Template:Flawed asset capsule

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

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, net across all outstanding transactions, would owe money, if all transactions were terminated. This is a notional debt that is not “due” as such, so it is money a solvent counterparty might not want to have pay out just because its counterparty has failed to perform its end of the bargain. On the other hand, the innocent counterparty doesn’t want to have to continue stoically paying away to a bankrupt counterparty that isn’t reciprocating.

The flawed asset provision allows the innocent party the best of these both worlds. It can stop, and sit on its hands, thereby not thereby crystallising the mark-to-market loss implied by its out-of-the-money position. The defaulting party’s “asset” – its right to be paid, or delivered to under the 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 an ISDA Master Agreement it {{{{{1}}}|Events of Default}} and even {{{{{1}}}|Potential Events of Default}}, but not {{{{{1}}}|Termination Event}}s or {{{{{1}}}|Additional Termination Event}}s — which, given the “culpability” and “event-of-defaulty-ness” of ATEs, is something of dissonance in itself.

Collateral

Flawed assets entered the argot in a simpler, more peaceable time when two-way, zero-threshold, daily-margined collateral arrangements were a fantastical sight. It was reasonably likely that a counterparty might be nursing a large unfunded mark-to-market liability which it would not want to have to fund just because the clot at the other end of the contract had blown up. This is a lot less likely in these days of mandatory regulatory margin. Nor did it occur to dealers, who typically insisted on the flawed assets clause, that they might be on the wrong end of it. The events of September 2018 were, therefore, quite the chastening experience.