(iii)}} were an ipso facto clause, it would not be enforceable. Whether it ''is'' an [[ipso facto clause]] is a subject of vigorous but tiresome debate. For our purposes, that people don’t easily agree about it is all you need to know.


In the aftermath of the [[Lehman]] collapse regulators showed some interest in curtailing the [[flawed asset]] provision. The Bank of England suggested a “use it or lose it” exercise period of 30 days. Ideas like this foundered on the practical problem that repapering tens of thousands of {{isdama}}s was not wildly practical, especially without a clear consensus on what the necessary amendment might look like. So the initiative withered on the vine somewhat.  
The UK has no statutory equivalent of America’s [[ipso facto rule]], but hundreds of years ago resourceful common law judges “discovered” an “anti‑deprivation” rule to the effect that, in the honeyed words of Sir William Page Wood V.C., in ''Whitmore v Mason'' (1861) 2J&H 204:{{quote|
“no person possessed of property can reserve that property to himself until he shall become bankrupt, and then provide that, in the event of his becoming bankrupt, it shall pass to another and not his creditors”.}}
This required some wilfulness on the bankrupt’s part and not just inadvertence or lucky hap, but still: if you set out to defeat the standing bankruptcy laws do not expect easily to get away with it.


In the meantime, other regulatory reform initiatives overtook the debate. These days flawed asset provision is largely irrelevant, seeing as brokers don’t tend to take massive uncollateralised directional bets. Compulsory [[variation margin]] means for the most part they ''can’t'', even if the Volcker rule allowed them to.  
It seems, at any rate, that Section {{{{{1}}}|2(a)(iii)}}, ''might'' resemble some kind of intended deprivation; merely crystallising one’s existing position and stopping it from going further down the Swanee, as one might do by closing out altogether, seems less likely to.


Since all swap counterparties now must pay the cash value of their negative [[mark-to-market]] exposures every day, the very thing the flawed asset seeks to avoid — paying out negative positions — has happened, there is a lot more to be said for immediately closing out an {{isda}}, whether or not it is [[out-of-the-money]].
Anyway: be aware: Section {{{{{1}}}|2(a)(iii)}} attracts insolvency lawyers.


For [[synthetic prime brokerage]] fiends, there is another reason to be unbothered by Section 2(a)(iii): you shouldn’t ''have'' a losing position, since you are meant to be perfectly delta-hedged. Right?
=== Rationale: avoiding a cleft stick ===
===Flawed assets generally===
{{drop|W|e can have}} a fine time rabbiting away about the ontology of assets, but isn’t there a more basic question: why would a {{{{{1}}}|Non-defaulting Party}}, presented with a counterparty in default, ever ''not'' want to just close out?
{{Flawed asset capsule}}
 
It all comes down to [[Moneyness|''moneyness'']].
 
The “[[The bilaterality, or not, of the ISDA|bilaterality]]” of a swap transaction means that either party may, net, be “[[out of the money]]” — that is, it would have to ''pay'' a net sum of money were the Transaction terminated — at any time. Unless something dramatic happens, this “moneyness” is only a “notional” debt: it only becomes “due” if an {{{{{1}}}|Early Termination Date}} is designated under the Master Agreement.
 
So an [[out-of-the-money]], {{{{{1}}}|Non-defaulting Party}} has a good reason ''not'' to close out the ISDA. Doing so would oblige it to crystallise and pay out a mark-to-market loss. Why should it have to do that just because a {{{{{1}}}|Defaulting Party}} has failed to perform its end of the bargain?
 
On the other hand, the Defaulting Party is, er, ''ipso facto'', not holding up its end of the bargain. Just as our innocent Non-defaulting Party does not wish to realise a loss by terminating, nor does it want to have to stoically pay good money away to a Defaulting Party who isn’t paying anything back.
 
A cleft stick, therefore.
 
Section {{{{{1}}}|2(a)(iii)}} allows our {{{{{1}}}|Non-defaulting Party}} the best of both worlds. The [[conditions precedent]] to payment not being satisfied, it can just stop performing and sit on its hands — thereby neither crystallising its ugly [[mark-to-market]] position nor pouring perfectly good money away (which is a form of drip-feeding away that mark-to-market position, if you think about it).
 
So much so good for the {{{{{1}}}|Non-defaulting Party}}.
 
But the {{{{{1}}}|Defaulting Party}}’s “asset” — its contingent claim for its in-the-money position against the {{{{{1}}}|Non-defaulting Party}} — is compromised. This, for an insolvency administrator and all the {{{{{1}}}|Defaulting Party}}’s other creditors, is a bummer. It deprives them of the “asset” represented by the {{{{{1}}}|Transaction}}.
 
===Which events?===
{{drop|E|xactly ''which'' default}} events can trigger the suspension? Under the [[ISDA Master Agreement|ISDA]], {{{{{1}}}|Events of Default}} and even ''Potential'' Events of Default do, but {{{{{1}}}|Termination Events}} and {{{{{1}}}|Additional Termination Event}} do not. This is because ''most'' {{{{{1}}}|Termination Events}} are softer, “Hey look, it’s no one’s fault, it’s just one of those things” kind of events. This is not usually true of {{{{{1}}}|Additional Termination Events}}, though: they tend to be credit-driven, and girded with more “culpability” and “event-of-defaulty-ness”. So this is a bit dissonant, but there are far greater dissonances, so we park this one and carry on.
 
[[JC]] has seen valiant efforts to insert {{{{{1}}}|Additional Termination Events}} to section {{{{{1}}}|2(a)(iii)}}, and ''Potential'' {{{{{1}}}|Additional Termination Event}}, a class of things that does not exist outside the laboratory, and must therefore be defined. All this for the joy of invoking a clause that is highly unlikely to ever come into play, and which makes little sense in the first place.
 
===Why the ISDA?===
{{quote|
{{script|Herculio}}: All well-meant, good [[Triago]]. Be not sour —<br>These are not grapes.<br>
{{script|Triago}}: Indeed not sir: rather, scrapes.<br>And scars and knocks — the job-lot doggedly sustained.<br>
{{script|Herculio}}: (''Aside'') Some more than others. The odd one feigned.<br>
But come, Sir Tig: what unrests you here?<br>
{{script|Triago}} (''waving paper''): A tract from a brother clerk in America.<br>
{{script|Herculio}}: Cripes abroad. Grim tidings?<br>
{{script|Triago}}: Forsooth: it wears the colours of a fight.<br>
A word-scape stain’d with tightly kernèd face<br>
And girded round with fontish weaponry.<br>
{{script|Herculio}} (''inspecting the document''): Verily, convenantry this dark<br>
Speaks of litiginous untrust.<br>
—[[Otto Büchstein]], [[Die Schweizer Heulsuse|''Die Schweizer Heulsuse'']]}}Why, then, is this flawed assets business special to ISDA? ''Is'' it special to ISDA?
 
Normal financing contracts are, by nature, one-sided. Loans, for example. One party — the dealer, broker, bank: we lump these various financial service providers together as ''The Man'' — provides services, lends money and “manufactures” risk outcomes; the other — the customer — ''consumes'' them.
 
So, generally, the customer presents risks to The Man, and not vice versa. If the customer fails, it can’t repay its loan. All the “fontish weaponry” is therefore pointed at the customer.
 
Though the ISDA is also a “risk creation contract” with these same characteristics, it is not designed like one. ''Either'' party can be out of the money, and either party can blow up. The fontish weaponry points ''both ways''.
 
This presented dealers with an unusual scenario: what happens if ''you'' blow up when ''I'' owe you money? That could not happen in a loan.  It is less likely to happen under a swap these days, too, thanks to the arrival of mandatory [[variation margin]] — that is one of JC’s main objections — but the [[ISDA Master Agreement]] was forged well before this modern era.
 
There is an argument the flawed asset clause wasn’t a good idea even then, but a better one that it is a bad idea now, but like so many parts of this sacred, blessed form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it.
 
===Developments between editions===
====“...a condition precedent for the purpose of this Section 2(a)(iii) ...”====
The {{2002ma}} trims back the third limb of Section {{{{{1}}}|2(a)(iii)}} from “all other conditions precedent” to just those that specifically say they mean to be caught by Section {{{{{1}}}|2(a)(iii)}}. This a sensible restriction in scope as far as it goes (but JC would go further and remove Section 2(a)(iii) altogether).
 
We have heard the argument advanced — apparently on the authority of that [[FT book about derivatives]] — that this restricted third limb somehow conditions the other conditions precedent in the clause (i.e., that there is no ongoing PEOD or EOD and that the Transaction has not already been terminated):
{{quote|
Section 2(a)(iii)(3) makes clear that if people want to stipulate any condition precedent other than the standard ones in Section 2(a)(iii)(1) and (2) they must clearly add the wording that the relevant condition will be “a condition precedent for the purposes of Section 2(a)(iii)”. ... Effectively this narrows the scope of the corresponding provision of the 1992 Agreement where no such statement was necessary.}}
It plainly does not, and nor do we see how you could read the FT book as making that argument. The extreme looseness of {{{{{1}}}|2(a)(iii)}} imported by ''any'' notified breach of the agreement, however technical, being a Potential Event of Default, remains.
====“No Early Termination Date ... has occurred”...====
New in the {{1992ma}} was the second condition precedent, that “...no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”.
 
This is tidy-up material to bring ''triggered'' {{{{{1}}}|Termination Event}}s into scope. There is a period between notice of termination and when the {{{{{1}}}|Early Termination Date}} is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the {{{{{1}}}|Transaction}} is still on foot and going, albeit headed inexorably at a brick wall.

Latest revision as of 10:31, 17 May 2024

Herculio: I have a thought. This meagre tract: not ninety words
Wrapp’d about with preliminal nicety and
Stamp’d as for affixation to a servic’d boiler
Conceals a clever trick.
Ser Jaramey: What kind of onion’d witchery is this?

Otto Büchstein, Ser Jaramey Slizzard

Assets, and flawed assets

What is the big deal about this, then? Well, it turns your ISDA into a “flawed asset”.

Flawed asset
/flɔːd ˈæsɛt/ (n.)

A financial asset that looks good, but thanks to a carefully buried conditions precedent, is not there when you, and more importantly, your insolvency administrator, most wants it.

In the language of financial obligations, the right to future payments under a contract is an asset. The creditor owns that right and, all other things being equal, can deal with it — that is, sell or raise money against it — the same way it can sell or mortgage a house, car, a portfolio of equities, or some decentralised cryptographic tokens representing abstract capital.

Assets have certain “ontological” properties, such as continuity in time and space. They might rust, depreciate, go out of fashion or stop working properly but they are nevertheless, existentially, still there. While you own them they therefore have some value to you, however parlous the state of your affairs might otherwise be.

Should your stars line up so that some official comes to be drawing up a closing account of your earthly financial existence — should you become bankrupt, heaven forfend — your assets can reliably be popped onto the “plus” side of the ledger. The difficulty subsists in working out what they are worth, but at least they are there.

This continuity is important to the administration of failing enterprises wherever they are based. It is a rude shock to find the assets you thought were there have without good explanation, gone. Many countries have rules preventing company managers from selling or giving away assets at an undervalue or otherwise granting unfair preferences as impending disaster looms. And nor can they enter contracts, even in times of fair weather, which would have the effect of granting unfair preferences, or depriving other creditors, should the clouds roll in.

An asset that doesn’t have that quality of continuity: that suddenly isn’t there, or that has the unnerving quality of winking in and out of sight at inopportune moments — is thus somehow imperfect: “flawed”.

Section {{{{{1}}}|2(a)(iii)}} seems to have that effect on a {{{{{1}}}|Defaulting Party}}’s claims under an ISDA — its asset. Just when the {{{{{1}}}|Defaulting Party}} goes insolvent or fails to perform, the {{{{{1}}}|Non-defaulting Party}} is entitled to suspend the performance of its obligations without terminating the {{{{{1}}}|Transaction}}. Not entitled, even — as we will see, it just happens.

Should the {{{{{1}}}|Defaulting Party}} then cure the default, the {{{{{1}}}|Transaction}} resumes and the {{{{{1}}}|Non-defaulting Party}} must resume all its obligations, including the suspended ones. But for so long as the default is not cured, the {{{{{1}}}|Non-defaulting Party}} does not have to do anything. The {{{{{1}}}|Defaulting Party}} is left hanging there, with this “flawed asset”.

Insolvency regimes: not keen.

The United States Bankruptcy Code renders unenforceable terms terminating or modifying a contract that are triggered by the simple fact of insolvency proceedings. These are known as “ipso facto” clauses, because the simple fact of bankruptcy “in itself” triggers the clause.

If Section {{{{{1}}}|2(a)(iii)}} were an ipso facto clause, it would not be enforceable. Whether it is an ipso facto clause is a subject of vigorous but tiresome debate. For our purposes, that people don’t easily agree about it is all you need to know.

The UK has no statutory equivalent of America’s ipso facto rule, but hundreds of years ago resourceful common law judges “discovered” an “anti‑deprivation” rule to the effect that, in the honeyed words of Sir William Page Wood V.C., in Whitmore v Mason (1861) 2J&H 204:

“no person possessed of property can reserve that property to himself until he shall become bankrupt, and then provide that, in the event of his becoming bankrupt, it shall pass to another and not his creditors”.

This required some wilfulness on the bankrupt’s part and not just inadvertence or lucky hap, but still: if you set out to defeat the standing bankruptcy laws do not expect easily to get away with it.

It seems, at any rate, that Section {{{{{1}}}|2(a)(iii)}}, might resemble some kind of intended deprivation; merely crystallising one’s existing position and stopping it from going further down the Swanee, as one might do by closing out altogether, seems less likely to.

Anyway: be aware: Section {{{{{1}}}|2(a)(iii)}} attracts insolvency lawyers.

Rationale: avoiding a cleft stick

We can have a fine time rabbiting away about the ontology of assets, but isn’t there a more basic question: why would a {{{{{1}}}|Non-defaulting Party}}, presented with a counterparty in default, ever not want to just close out?

It all comes down to moneyness.

The “bilaterality” of a swap transaction means that either party may, net, be “out of the money” — that is, it would have to pay a net sum of money were the Transaction terminated — at any time. Unless something dramatic happens, this “moneyness” is only a “notional” debt: it only becomes “due” if an {{{{{1}}}|Early Termination Date}} is designated under the Master Agreement.

So an out-of-the-money, {{{{{1}}}|Non-defaulting Party}} has a good reason not to close out the ISDA. Doing so would oblige it to crystallise and pay out a mark-to-market loss. Why should it have to do that just because a {{{{{1}}}|Defaulting Party}} has failed to perform its end of the bargain?

On the other hand, the Defaulting Party is, er, ipso facto, not holding up its end of the bargain. Just as our innocent Non-defaulting Party does not wish to realise a loss by terminating, nor does it want to have to stoically pay good money away to a Defaulting Party who isn’t paying anything back.

A cleft stick, therefore.

Section {{{{{1}}}|2(a)(iii)}} allows our {{{{{1}}}|Non-defaulting Party}} the best of both worlds. The conditions precedent to payment not being satisfied, it can just stop performing and sit on its hands — thereby neither crystallising its ugly mark-to-market position nor pouring perfectly good money away (which is a form of drip-feeding away that mark-to-market position, if you think about it).

So much so good for the {{{{{1}}}|Non-defaulting Party}}.

But the {{{{{1}}}|Defaulting Party}}’s “asset” — its contingent claim for its in-the-money position against the {{{{{1}}}|Non-defaulting Party}} — is compromised. This, for an insolvency administrator and all the {{{{{1}}}|Defaulting Party}}’s other creditors, is a bummer. It deprives them of the “asset” represented by the {{{{{1}}}|Transaction}}.

Which events?

Exactly which default events can trigger the suspension? Under the ISDA, {{{{{1}}}|Events of Default}} and even Potential Events of Default do, but {{{{{1}}}|Termination Events}} and {{{{{1}}}|Additional Termination Event}} do not. This is because most {{{{{1}}}|Termination Events}} are softer, “Hey look, it’s no one’s fault, it’s just one of those things” kind of events. This is not usually true of {{{{{1}}}|Additional Termination Events}}, though: they tend to be credit-driven, and girded with more “culpability” and “event-of-defaulty-ness”. So this is a bit dissonant, but there are far greater dissonances, so we park this one and carry on.

JC has seen valiant efforts to insert {{{{{1}}}|Additional Termination Events}} to section {{{{{1}}}|2(a)(iii)}}, and Potential {{{{{1}}}|Additional Termination Event}}, a class of things that does not exist outside the laboratory, and must therefore be defined. All this for the joy of invoking a clause that is highly unlikely to ever come into play, and which makes little sense in the first place.

Why the ISDA?

Herculio: All well-meant, good Triago. Be not sour —
These are not grapes.
Triago: Indeed not sir: rather, scrapes.
And scars and knocks — the job-lot doggedly sustained.
Herculio: (Aside) Some more than others. The odd one feigned.
But come, Sir Tig: what unrests you here?
Triago (waving paper): A tract from a brother clerk in America.
Herculio: Cripes abroad. Grim tidings?
Triago: Forsooth: it wears the colours of a fight.
A word-scape stain’d with tightly kernèd face
And girded round with fontish weaponry.
Herculio (inspecting the document): Verily, convenantry this dark
Speaks of litiginous untrust.
Otto Büchstein, Die Schweizer Heulsuse

Why, then, is this flawed assets business special to ISDA? Is it special to ISDA?

Normal financing contracts are, by nature, one-sided. Loans, for example. One party — the dealer, broker, bank: we lump these various financial service providers together as The Man — provides services, lends money and “manufactures” risk outcomes; the other — the customer — consumes them.

So, generally, the customer presents risks to The Man, and not vice versa. If the customer fails, it can’t repay its loan. All the “fontish weaponry” is therefore pointed at the customer.

Though the ISDA is also a “risk creation contract” with these same characteristics, it is not designed like one. Either party can be out of the money, and either party can blow up. The fontish weaponry points both ways.

This presented dealers with an unusual scenario: what happens if you blow up when I owe you money? That could not happen in a loan. It is less likely to happen under a swap these days, too, thanks to the arrival of mandatory variation margin — that is one of JC’s main objections — but the ISDA Master Agreement was forged well before this modern era.

There is an argument the flawed asset clause wasn’t a good idea even then, but a better one that it is a bad idea now, but like so many parts of this sacred, blessed form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it.

Developments between editions

“...a condition precedent for the purpose of this Section 2(a)(iii) ...”

The 2002 ISDA trims back the third limb of Section {{{{{1}}}|2(a)(iii)}} from “all other conditions precedent” to just those that specifically say they mean to be caught by Section {{{{{1}}}|2(a)(iii)}}. This a sensible restriction in scope as far as it goes (but JC would go further and remove Section 2(a)(iii) altogether).

We have heard the argument advanced — apparently on the authority of that FT book about derivatives — that this restricted third limb somehow conditions the other conditions precedent in the clause (i.e., that there is no ongoing PEOD or EOD and that the Transaction has not already been terminated):

Section 2(a)(iii)(3) makes clear that if people want to stipulate any condition precedent other than the standard ones in Section 2(a)(iii)(1) and (2) they must clearly add the wording that the relevant condition will be “a condition precedent for the purposes of Section 2(a)(iii)”. ... Effectively this narrows the scope of the corresponding provision of the 1992 Agreement where no such statement was necessary.

It plainly does not, and nor do we see how you could read the FT book as making that argument. The extreme looseness of {{{{{1}}}|2(a)(iii)}} imported by any notified breach of the agreement, however technical, being a Potential Event of Default, remains.

“No Early Termination Date ... has occurred”...

New in the 1992 ISDA was the second condition precedent, that “...no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”.

This is tidy-up material to bring triggered {{{{{1}}}|Termination Event}}s into scope. There is a period between notice of termination and when the {{{{{1}}}|Early Termination Date}} is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the {{{{{1}}}|Transaction}} is still on foot and going, albeit headed inexorably at a brick wall.