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| This is a page about the general concept of [[cross default]].
| | #redirect[[Cross Default - ISDA Provision]] |
| ==Before we start==
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| ===As a standard term in master trading documents===
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| For specific provisions see:
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| *{{isdaprov|Cross Default}} ({{tag|ISDA}})
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| *{{gtmaprov|Cross Default}} ([[GTMA]])
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| *{{efetprov|Cross Default}} ([[EFET]])
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| *'''Stock lending and repo have no cross default''': Neither the {{gmsla}} nor the {{gmra}} have, as standard, either a [[cross default]] or a [[default under specified transaction]] provision.
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| ===Compare and contrast===
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| *'''[[Default under specified transaction]]''': Like cross default, but just between you and me;
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| *'''[[Cross acceleration]]''': like cross default, only for a kinder, gentler world.
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| ==History==
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| [[Cross default]] developed in the loan market. If a [[lender]] advanced a large sum to a [[borrower]] with only periodic interest or principal repayments, there would be long periods — months; quarters; even ''years'' — where the borrower was not scheduled to make any payments to the lender at all.
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| Now a borrower that is not due to pay anything, can hardly [[Failure to pay|fail to pay]]. Can it?
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| This presented our lender with a risk: if, in the meantime, the borrower failed to pay under a loan from ''another'' lender, ''our'' lender would be in a difficult spot: it has good reason to think the borrower is in trouble, but the borrower hasn’t missed any payments — how could it? ''None were due''. Waiting for the next payment to see if the borrower will meet it, won’t do. Our borrower wants to accelerate its loan ''now'' — ideally, before the other lender accelerates its loan: Our lender wants to get in while the going is still tolerably good.
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| Whence came the notion of a [[cross default]]:
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| :''If you default under a loan you have borrowed from someone else, you default under your [[loan]] with me.''
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| This is a drastic measure. It means the borrower and multiple lenders are in a Mexican stand-off: Each lender is incentivised to be trigger happy, to get in before some other blighter accelerates first. Therefore some thresholds were put around it: The size of the loan being defaulted on would need to be material enough to threaten the borrower’s very solvency.
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| Note the key "vulnerabilities" of a lender that a [[cross default]] clause is designed to protect against:
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| *'''Material indebtedness''': Our lender's contract is one where it takes significant credit exposure to the borrower;
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| *'''Infrequent payments''': Our lender is owed infrequent payment obligations and canot therefore rely on a [[failure to pay]].
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| *''Material default''': The borrower may default on ''other'' indebtedness in a size big enough to threaten its own viability.
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| ==={{isdaprov|Cross default}} in the {{isdama}}===
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| In their infinite wisdom (or jest), the framers of the [[1987 ISDA Interest Rate and Currency Exchange Agreement]] ([[cro-magnon man]] to the {{2002ma}}’s metropolitan hipster) thought it might be wise to include a cross default provision, perhaps because, in those heady days, crfedit support annexes weren’t run-of-the-mill.
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| [[Mediocre lawyer|Lawyers]] being the creatures of habit they are, especially when sequestered into an [[ISDA working group]], never thought to take it out, and even our artisanal coffee swilling {{2002ma}} boasts a tedious Cross Default provision, an embarrassing relic of its agricultural ancestry.
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| But, for a [[master trading agreement]], it’s a nonsense.
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| A counterparty to an {{isdama}}, particularly one with a zero-threshold daily {{isdaprov|CSA}} and many {{isdaprov|transaction}}s under it, suffers none of those weaknesses.
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| *'''Little indebtedness''': An {{isdama}} is not a contract of [[indebtedness]], and any [[mark-to-market]] exposure that may ''resemble'' indebtedness is zeroed daily by means of a collateral call;
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| *'''Frequent payments''': particularly where there are many transactions, or where the net mark-to-market position is shifting, there are payment obligations flowing every day, ''and if there are not that means there is no net indebtedness at all to the counterparty''.
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| So the two main reasons for inserting a cross default aren't really there in an a collateralised trading agreement. For a bank, there are key treasury concerns about giving away a cross default, because it can affect our liquidity buffer calculations, but credit to date has not been persuaded to worry about these.
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| DUST, on the other hand, is between just the two parties, and here any direct failure to us under any transaction, whether or not under the ISDA should allow us to close out the ISDA (just as a payment default under the ISDA itself would). The better your dust, the less need, in fact, you have for a cross default. Dust doesn’t need to cover indebtedness because it’s covered already by default, but you’re right – it’s slightly odd that indebtedness between parties is excluded from specified transactions – but there you have it.
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| ==Introduction==
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| A cross default provision in an agreement allows a [[non-defaulting party]], on a [[default]] by the other party under any separate contract it may have entered for [[borrowed money]], to [[close out]] the agreement containing the cross default provision. Compare this with:
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| *a [[cross acceleration]] provision, where the lender of the [[borrowed money]] must actually have taken steps to accelerate the [[borrowed money]] as a result of the default before the default becomes available as a termination right under the first agreement; and
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| * [[default under specified transaction]] which references default under financial contracts which do '''not''' represent indebtedness, but only as between the two counterparties to the present contract.
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| Cross default is potentially a very damaging clause, as this picture to the right amply illustrates. Or would do, if there were a picture to the right. To the extent it doesn't:
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| ===Cross Default===
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| a cross default provision against a party imports into the [[ISDA]] all of the termination rights upon default under any {{isdaprov|Specified Indebtedness}} owed by that party:
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| *It has the effect of dramatically (and indeterminately) widening the definition of Event of Default.
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| *Cross default entitles a [[Counterparty]] to [[cross accelerate|accelerate]] the ISDA whether or not the Specified Indebtedness in question itself has been accelerated.
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| *Depending on the market value of the transactions under the ISDA at the time of termination, therefore exercise of a cross default may lead to an immediate capital outflow.
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| ===Specified Indebtedness===
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| Specified Indebtedness means, generally, any [[borrowed money|borrowings]] that, in aggregate, exceed a designated {{isdaprov|Threshold Amount}}. Because of the aggregation right, even comparatively trivial agreements can trigger the provision where they are relatively homogenous and affected by the same local circumstances (for example, retail deposits). A low Threshold Amount, therefore, presents three challenges:
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| *It allows a more varied (and difficult to monitor) range of potential termination rights, because a greater number of agreements will qualify as Specified Indebtedness.
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| *It “lowers the bar” so failures to comply with comparatively trivial financial commitments could be aggregated to trigger the Cross Default.
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| *By not excluding bank deposits, it raises the possibility of being triggered by localised events unrelated to BBPLC’s credit (for example, political action in a single jurisdiction which affects BBPLC’s ability to pay on its local deposits)
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| *Note that [[repo]] is not considered specified indebtedness: see [[borrowed money]].
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| ===Derivatives as Specified Indebtedness===
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| Derivatives should '''never''' be included in the definition of {{isdaprov|Specified Indebtedness}}, no matter how hight the {{isdaprov|Threshold Amount}}. the Cross Default language aggregates up all individual defaults, so even though a single ISDA would be unlikely to have a net out-of-the-money MTM of anything like 3% of shareholder funds, a large number of them taken together may, particularly if you’re selective about which ones you’re counting. Which the cross default language entitles you to be.
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| Thus, where you have a number of small failures, you can still theoretically have a big problem. This is why we don’t include deposits: operational failure or regulatory action in one jurisdiction can create an immediate problem.
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| The same could well be true for derivatives. Individual net [[MTM]]s under derivative [[ISDA Master Agreement|Master Agreement]]s can be very large. We have a lot of Master Agreements (18000+).
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| Say we have an operational failure (triggering a regulatory announcement, therefore public) or a government action in a given jurisdiction preventing us from making payments on all derivatives in that jurisdiction. We could have technical events of default on a large number of agreements at once – unlikely to be triggered, but for a cross default, that doesn’t matter.
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| The net MTM across all those agreements may well not be significant. But an opportunistic counterparty could tot up all the negative mark to markets, ignore the positive ones, and reach a large number very quickly.
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| Cross Default is a banking concept intended to reference borrowed money - indebtedness etc - and it really doesn’t make economic sense to apply it to derivatives – the fact that there’s a cross default in derivatives documentation at all is something of a historical accident. There are good points made below about the difficulty of calculating it and knowing what to apply it to ([[MTM]]? {{isdaprov|Termination Amount}}? Payments due on any day?) – bear in mind these values are not nearly as deterministic as amounts due wrt borrowed money: on a failure of a derivative contract the valuation of the termination amount (off which {{isdaprov|Cross Default}} would calculate) is extremely contentious. The market is still in dispute with Lehman, for example.
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| ===Credit Mitigation===
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| Cross Default is intended to be a tool for mitigating credit exposure. It should be set at a level which reflects a material credit concern in the context of the entire enterprise. By convention, the market generally imposes a Threshold Amount equating to between 2 and 3 percent of shareholders’ funds.
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| ===Credit Support Annex===
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| There are other ways of mitigating credit exposure (such as a zero threshold {{csa}}). If a Counterparty's positive [[mark-to-market|exposure]] to {{Bank}} will be fully collateralised on a daily basis, meaning its overall exposure to {{Bank}} at any time will be intra-day movement in the net derivatives positions (a failure to post collateral itself is grounds for immediate termination).
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| ===Contagion risk===
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| It is important to maintain minimum standards which are reflective of genuine credit concerns against the bank so as to limit a “snowball” effect: were we to allow a £50mm Threshold Amount, we would potentially be open to a large number of derivative counterparties simultaneously (and opportunistically) closing out out-of-the-money derivatives positions, which in itself could have massive liquidity and capital implications.
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