Template:Isda 2(a)(iii) summ

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.

The problem with bilateral agreements

Triago: Forsooth: it wears the colours of a fight.
A word-scape stain’d with tightly kernèd face
And girded round with fontish weaponry.
Herculio (inspecting the document): Verily, convenantry this dark
Speaks of litiginous untrust.

—Otto Büchstein, Die Schweizer Heulsuse

As we have remarked before, most financing contracts are decidedly one-sided. One party — the dealer, broker, bank: we lump these various financial service providers together as The Man — provides services, lends money and manufactures risk outcomes; the other — the customer — consumes them.

Generally, the customer presents risks to The Man, and not vice versa. In a loan, all the “fontish weaponry” is pointed in the same direction: the customer’s. It goes without saying that should the customer “run out of road”, The Man stands to lose something. What is to be done should The Man run out of road is left undetermined but implicitly it is unlikely, and not expected to change anything for the customer. Whatever you owe, you will continue to owe; just to someone else.

Though the ISDA is also, in practice, a “risk creation contract” and has these same characteristics, it is not, in theory, designed like one. Either party can be out-of-the-money, and either party can blow up. The ISDA’s fontish weaponry points both ways.

This presented dealers with an unusual scenario: what happens if you blow up when I owe you money? I might not want to crystallise my contract: that will involve me paying you a mark-to-market replacement cost I hadn’t budgeted for paying out just now. (This is less true in these days of mandatory variation margin — that is one of JC’s main objections — but the ISDA Master Agreement was forged well before this modern era).

The ISDA answers this with the “flawed asset” provision of Section {{{{{1}}}|2(a)(iii)}}. This allows an innocent, but out-of-the-money, party faced with its counterparty’s default, to not close out the ISDA, but just freeze its own obligations until the default situation is resolved.

There is an argument the flawed asset clause wasn’t a good idea even then, but a better one that it is a bad idea now, but like so many parts of this sacred, blessed form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it.

Ask a chary credit officer what she thinks of Section {{{{{1}}}|2(a)(iii)}} and her eyes are sure to glister as she regales you with the countless times it's got her out of a scrape at the first sign of {{{{{1}}}|Potential Event of Default}}. Regulators are less enamoured, especially after the global financial crisis, and took some steps to impose at least as “use it or lose it” drop-dead point, but institutional inertia and the brick wall of reality has long since arrested that drift.

Does not apply to {{{{{1}}}|Termination Events}}

Since most ISDA Master Agreements that reach the life support machine in an ICU get there by dint of a {{{{{1}}}|Failure to Pay}} or {{{{{1}}}|Bankruptcy}} this does not, in point of fact, amount to much, but it is worth noting that while {{{{{1}}}|Event of Default}}s — and even events that are not yet but with the passing of time might become {{{{{1}}}|Events of Default}} — can, without formal action by the {{{{{1}}}|non-Defaulting Party}} trigger a {{{{{1}}}|2(a)(iii)}} suspension, a mere Section {{{{{1}}}|5(b)}} {{{{{1}}}|Termination Event}} — even a catastrophic one like an {{{{{1}}}|Additional Termination Event}} (such as a NAV trigger, key person event or some such) — cannot, until the {{{{{1}}}|Transaction}} has been formally terminated, at which point it really ought to go without saying.

This might rile and unnerve credit officers — by nature an easily perturbed lot — but given our arguments below for what a train wreck the whole {{{{{1}}}|2(a)(iii)}} thing is, those of stabler personalities will consider this in the round a good thing.

Nevertheless, the JC has seen valiant efforts to insert {{{{{1}}}|Additional Termination Events}} to section {{{{{1}}}|2(a)(iii)}}, and — quel horreur — Potential {{{{{1}}}|Additional Termination Event}}s, a class of things that does not exist outside the laboratory, and must therefore be defined. All this for the joy of invoking a clause that doesn’t make any sense in the first place.

“Some things are better left unsaid,” said no ISDA ninja ever.

Developments between editions

“...a condition precedent for the purpose of this Section 2(a)(iii) ...”

The 2002 ISDA trims back the third limb of Section 2(a)(iii) from “all other conditions precedent” to just those that specifically say they mean to be caught by Section 2(a)(iii). This a sensible restriction in scope as far as it goes (but JC would go further and remove Section 2(a)(iii) altogether).

We have heard the argument advanced — apparently on the authority of that FT book about derivatives — that this restricted third limb somehow conditions the other conditions precedent in the clause (i.e., that there is no ongoing PEOD or EOD and that the Transaction has not already been terminated):

Section 2(a)(iii)(3) makes clear that if people want to stipulate any condition precedent other than the standard ones in Section 2(a)(iii)(1) and (2) they must clearly add the wording that the relevant condition will be “a condition precedent for the purposes of Section 2(a)(iii)”. ... Effectively this narrows the scope of the corresponding provision of the 1992 Agreement where no such statement was necessary.

It plainly does not, and nor do we see how you could read the FT book as making that argument. The extreme looseness of {{{{{1}}}|2(a)(iii)}} imported by any notified breach of the agreement, however technical, being a Potential Event of Default, remains.

“No Early Termination Date ... has occurred”...

New in the 1992 ISDA was the second condition precedent, that “...no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”.

This is tidy-up material to bring triggered {{{{{1}}}|Termination Event}}s into scope. There is a period between notice of termination and when the {{{{{1}}}|Early Termination Date}} is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the {{{{{1}}}|Transaction}} is still on foot and going, albeit headed inexorably at a brick wall.