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| The controversial protections in master trading agreements are there for one reason: To stop you losing money. They’re “''[[credit mitigant|credit mitigants]]''”:
| | #redirect[[credit risk mitigation]] |
| ====[[Event of default|Events of default]]====
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| *'''Direct [[Failure to pay]]''': If a party [[failure to pay|fails to pay]] or deliver things it owes under the agreement. This is the cleanest of all default events. If you could precipitate a [[failure to pay]] on any day, you wouldn’t really need the other events of default - each other event has associated anxieties, and will generally take longer to activate. Most master agreements date from an era where there were ''not'' regular payments: a fixed rate interest swap may only require quarterly payments.
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| *'''Indirect credit issues''': Things that increase the likelihood that the party will be unable to do so in the future:
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| **'''[[Bankruptcy]]''': The party goes [[insolvent]] (or gets close to it)
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| **'''Credit impairment''': The party’s [[credit rating]]s are prejudiced (via a merger)
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| **'''[[Cross default]]''': The party breaches important obligations owed to other counterparties
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| *'''[[Misrepresentation]]''': Things that tend to undermine the comfort you took as to the party’s creditworthiness at the outset of the arrangement, such as representations and warranties no longer being true.
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| *'''[[Credit support provider]] issues''': similar things happening to the counterparty’s named guarantors or [[credit support provider]]s.
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| These [[events of default]] live in the pre-printed the agreement, and tend not to be negotiated (except perhaps [[cross-default]], and that's a whole different story).
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| ====[[Additional termination events]]====
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| Brokers will usually also require customised “[[additional termination event|additional termination events]]” tailored to the idiosyncrasies of their clients. For example, they will require of [[hedge fund]]s the right to terminate:
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| *'''[[Key person]] events''': if named individual investment managers cease to be associated with the fund;
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| *'''[[NAV trigger]]s''': if [[NAV trigger]]s granting close-out rights related to significant decreases in the [[net asset value]] of the fund.
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| These customised events tend to be more controversial, harder to articulate and more complicated: [[NAV trigger]]s may be set at different thresholds over different periods. Additionally, having such events represent termination events potentially cause the counterparty issues with its own market counterparties, who conceivably could use them to trigger [[cross default]]s.
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| ====[[Netting]] and [[margin]]====
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| There are less invasive credit mitigation techniques.
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| *'''[[Netting]]''': Rights to offset positive and negative transaction values under the same agreement upon [[close out]];
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| *'''[[Margin]]''': The obligation:
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| **'''[[Variation margin]]''': To regularly transfer cash or assets representing the present net [[mark-to-market]] value of transactions under the agreement;
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| **'''[[Initial margin]]''': To transfer assets representing the worst-case market movements in transactions values between [[variation margin]] payments.
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| So here’s the thing: As long as margin can be regularly collected and is paid when due, and as long as you’ve generously calculated the initial margin so that it covers any “[[gap loss]]” if your counterparty goes bust — you’re covered. The moment the counterparty misses a margin call, you have a [[failure to pay]]. It’s the cleanest event there is. You may have to wait out a grace period of a day or two — but you took initial margin to look after that.
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| These days, [[regulatory margin]] must be calculated and collected daily. True, at the time your counterparty is struggling, the market positions may not move in your favour, so there may be no payments to fail (but by definition you will be structurally over-collateralised in this case). If you had a means of forcing a payment on any day — if you were entitled to raise [[initial margin]], for example — then even this reservation falls away.
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| So first thing:
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