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:—''Monty Python and the Magnetic Anomaly from Airplane!''
:—''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}}.  
{{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}}'').


This inverts the normal order of things under the {{isdama}} 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.
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)}}. }}
}}


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


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.  
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.  


Others — for example the learned author of {{coc}} — 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.
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.


====It’s not about the window====
(Could a {{{{{1}}}|NDP}} ''pre''-waive in anticipation? See “{{pjchotlink|Anticipatory waiver?}}” in the premium section.)
{{dialogue|
{{dkt windows}}
—{{buchstein}}, {{br|Talentdämmerung}}
}}
{{{{{1}}}|Automatic Early Termination}} is as much to do with managing [[Tier 1 capital|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 [[in-house legal|obliged to read netting opinions]] on their behalf at any rate, care a lot about it.  
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.


Other market counterparties, perhaps less so.
====The theory====
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.<ref>For the little it is worth, I get to that conclusion as follows: the risk that is that:{{L3}}
{{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]]''”
Your counterparty goes bankrupt without an intervening Failure to Pay '' and''<li>
:—{{br|The phase transition of bankruptcy}}}}
It is significantly net  [[out-of-the-money]] on a  collateralised basis when it does so '' and''<li>
{{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.
Its receiver cherry-picks its in-the-money Transactions and gets a local judgment against you for those '' and''<li>
''Your'' home courts enforce the foreign judgment even though the netting is robust in your jurisdiction. </ol>
This risk is, I think, vanishingly low. It does not seem to have happened even once in the 43-year history of the global OTC derivatives market.
 
Against that contingency pit the ''present'' risk that you are, without notice, prematurely catapulted out of adequately capitalised Transactions you were happy to remain in, that were perhaps even out of the money to you, and for which you might have preferred to roll the dice and risk not being able to close out later in the optimistic hope that reasonableness and consensus might yet prevail at a time of lower volatility, thereby reducing the risk of off-market loss for both parties.</ref>


====The theory====
[[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}}.
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:
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.
{{L1}}'''Discretionary termination right itself''': Firstly, insolvency rules may prevent the {{{{{1}}}|Non-Defaulting Party}} closing out {{{{{1}}}|Transactions}} ''at all''. They may give the administrator the [[discretion]] to affirm or avoid individual {{{{{1}}}|Transactions}}. This ''bigly'' messes with the fundamental philosophy of the {{isdama}}:
{{quote|
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 {{{{{1}}}|Transactions}} 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.<li>
'''Netting right''': Beyond that, having exercised its early termination right, the  “[[single agreement]]” operates to net all {{{{{1}}}|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.</ol></li>
====History====
====History====
{{{{{1}}}|AET}} It was introduced in the {{1987ma}}, but was not labelled “{{{{{1}}}|Automatic Early Termination}}”: it just sat there and applied across the board. Unlike in later editions, it was not conceived as an election to be used with caution only when needed against counterparties in jurisdictions vulnerable to bankruptcy shenanigans.
{{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}}.
 
While under the [[Modern ISDAs]] {{{{{1}}}|AET}} is only triggered by ''certain'' events under the {{{{{1}}}|Bankruptcy}} [[Events of Default - ISDA Provision|event of default]], in the {{1987ma}} ''any'' Bankruptcy Event triggered it, against ''any'' counterparty in any jurisdiction. This is just one more reason not to use the {{1987ma}}, if there are any [[Burmese Junglers]] still out there looking for a way back to civilisation.  


By 1992, {{icds}} had realised that the risk of “bankruptcy shenanigans” largely arose in ''formal'' bankruptcy procedures and not as a result of “soft” economic events tending to indicate mere ''[[insolvency]]''. As we note [[Bankruptcy as a phase transition|elsewhere]], the ISDA’s {{{{{1}}}|Bankruptcy}} definition somewhat jumbles the distinct concepts of “[[bankruptcy]]” and “[[insolvency]]”.
{{financialisation of the markets}}


In any case, a Counterparty’s “inability to pay its debts as they fall due”, its “[[technical insolvency]]” or a creditor’s enforcement of security — is no more of a challenge to close-out netting than any other Event of Default, so the {{1992ma}} reduced its scope by excluding the soft insolvency events captured in limbs (2) and (7) of the {{{{{1}}}|Bankruptcy}} definition.
====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.  


====It is now an election====
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}}.
Though the {{1987ma}} triggered automatic termination upon the {{{{{1}}}|Bankruptcy}} of''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. <ref>The ones where it does are the Germanic ones ([[Germany]], Austria, [[Switzerland]]) and also Japan. though, of course, check your netting opinions!</ref>
=====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>


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 {{isdama}} is founded. Hence, Automatic Early Termination!
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)}}.  


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


====It only has limited use====
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.
{{Drop|A|utomatic Early Termination}} is only really useful to a regulated financial institution, which would incur a capital charge if it doesn’t have a [[netting opinion]], and where it wouldn’t ''get'' that netting opinion for a particular counterparty unless {{{{{1}}}|Automatic Early Termination}} applied to its ISDA. <br>


There are only a few counterparty types in a few jurisdictions where these conditions prevail. There are not many because {{{{{1}}}|Automatic Early Termination}} is a bit of an oh-do-me-a-favour-no-one-will-seriously-fall-for-that-will-they? gambit. This sort of thing passed for sport in the eighties and nineties — [[I’ll be gone; you’ll be gone]] — but only really passes muster these days because AET is now so deeply ingrained into our documents and our way of doing thingsthat 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.
=====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}}.  


I mean, ''really''? [[Deem]]ing 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}}}|Automatic Early Termination}} 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.)
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]].


====Why not just switch it on, to be on the safe side?====
====Few and far between====
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}}.  
{{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.


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 {{isdama}} 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.  
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''.


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


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


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.  
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.


There is an extended rant on the [[close-out netting]] page.
We will talk about that at great length in the premium section.

Latest revision as of 12:24, 12 October 2024

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 one hundred per cent. failure, within 72 hours.

Poole: Surely, you can’t be serious?

HAL 9000: I am serious. And don’t call me “Shirley”.

Bowman: (sticking to the script) I don’t know what you’re talking about, HAL?

Cue musical introduction

HAL9000: Well, I’ll tell you.

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!

Carries on for three hours in this vein

—Monty Python and the Magnetic Anomaly from Airplane!

Automatic 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:

Recommended background reading

{{{{{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 lexophysical swaptime is required. We will discuss this at some length and with wistful pedantry, in the premium content section.

In taking things out of the {{{{{1}}}|Non-Defaulting Party}}’s hands, AET subverts the normal order of things under the ISDA Master Agreement. 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 “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

“Formal bankruptcy is a “phase transition”: the whole “legal context” surrounding a company changes. Erstwhile certainties vanish: normal rules of contract, debt and credit are suspended; in their place arise uncontrollable vagaries. The court appoints a bankruptcy administrator and invests her with wide, nightmarish discretions 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 mercy”

—The phase transition of bankruptcy

Where 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 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 ISDA Master Agreement.

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

We rarely look back to the 1987 ISDA 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 1987 ISDA.

Bear in mind the broad sweep of three historical trends that converged in the 1980s.

Financialisation

First, the rapid onset of financialisation of, well, everything, due to parallel developments in information technology. Through the Seventies and Eighties, Western markets acquired the mental habits and technical systems they needed to look at financial risk in a much more detailed, segmentable way: as “substrate-neutral” derivatives of real-world propositions.

Financial instruments traded electronically. Increasingly, institutions modelled their risk with computers. They unbundled big, organic, ineffable risks into discrete tradable components: first, market risk and credit risk. Then into more esoteric measures: volatility. Liquidity. Convexity. Correlation. Credit and debt value.

At the same time, the market developed the legal and contractual tools to implement this new way of thinking about risks. Principle among them was a new class of bilateral financial contracts unlike anything the world had seen before, in which the usual master-slave relationship between creditors and debtors and between bankers and their customers were rendered — apparently — moot. There was no lender or borrower. The parties were equals: traders.

The ISDA Master Agreement was at the vanguard of these new bilateral contracts.[1]

At the same time, powered by the same irrepressible forces of modernity, the market internationalised. Reducing financial instruments to electronic impulses made cross-border trade easier. While central banks could manage prudential supervision in their own jurisdictions, it was difficult for them to do it across global financial markets where different regulatory regimes presented all kinds of arbitrage opportunities.

New capital regulation

These developments in banking and market technology called for a more sophisticated framework for managing institutional risk in the global markets. Banks were increasingly interconnected, both across exchanges and in private over-the-counter markets, and the speed at which they traded, and at which trading values fluctuated, meant there was heightened systemic risk should major institutions get into trouble. The Latin American debt crisis was a case in point. Even smaller participants could have a disproportionate effect on system stability. We saw this, a bit later, when the brainbox-stuffed pioneering relative value arbitrage hedge fund Long Term Capital Management blew up and almost took Western banking civilisation with it. Some would say that would have been no bad thing.

At the same time the innovative financial instruments, which tended to be leveraged and shared few of the characteristics of traditional financial instruments, meant effective capital ratios at financial institutions declined over the 1980s. It became apparent that the worst-case loss scenario for a master trading agreement like the ISDA was orders of magnitude greater than that presented by exposure to, for example, a syndicated loan. As a result, the Basel Committee on Banking Supervision introduced harmonised global standards for the capital treatment of financial instruments, including these new swap contracts. These rules, now known as Basel I, were first published in 1986. The following year, the 1987 ISDA arrived.

Corporate resolution didn’t change

While there was a good deal of harmony in the international capital markets, many domestic bankruptcy regimes — which were targeted at small and medium-sized enterprises and typically did not have such an international focus — did not similarly change or update.

Swaps remained an arcane part of the international capital markets. They were not relevant to the SMEs. Companies regulators, assignees and administrators did not well understand them, or how they worked. Having local tax and employment liabilities and “trade credit” arrangements in mind, Bankruptcy regimes tended to confer broad discretions on receivers and liquidators to ensure fair outcomes for all claimants upon a company’s resolution.

But broad discretion means lack of certainty, and financial markets do not like uncertainty. Especially not for highly unusual, levered arrangements like swaps, which are not by nature creditor-debtor arrangements. Should an administrator try to “cherry-pick” the in-the-money transactions in a swap portfolio, the implications for swap dealers — who had only entered into them at all on the assumption that all exposures, positive and negative, would net down to a single number — could be far worse, and far more volatile, than the corresponding risks presented by an ordinary loan or trade invoice.

Basel I addressed this “local insolvency risk” by requiring swap dealers to obtain written and reasoned legal opinions that, under local bankruptcy rules, their master agreements could not be cherry-picked in this way. that the “single agreement” concept would work, and their rights to apply close-out netting would be respected.

And this is where the phase transition into bankruptcy becomes important. Typically, while a company is still solvent and trading in the ordinary course, its master trading agreements may be enforced, and netted, according to their terms. It is only at the point of formal bankruptcy that the phantom shenanigans of wide-ranging equitable discretion hove into view. In some jurisdictions, the point at which everything changes is a split second, and getting the right side of it makes all the difference.

Insolvency versus bankruptcy

As we note 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.[2] 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/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

In the 1987 ISDA 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.[3]

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 1992 ISDA 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”. ISDA’s crack drafting squad™ 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 1992 ISDA.

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

As 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 deems 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: ISDA Master Agreements 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.

  1. ↑ Though see a swap as a loan for a contrarian argument on that.
  2. ↑ Not helped by confusion in terminology in company regulations and ~cough~ market standard contracts.
  3. ↑ By providing that the final sentence of Section 6(a) will not apply to Party A and Party B, or some such thing.
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