Template:Isda 2(a)(iii) summ

Technical nuts and bolts

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.

This poses some rather intriguing questions:

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?

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 Unpaid Amount?

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 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.

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 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.

...These days?

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.

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.

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 eagles 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.

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 ISDA Master Agreements 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.

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.

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.

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?

Flawed assets generally

Flawed asset
/flɔːd ˈæsɛt/ (n.)
A “flawed asset” provision allows the “innocent” party to a financial transaction to suspend performance of its own obligations if its counterparty suffers certain default events without finally terminating or closing out the transaction. Should the defaulting side cure the default scenario, the transaction resumes and the suspending party must perform all its obligations including the suspended ones. For so long as it not cured, the innocent party may close the Master Agreement out at any time, but is not obliged to.

Rationale: avoiding a cleft stick

Why would a party ever want to not close out a defaulting counterparty? It all comes down to moneyness.

The “bilaterality” of most derivatives arrangements means that either party may, net, be “out of the money” — that is, across all outstanding transactions, it would have to pay a net sum of money if all transactions were terminated. This is a notional debt that only becomes “due” as such if you designate an {{{{{1}}}|Early Termination Date}} under the Master Agreement. So an out-of-the-money {{{{{1}}}|Non-defaulting Party}} has a good reason therefore not to close out the ISDA. Why should it have to pay out just because a {{{{{1}}}|Defaulting Party}} has failed to perform its end of the bargain? On the other hand, if it forebears from terminating against a bankrupt counterparty the {{{{{1}}}|Non-defaulting Party}} doesn’t want to have to continue stoically paying good money away to a bankrupt counterparty who isn’t reciprocating.

An out-of-the-money, {{{{{1}}}|Non-defaulting Party}} seems to be, therefore, in a bit of a cleft stick.

Section {{{{{1}}}|2(a)(iii)}} allows the {{{{{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 and thereby not thereby crystallise the mark-to-market loss implied by its out-of-the-money position.

The {{{{{1}}}|Defaulting Party}}’s “asset” — its right to be paid, or delivered to under the {{{{{1}}}|Transaction}} — is “flawed” in the sense that its rights don’t apply for so long as the conditions precedent to payment are not fulfilled.

Conceivably you could invoke a flawed asset provision even if you were in-the-money, but you would be mad to.

Which events?

Exactly which default events can trigger a flawed asset clause will depend on the contract. Under the ISDA, {{{{{1}}}|Events of Default}} and even Potential {{{{{1}}}|Events of Default}} do, but {{{{{1}}}|Termination Event}}s and {{{{{1}}}|Additional Termination Event}}s do not.

This is because most Termination Events are softer, “hey look, it’s no-one’s fault, it’s just one of those things” kind of closeouts — but this is not really true of {{{{{1}}}|Additional Termination Event}}s, which tend to be credit-driven and girded with more “culpability” and “event-of-defaulty-ness”.

This is, a bit dissonant, but there are far greater dissonances, so we park this one and carry on.

2(a)(iii) in a time of Credit Support

Flawed assets entered the argot in a simpler, more (less?) peaceable time when two-way, zero-threshold, daily-margined collateral arrangements were an unusual sight. Nor, in those times, were dealers often of the view that they might be on the wrong end of a flawed assets clause. They presumed if anyone was going bust, it would be their client. Because — the house always wins, right? The events of September 2018 were, therefore, quite the chastening experience.

In any case without collateral, a {{{{{1}}}|Non-defaulting Party}} could, be nursing a large, unfunded mark-to-market liability which it would not want to pay out just because the clot at the other end of the contract had driven his fund into a ditch.

That was then: in these days of mandatory regulatory margin, counterparties generally cash-collateralise their net market positions to, or near, zero each day, so a large uncollateralised position is a much less likely scenario. So most people will be happy enough just closing out: the optionality not to is not very valuable.