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: 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, therefore, to be in a bit of a cleft stick.

Section 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 crystallising 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 Master Agreement it {{{{{1}}}|Events of Default}} and even {{{{{1}}}|Potential Events of Default}} do, but {{{{{1}}}|Termination Event}}s and {{{{{1}}}|Additional Termination Event}}s do not. {{{{{1}}}|Termination Event}}s are softer, “hey look, it’s no-one’s fault, it’s just one of those things” kind of close outs, so that makes some sense — but on the other hand this is not really true of {{{{{1}}}|Additional Termination Event}}s, which tend to be credit-driven and with more “culpability” and “event-of-defaulty-ness” about them. 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 a fantastical sight. It was therefore reasonably likely that a {{{{{1}}}|Non-defaulting Party}} might be nursing a large unfunded mark-to-market liability which it would not want to have to pay out on just because the clot at the other end of the contract had driven his fund into a ditch. A large uncollateralised position is a less likely scenario in these days of mandatory regulatory margin in which counterparties generally cash-collateralise their net market positions to, or near, zero each day.

Nor, we think, 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.