Credit mitigation

The controversial protections in master trading agreements are there for one reason: To stop you losing money. They’re “credit mitigants”:

Events of default

• Direct Failure to pay: If a party fails to pay or deliver things it owes under the agreement
• Indirect credit issues: Things that increase the likelihood that the party will be unable to do so in the future:
  • Bankruptcy: The party goes insolvent (or gets close to it)
  • Credit impairment: The party’s credit ratings are prejudiced (via a merger)
  • Cross default: The party breaches important obligations owed to other counterparties
• Misrepresentation: Things that tend to undermine the comfort you took as to the party’s creditworthiness at the outset of the arrangement, such as representations and warranties no longer being true.
• Credit support provider issues: similar things happening to the counterparty’s named guarantors or credit support providers.

These events of default live in the pre-printed the agreement, and tend not to be negotiated (except perhaps cross-default, and that's a whole different story).

Additional termination events

Brokers will usually also require customised “additional termination events” tailored to the idiosyncrasies of their clients. For example, they will require of hedge funds the right to terminate:

• Key person events: if named individual investment managers cease to be associated with the fund;
• NAV triggers: if NAV triggers granting close-out rights related to significant decreases in the net asset value of the fund.

These customised events tend to be more controversial, harder to articulate and more complicated: NAV triggers may be set at different thresholds over different periods.

Netting and margin

There are less invasive credit mitigation techniques.

• Netting: Rights to offset positive and negative transaction values under the same agreement upon close out;
• Margin: The obligation:
  • Variation margin: To regularly transfer cash or assets representing the present net mark-to-market value of transactions under the agreement;
  • Initial margin: To transfer assets representing the worst-case market movements in transactions values between variation margin payments.

So here’s the thing: As long as margin is regularly collected and paid when due, and as long as you’ve correctly calculated the initial margin you need so that it covers any “gap loss” if your counterparty goes bust — you’re covered. The moment the counterparty misses a margin call, you have a failure to pay. It’s the cleanest event there is. You may have to wait out a grace period of a day or two - but you took initial margin to look after that.