Template:Flawed asset capsule: Difference between revisions
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Following certain default events,<ref>Exactly ''which'' defaults will depend on the contract: under an {{isdama}} it will include | Following certain default events,<ref>Exactly ''which'' defaults will depend on the contract: under an {{isdama}} it will include Events of Default and Potential Events of Default, but not Termination Events or Additional Termination Events — which, given the “culpability” of [[ATE]]s, is something of a dissonance in itself.</ref> a “[[flawed asset]]” provision allows an innocent, but [[out-of-the-money]] counterparty to a {{tag|derivative}} or {{tag|securities finance}} transaction to suspend performance of its obligations ''without'' terminating the transaction and thereby crystallising a [[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 it doesn’t apply for so long as ''the [[conditions precedent]] to payment are not fulfilled''. | The defaulting party’s asset – its right to be paid, or delivered to under the transaction – is “flawed” in the sense that it doesn’t apply for so long as ''the [[conditions precedent]] to payment are not fulfilled''. | ||
Revision as of 13:59, 10 May 2023
Following certain default events,[1] a “flawed asset” provision allows an innocent, but out-of-the-money counterparty to a derivative or securities finance transaction to suspend performance of its obligations without terminating the transaction and thereby crystallising a 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 it doesn’t apply for so long as the conditions precedent to payment are not fulfilled.
The most famous flawed asset clause is Section {{{{{1}}}|2(a)(iii)}} of the ISDA Master Agreement. It entered the argot in a simpler, more peaceable time, when two-way, zero-threshold, daily margined CSAs were a rather fantastical sight, and 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 gone belly-up. Closing out the contract would crystallise that liability, so the flawed asset provision allowed that innocent fellow to just stop performing the contract altogether, rather than paying out its mark-to-market loss.
That was then; 1987; they hadn’t even invented the 1995 CSA. Even once they had, it would be common for a muscular broker/dealers to insist on one-way margining: “You, no-name pipsqueak highly levered hedge fund type, are paying me variation margin and initial margin; I, highly-capitalised, prudentially regulated, balance-sheet levered[2] financial institution, am not paying you any margin.”
Well, those days are gone, and bilateral zero-threshold margin arrangements are more or less obligatory nowadays, so it’s hard to see the justification for a flawed asset provision. But we still have one, and modish post-crisis threats by regulators worldwide to stamp them out seem, some time in 2014, to have come to a juddering halt.
One can level many criticisms at the flawed assets concept these days, and the JC does. Not only is it often triggered by vague, indeterminate things, there are many cases where its technical application makes absolutely no sense. Really, if a counterparty doesn’t like the position it is in when a counterparty defaults, its remedy is simple. Close out. Just saying “talk to the hand” really ought not do in these enlightened, margined times.
- ↑ Exactly which defaults will depend on the contract: under an ISDA Master Agreement it will include Events of Default and Potential Events of Default, but not Termination Events or Additional Termination Events — which, given the “culpability” of ATEs, is something of a dissonance in itself.
- ↑ Amazing in hindsight, really, isn’t it.