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=====Cross default is not needed in a swap=====
=====Cross default is not needed in a swap=====
In any case, the characteristics of loans that {{{{{1}}}|Cross Default}} address, broadly, no not hold for swap transactions:
In any case, the risks of loans that {{{{{1}}}|Cross Default}} address, broadly, do not hold for swaps:


''Firstly'', swaps — especially bilaterally margined swaps —  are not primarily instruments of uncollateralised indebtedness. They are ''implied financings'' and any market exposure that would ''resemble'' “indebtedness” is zeroed out by variation margin each day.<ref<>A “financing” is an arrangement where a customer raises cash against a margined asset; a “loan” is where a customer raises cash against its own un-margined promise to repay.</ref>
''Firstly'', swaps are not ''primarily'' instruments of uncollateralised indebtedness.


''Secondly'', swap Transaction notionals tend to be relatively small compared to commercial banking facilities.  There tend to be lots of Transactions, and each has its own payment dates.
''Secondly'', there tend to be ''multiple'' small Transactions rather than a single big one: therefore payments under the ISDA architecture are frequent and flow in both directions, especially under an {{isdama}} with multiple Transactions. You don’t have the “no coupon due for six months” problem.


''Thirdly'', swap payments are therefore usually frequent and flow in both directions, especially under an {{isdama}} with multiple Transactions.
''Thirdly'', {{isdama}}s are typically [[margin|margined]], so even though it is conceptually ''possible'' for uncollateralised exposure to arise under an ISDA, in practice, it there won’t be much and it will be quickly reset.


''Fourthly'', {{isdama}}s are typically daily [[margin|margined]] to a zero {{vmcsaprov|Threshold}}, so even though it is conceptually ''possible'' for indebtedness to arise under an ISDA, in practice, it mostly does not.
''Lastly'', the majority of swap end users will not have significant unmargined third-party debt: [[investment fund]]s<ref>In this I include [[hedge fund]]s, mutual funds, index funds, ETFs, pension funds, life insurance plans, private equity funds and sovereign wealth funds.</ref> tend to invest on margin. They do not borrow under uncollateralised loans. So there are few instances of specified indebtedness that they are likely to trigger. It is far more likely that a bank counterparty or swap dealer will have material specified indebtedness. This is a bit of a self own.  


''Lastly'', many customers will not have significant unmargined third-party indebtedness: swap users like [[investment fund]]s tend to invest on margin and do not borrow under uncollateralised loans. As we will see, asset financing arrangements tend ''not'' to have cross default terms in them — the one exception being the ISDA.
You would not expect {{{{{1}}}|Cross Default}} to often arise as a sole means of closing out an {{isdama}}. Usually, there would long since have been a {{{{{1}}}|Failure to Pay or Deliver}} or {{{{{1}}}|Bankruptcy}}, and both of those events are a much more deterministic, identifiable and therefore safe means of bringing an ISDA arrangement to an end.  
 
You would not therefore expect to have to use {{{{{1}}}|Cross Default}} often to close out an {{isdama}}. Usually, there would long since have been a {{{{{1}}}|Failure to Pay or Deliver}} or {{{{{1}}}|Bankruptcy}}, and both of those events are a much more deterministic, identifiable and therefore safe means of bringing an ISDA arrangement to an end.
 
And this is the general experience: {{{{{1}}}|Cross Default}} is much talked about seldom seen.


====How does Cross Default work?====
====How does Cross Default work?====
{{drop|I|magine swap counterparty}} X who, alongside its {{Isdama}} with you, has {{{{{1}}}|Specified Indebtedness}}” - outstanding loan obligations to lenders A, B and C.  
{{drop|I|magine swap counterparty}} N who, alongside its {{Isdama}} with you, has significant {{{{{1}}}|Specified Indebtedness}} to lenders A, B and C.  


Should X default under loans A, B or C in a total sum over the specified “{{{{{1}}}|Threshold Amount}}”, your ISDA will entitle you to accelerate all outstanding Transactions under your ISDA.
Should N default under any (or all) of that indebtedness — that is, should those lenders become ''entitled'' to call in their loans, whether or not they actually ''do'' — in a total sum exceeding the “{{{{{1}}}|Threshold Amount}}” in your ISDA, you would be entitled to close out your ISDA.
 
=====“Capable of acceleration” versus failure to pay=====
 
Fussily, Section {{{{{1}}}|5(a)(vi)}} distinguishes between the general right to accelerate {{{{{1}}}|Specified Indebtedness}} — a general default at any time before maturity —  and a failure to pay ''at'' maturity. The distinction is technical: with a loan, the lion’s share of the borrower’s payment obligation falls on the maturity date, at which point the loan cannot logically be “accelerated” because it is already due. {{icds}}’s drafting simply catches the distinction between a default event happening before the termination date and that final fundamental repayment failure.


===== “Specified Indebtedness” =====
===== “Specified Indebtedness” =====
What counts as “{{{{{1}}}|Specified Indebtedness}}”? The ISDA itself defines it as “[[Borrowed money|borrowed money]]” without further elaborating on what that means.
======Payment obligations======
This is considerably narrower than “all payment obligations”, Though it is not unknown for sophisticated counterparties to widen the definition to include all of these. This is madness.
======Financing arrangements======
“Borrowed money” excludes margined [[financing]] arrangements.<ref>See [[Lending versus financing|elsewhere]].</ref> “Financing arrangements” includes a wide selection of capital markets transactions including [[margin loan]]s, [[synthetic prime brokerage]], [[swap]]s, [[stock loan]]s and [[repo]]s.


What counts as “{{{{{1}}}|Specified Indebtedness}}” is a topic of hot debate.
These are “asset transformations” rather than borrowings and do not involve uncollateralised “[[indebtedness]]” as such: at inception, the party raising money gives title to an asset of greater value to the financer, and is subsequently margined to that asset value. Therefore net, the financing beneficiary is not a debtor at all, but a ''creditor''.
 
The ISDA itself restricts “{{{{{1}}}|Specified Indebtedness}}” to “[[Borrowed money|borrowed money]]” without further elaborating on what that means.
======Financing arrangements======
[[Financing]] arrangements are not caught in the standard wording, as discussed [[Lending versus financing|elsewhere]]. They do not involve uncollateralised “[[indebtedness]]” as such but rather are margined transformations of owned assets.  


This does not stop [[credit officer]]s fiddling with the definition of {{{{{1}}}|Specified Indebtedness}} to bring them into scope — a favourite tweak is to include derivatives and securities financing arrangements as {{{{{1}}}|Specified Indebtedness}} without stopping to clarify how the “[[borrowed money]]” under them (hint, under a margined ISDA, there will not be any) is to be measured.  
This does not stop [[credit officer]]s expanding the definition of {{{{{1}}}|Specified Indebtedness}}to bring them into scope — a favourite tweak is to include derivatives and securities financing arrangements as {{{{{1}}}|Specified Indebtedness}} without stopping to clarify how the “[[borrowed money]]” under them (hint, under a margined ISDA, there will not be any) is to be measured.  


For reasons we will come to, this is a grave mistake.
For reasons we will come to, this is a grave mistake.


======Bank deposits======
======Bank deposits======
Deposits plainly ''are'' “[[borrowed money]]”, and they mightily add up: as we will see, aggregation is important when calculating the {{{{{1}}}|Threshold Amount}}. In the normal loan market, they were never really a problem, because the only typeof business allowed to accept deposits is a bank, and a bank is typically the one lending, not borrowing, under a loan contract.  
Bank deposits plainly ''are'' “[[borrowed money]]”, and they mightily add up: as we will see, aggregation is important when calculating the {{{{{1}}}|Threshold Amount}}.  


But since the ISDA is bilateral, a failure to pay bank deposits could trigger a  {{{{{1}}}|Cross Default}}. It is not out of the question that a bank could be prevented from repaying deposits through operational error, IT outage or geographical incident and therefore technically be in default on a large number of its deposits at once.  
Bank deposits illustrate the problem of applying cross default in a bidirectional financing contract:  In the traditional loan market, bank deposits are not in scope for Cross Default because only credit institutions — banks — can accept deposits, and they are the lending party and cross default does not apply. End users cannot take deposits.  


For this reason, banks usually exclude [[Deposit|retail deposits]] from the ambit of {{{{{1}}}|Specified Indebtedness}}. This is sensible and they will not lightly resile from it, so [[buy-side legal eagle]]s looking for a [[I’m not going to die in a ditch about it|ditch to die in]] are advised to avoid this one.
But the ISDA is bilateral, so deposits are in scope and could trigger a {{{{{1}}}|Cross Default}} against a bank. It is not out of the question that a bank could be prevented from honouring deposits through operational error, IT outage or geopolitical incident. This would put it in technical default on a large number of its deposits at once.
 
Therefore, banks exclude [[Deposit|retail deposits]] from the ambit of {{{{{1}}}|Specified Indebtedness}}. They will not lightly resile from this position, so [[buy-side legal eagle]]s looking for a [[I’m not going to die in a ditch about it|ditch to die in]] are advised to avoid this one.


======Public indebtedness======
======Public indebtedness======
{{{{{1}}}|Specified Indebtedness}} typically arises under ''private'' loan contracts. The only exception to this are public bond issuances. Beyond that, generally speaking, the market will have no reliable real-time information about the level of a given borrower’s indebtedness, much less whether it has defaulted on it.  
wWth the honourable exception of publicbond issuances, most {{{{{1}}}|Specified Indebtedness}} arises under ''private'' arrangements about which the market will have no reliable real-time information. No one will know how much a given borrower owes, much less whether it has defaulted.  


This makes practical policing and enforcement of a {{{{{1}}}|Cross Default}} right fraught, where it is even possible.
This makes practical policing and enforcement of a {{{{{1}}}|Cross Default}} right fraught, where it is even possible.
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=====“Default”=====
=====“Default”=====


“Default” is described widely and (at least in the {{2002ma}}) is not restricted to payment defaults. A technical breach of representations that entitled a lender to accelerate would be an actionable {{{{{1}}}|Cross Default}}.  
“Default” is described widely and (at least in the {{2002ma}}) is not restricted to payment defaults. A technical breach of representations that entitled a lender to accelerate indebtedness over the {{{{{1}}}|Threshold Amount}} would be an actionable {{{{{1}}}|Cross Default}}.  


======The lender does not have to accelerate======
======The lender does not have to accelerate======
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See below for our discussion of [[cross acceleration]] — a weakened version of {{{{{1}}}|Cross Default}} that requires the loan to be actually called in.  
See below for our discussion of [[cross acceleration]] — a weakened version of {{{{{1}}}|Cross Default}} that requires the loan to be actually called in.  
======“Most favoured nation”======
{{{{{1}}}|Cross Default}} also introduces an unusual variability to the ISDA universe: While the other {{{{{1}}}|Events of Default}}  are for the most part standardised and inviolate, default events under a bilaterally-negotiated loan facility that Cross Default triggers will be customised.
Especially since Section {{{{{1}}}|5(a)(vi)}} references:
{{quote|
“a default, event of default or other similar condition or event (however described) in respect of such party”.}}
This is loose and could for example include ''potential'' events of default (those which will become an event of default on expiry of a [[grace period]]).
In any case, {{{{{1}}}|Cross Default}} is a “most favoured nation” clause importing into the ISDA every single “default or similar event” from the counterparty’s other third-party loan contracts: any defaults rights you have given away to any other material lender you must also give to me. This is wide, and, as noted elsewhere acts as much as anything else to ''destabilise'' the creditworthiness of the counterparty.


===== “Threshold Amount” =====
===== “Threshold Amount” =====
The {{{{{1}}}|Threshold Amount}} is the level over which accumulated defaults in {{{{{1}}}|Specified Indebtedness}} trigger {{{{{1}}}|Cross Default}}.  
The {{{{{1}}}|Threshold Amount}} is the level over which accumulated defaults in {{{{{1}}}|Specified Indebtedness}} trigger {{{{{1}}}|Cross Default}}.  


The {{{{{1}}}|Threshold Amount}} is usually a [[cash]] amount ''or'' a percentage of [[Tier 1 capital|shareholder funds]], or both, in which case — [[Trick for young players|schoolboy error]] hazard alert — be careful to say whether it is the ''greater'' or ''lesser'' of the two.  
The {{{{{1}}}|Threshold Amount}} is usually a [[cash]] amount ''or'' a percentage of [[Tier 1 capital|shareholder funds]], or both, in which case — [[Trick for young players|schoolboy error]] hazard alert — be careful to say whether it is the ''greater'' or ''lesser'' of the two.  
======Snowball======
======It should be existentially-threateningly large======
This “accumulation” feature means that relatively trivial amounts of indebtedness can be problematic particularly where the default is technical, systemic or operational. Should a system outage prevent the bank from honouring its deposits — in aggregate, likely to be greater than 2% of its shareholder equity — it might instantly trigger a catastrophic cross-default right across all {{isdama}}s.
Because of the extreme risk that cross-default presents, the threshold amount should be set at an amount representing an existential threat to the counterparty’s solvency. For a bank counterparty, that is typically two or three per cent of its shareholders’ equity or the cash equivalent. Note a cash equivalent runs the risk of decoupling from the value of shareholders’ equity so, while it is easier to measure and monitor, it presents a greater systemic risk, and you may find it more prudent to stick with an equity-linked threshold.
======Snowball risk======
This “accumulation” feature means that relatively trivial amounts of indebtedness can be problematic particularly where there are a lot of them — see bank deposits and swap transactions — or where the default is technical, systemic or operational. Should a system outage prevent a counterparty honouring a class of contracts it might instantly trigger a catastrophic cross-default right across all {{isdama}}s.


Because of the [[snowball effect]] that a [[cross default]] clause can have<ref>See the premium section about that.</ref> the {{{{{1}}}|Threshold Amount}} for should be ''big'': like, [[bankruptcy|life-threateningly]] big. So, expect a [[swap dealer]] to accept little less than 2-3% of shareholder funds, or sums in the order of hundreds of millions of dollars.  
For buy-side parties (especially for thinly capitalised investment vehicles) the {{{{{1}}}|Threshold Amount}} may be a lot lower than that — like, ten million dollars or so — and, of course, for fund entities will key off [[NAV]], not shareholder funds.  


For buy side parties (especially for thinly capitalised investment vehicles) the {{{{{1}}}|Threshold Amount}} may be a lot lower than that — like, ten million dollars or so — and, of course, for fund entities will key off [[NAV]], not shareholder funds.
======Problematic derivatives======
======Derivatives create another problem======
Bear in mind, too, that if even one of your ISDA contracts has a lower {{{{{1}}}|Threshold Amount}}, that can create a chain reaction: because the exposure under that ISDA, once it has been triggered by a {{{{{1}}}|Cross Default}}, then contributes to the total amount of defaulted Specified Indebtedness and may itself lead to {{{{{1}}}|Threshold Amount}}s being triggered in other ISDAs. And each of those then contributes … you get the idea.
Bear in mind, too, that if even one of your ISDA contracts has a lower {{{{{1}}}|Threshold Amount}}, that can create a chain reaction: because the exposure under that ISDA, once it has been triggered by a {{{{{1}}}|Cross Default}}, then contributes to the total amount of defaulted Specified Indebtedness and may itself lead to {{{{{1}}}|Threshold Amount}}s being triggered in other ISDAs. And each of those then contributes … you get the idea.
======Cherry-picking======
There is one last problem with including swaps: what is the “indebtedness” you are measuring? You could look at individual Transaction exposures and aggregate them. Nothing requires you to apply a [[Single agreement|Single Agreement]] concept or cross-transactional netting to those exposures. (Why would it? ISDA contracts are designed to be out of scope for {{{{{1}}}|Cross Default}}). If you bring them into scope you could, in theory, [[cherry-pick]] all out-of-the-money {{{{{1}}}|Transactions}}, total them up and cross a {{{{{1}}}|Threshold Amount}} fairly easily.


There is one last problem with including ISDAs within {{{{{1}}}|Specified Indebtedness}}: what is the “indebtedness” you are measuring? You can look at individual transaction exposures and aggregate them. Nothing requires you to apply a [[Single agreement|Single Agreement]] concept or any kind of cross-transactional netting to those exposures. (Why would it? ISDA contracts are designed to be out of scope for {{{{{1}}}|Cross Default}}). If you bring them into scope you could, in theory, [[cherry-pick]] all out-of-the-money {{{{{1}}}|Transactions}}, total them up and cross a {{{{{1}}}|Threshold Amount}} fairly easily.  
Even if {{{{{1}}}|Specified Indebtedness}} is calculated by reference to a ''net'' close-out amount, this only really points up the imbalance between dealers and their customers. Sure, big fund managers may have ten, twenty or even fifty {{Isdama}}s, but they will be split across dozens of different funds, each a different entity with its own {{{{{1}}}|Threshold Amount}}. [[Swap dealer]]s, on the other hand, will have literally ''hundreds of thousands'' of [[master agreement]]s, all facing the same legal entity. ''Dealers are the wrong side of this risk''.  


Now it is true that you can require the {{{{{1}}}|Specified Indebtedness}} of a [[master trading agreement]] to be calculated by reference to its net close-out amount, but this only really points up the imbalance between dealers and their customers. Sure, big fund managers may have fifty or even a hundred {{Isdama}}s, but they will be split across dozens of different funds, each a different entity with its own {{{{{1}}}|Threshold Amount}}. [[Swap dealer]]s, on the other hand, will have literally ''hundreds of thousands of [[master agreement]]s, all facing the same legal entity''. ''Dealers are the wrong side of this risk''.  
Now, you ''could'' manage this by careful negotiation — but there is a better way: ''excluding financing transactions altogether'', for the perfectly sensible reason that ''they are not “[[borrowed money]]''.


This can of course be managed by careful negotiation, but JC would say there is a much better means of managing this risk:  excluding transactions under collateralised master trading agreements altogether, for the perfectly sensible reason that they should not be considered as “[[borrowed money]]”.
======Cross default as a “most favoured nation” clause======
While the ISDA {{{{{1}}}|Events of Default}} are standardised, bilaterally-negotiated default events under private loans will be highly customised.  


Now seeing as most [[master trading agreement]]s are fully collateralised, and so don’t represent material [[indebtedness]] on a net basis anyway, it may be that — if correctly calibrated to catch the net mark-to-market exposure, no-one’s {{{{{1}}}|Threshold Amount}} will ever be seriously threatened.
Especially since Section {{{{{1}}}|5(a)(vi)}} Is loose about what counts as a qualifying default:
 
{{quote|
But if no {{{{{1}}}|Threshold Amount}} is ever likely to be breached, then ''why are you including Specified Indebtedness in the first place?
“a default, event of default or other similar condition or event (however described) in respect of such party”.}}  
This is loose and could for example include ''potential'' events of default (those which will become an event of default on expiry of a [[grace period]]).


O tempora. O [[paradox]].
This turns {{{{{1}}}|Cross Default}} into a “most favoured nation” clause, dragging into the ISDA every single “default or similar event” from the counterparty’s {{{{{1}}}|Specified Indebtedness}}. This is wide, swingeing term and Is likely to be much more severe against bank and dealer counterparties than end users,  since banks will have a lot more indebtedness.

Revision as of 12:04, 9 November 2024

Cross Default covers the unique risks that come from lending money to people who have also borrowed heavily from others, likely on better terms than you. The basic vibe is:

If any of your other loans become payable, I want mine to be payable too.

In the ISDA Master Agreement that means I get an {{{{{1}}}|Event of Default}}. Sounds simple? Well: ride with me a while.

Origins in the loan market

Cross default is grew out of the traditional loan market, and was transplanted into derivatives at the dawn of the Age of Swaps. Consider a traditional unsecured loan. Its characteristics are as follows:

Firstly, there is an identifiable lender — usually a bank — and borrower — usually a business — in a formalised relationship of dominance and subservience. Their roles in this power structure cannot change. The lender is, always, the lender: it gives away its money against the borrower’s bare promise to later give it back. The borrower does not have risk to the lender.

Secondly, a loan is an outright allocation of capital from lender to borrower. There, intrinsically, credit risk. The lender’s main concern is that the borrower can give the money back. It will want the right to force it to if the borrower’s creditworthiness takes a turn for the worse. The bank therefore wants its “weapons” pointed on the borrower. The borrower, contrast, has no need to point any weapons at the bank.

Thirdly, the borrower has few payment obligations: usually, only periodic interest and final repayment. Most of the borrower’s obligations come at the end of the contract.

Fourthly, unless the borrower defaults, the bank cannot get its money back before expiry of the term. All it is entitled to is periodic interest on the amount loaned.

Because the borrower has infrequent payment obligations, and they are large, the bank will want to be able to call a default as soon as it thinks the customer will not be able to repay. It will not want to wait and see.

But what default events can it look to? “Failure to pay” or “breach of agreement” won’t do, because there might not be any payment obligations due under the loan. If the borrower has loans with other banks, it may owe interest on them before it owes anything under this loan.

This will make all bank lenders nervous: if the borrower becomes distressed, everyone will want to use their weapons as soon as possible: there is an advantage to being the first lender to pull the trigger. If one lender shoots — if it even becomes entitled to shoot — then the other banks will want to be able to shoot, too.

Hence, the concept of “cross default”: should a borrower be in material default under a third-party loan, cross default permits the bank to call in its loan, too, even though the borrower has not missed any payments directly. Even if none were even due.

This puts the borrower’s lenders into a standoff: all will have “twitchy trigger fingers”. All will want to accelerate their loans as soon as anybody else is entitled to.

There is a curious “systemantic” effect here: though {{{{{1}}}|Cross Default}} is designed as credit mitigant, its very existence makes a credit default more likely.

The loan market therefore developed some “thresholds” around the cross-default concept: firstly, you could only invoke {{{{{1}}}|Cross Default}} if the borrower’s default exceeded a certain monetary value. {{{{{1}}}|Cross Default}} should only apply to events material enough to threaten the borrower’s solvency.

Recap: {{{{{1}}}|Cross Default}} is meant to protect against the risk of material uncollateralised indebtedness, on terms containing infrequent payment obligations, where the borrower also has significant indebtedness to other lenders in the market. It is a one-way right. A borrower has no cross-default right against a lender.

The ISDA evolved from the loan market

We have seen that the ISDA Master Agreement developed out of the loan market. Early swaps were offsetting loans. They were documented by lawyers who were banking specialists: they were used to thinking about the world in terms of lending.

It was only natural that early versions of the ISDA Master Agreement included the usual set of banker’s “weapons” to manage the risk of default. That included {{{{{1}}}|Cross Default}}.

Swaps are different

But swaps are not very much like outright loans. They are financing, not lending arrangements: The swap dealer does not allocate capital outright to the customer, as a lender does. Financing and lending are fundamentally different activities. They present different risks.

Swaps, also, are by their nature fully bi-directional. There is no fixed lender and borrower. (In theory there’s no lender or borrower at all). Under a swap, either party can “owe money”. Who is “in-the-money” can change suddenly, without warning and it has nothing to do with the parties’ relative creditworthiness.

This means the {{{{{1}}}|Events of Default}} under the ISDA Master Agreement must be symmetrical and bi-directional: if there is to be a {{{{{1}}}|Cross Default}} right, it must point in both directions. Therefore, unlike in a traditional loan the {{{{{1}}}|Cross Default}} in the ISDA Master Agreement applies equally to the bank as it does to the customer.

This presents some rather curly conceptual challenges, as we will see.

Cross default is not needed in a swap

In any case, the risks of loans that {{{{{1}}}|Cross Default}} address, broadly, do not hold for swaps:

Firstly, swaps are not primarily instruments of uncollateralised indebtedness.

Secondly, there tend to be multiple small Transactions rather than a single big one: therefore payments under the ISDA architecture are frequent and flow in both directions, especially under an ISDA Master Agreement with multiple Transactions. You don’t have the “no coupon due for six months” problem.

Thirdly, ISDA Master Agreements are typically margined, so even though it is conceptually possible for uncollateralised exposure to arise under an ISDA, in practice, it there won’t be much and it will be quickly reset.

Lastly, the majority of swap end users will not have significant unmargined third-party debt: investment funds[1] tend to invest on margin. They do not borrow under uncollateralised loans. So there are few instances of specified indebtedness that they are likely to trigger. It is far more likely that a bank counterparty or swap dealer will have material specified indebtedness. This is a bit of a self own.

You would not expect {{{{{1}}}|Cross Default}} to often arise as a sole means of closing out an ISDA Master Agreement. Usually, there would long since have been a {{{{{1}}}|Failure to Pay or Deliver}} or {{{{{1}}}|Bankruptcy}}, and both of those events are a much more deterministic, identifiable and therefore safe means of bringing an ISDA arrangement to an end.

How does Cross Default work?

Imagine swap counterparty N who, alongside its ISDA Master Agreement with you, has significant {{{{{1}}}|Specified Indebtedness}} to lenders A, B and C.

Should N default under any (or all) of that indebtedness — that is, should those lenders become entitled to call in their loans, whether or not they actually do — in a total sum exceeding the “{{{{{1}}}|Threshold Amount}}” in your ISDA, you would be entitled to close out your ISDA.

“Specified Indebtedness”

What counts as “{{{{{1}}}|Specified Indebtedness}}”? The ISDA itself defines it as “borrowed money” without further elaborating on what that means.

Payment obligations

This is considerably narrower than “all payment obligations”, Though it is not unknown for sophisticated counterparties to widen the definition to include all of these. This is madness.

Financing arrangements

“Borrowed money” excludes margined financing arrangements.[2] “Financing arrangements” includes a wide selection of capital markets transactions including margin loans, synthetic prime brokerage, swaps, stock loans and repos.

These are “asset transformations” rather than borrowings and do not involve uncollateralised “indebtedness” as such: at inception, the party raising money gives title to an asset of greater value to the financer, and is subsequently margined to that asset value. Therefore net, the financing beneficiary is not a debtor at all, but a creditor.

This does not stop credit officers expanding the definition of “{{{{{1}}}|Specified Indebtedness}}” to bring them into scope — a favourite tweak is to include derivatives and securities financing arrangements as {{{{{1}}}|Specified Indebtedness}} without stopping to clarify how the “borrowed money” under them (hint, under a margined ISDA, there will not be any) is to be measured.

For reasons we will come to, this is a grave mistake.

Bank deposits

Bank deposits plainly areborrowed money”, and they mightily add up: as we will see, aggregation is important when calculating the {{{{{1}}}|Threshold Amount}}.

Bank deposits illustrate the problem of applying cross default in a bidirectional financing contract: In the traditional loan market, bank deposits are not in scope for Cross Default because only credit institutions — banks — can accept deposits, and they are the lending party and cross default does not apply. End users cannot take deposits.

But the ISDA is bilateral, so deposits are in scope and could trigger a {{{{{1}}}|Cross Default}} against a bank. It is not out of the question that a bank could be prevented from honouring deposits through operational error, IT outage or geopolitical incident. This would put it in technical default on a large number of its deposits at once.

Therefore, banks exclude retail deposits from the ambit of {{{{{1}}}|Specified Indebtedness}}. They will not lightly resile from this position, so buy-side legal eagles looking for a ditch to die in are advised to avoid this one.

Public indebtedness

wWth the honourable exception of publicbond issuances, most {{{{{1}}}|Specified Indebtedness}} arises under private arrangements about which the market will have no reliable real-time information. No one will know how much a given borrower owes, much less whether it has defaulted.

This makes practical policing and enforcement of a {{{{{1}}}|Cross Default}} right fraught, where it is even possible.

“Default”

“Default” is described widely and (at least in the 2002 ISDA) is not restricted to payment defaults. A technical breach of representations that entitled a lender to accelerate indebtedness over the {{{{{1}}}|Threshold Amount}} would be an actionable {{{{{1}}}|Cross Default}}.

The lender does not have to accelerate

Vitally, the lender need not actually accelerate the loan. The cross-default right arises as soon as it is entitled to. This makes the {{{{{1}}}|Cross Default}} event a very powerful and sensitive tool. Too powerful. Too sensitive.

See below for our discussion of cross acceleration — a weakened version of {{{{{1}}}|Cross Default}} that requires the loan to be actually called in.

“Threshold Amount”

The {{{{{1}}}|Threshold Amount}} is the level over which accumulated defaults in {{{{{1}}}|Specified Indebtedness}} trigger {{{{{1}}}|Cross Default}}.

The {{{{{1}}}|Threshold Amount}} is usually a cash amount or a percentage of shareholder funds, or both, in which case — schoolboy error hazard alert — be careful to say whether it is the greater or lesser of the two.

It should be existentially-threateningly large

Because of the extreme risk that cross-default presents, the threshold amount should be set at an amount representing an existential threat to the counterparty’s solvency. For a bank counterparty, that is typically two or three per cent of its shareholders’ equity or the cash equivalent. Note a cash equivalent runs the risk of decoupling from the value of shareholders’ equity so, while it is easier to measure and monitor, it presents a greater systemic risk, and you may find it more prudent to stick with an equity-linked threshold.

Snowball risk

This “accumulation” feature means that relatively trivial amounts of indebtedness can be problematic particularly where there are a lot of them — see bank deposits and swap transactions — or where the default is technical, systemic or operational. Should a system outage prevent a counterparty honouring a class of contracts it might instantly trigger a catastrophic cross-default right across all ISDA Master Agreements.

For buy-side parties (especially for thinly capitalised investment vehicles) the {{{{{1}}}|Threshold Amount}} may be a lot lower than that — like, ten million dollars or so — and, of course, for fund entities will key off NAV, not shareholder funds.

Problematic derivatives

Bear in mind, too, that if even one of your ISDA contracts has a lower {{{{{1}}}|Threshold Amount}}, that can create a chain reaction: because the exposure under that ISDA, once it has been triggered by a {{{{{1}}}|Cross Default}}, then contributes to the total amount of defaulted Specified Indebtedness and may itself lead to {{{{{1}}}|Threshold Amount}}s being triggered in other ISDAs. And each of those then contributes … you get the idea.

Cherry-picking

There is one last problem with including swaps: what is the “indebtedness” you are measuring? You could look at individual Transaction exposures and aggregate them. Nothing requires you to apply a Single Agreement concept or cross-transactional netting to those exposures. (Why would it? ISDA contracts are designed to be out of scope for {{{{{1}}}|Cross Default}}). If you bring them into scope you could, in theory, cherry-pick all out-of-the-money {{{{{1}}}|Transactions}}, total them up and cross a {{{{{1}}}|Threshold Amount}} fairly easily.

Even if {{{{{1}}}|Specified Indebtedness}} is calculated by reference to a net close-out amount, this only really points up the imbalance between dealers and their customers. Sure, big fund managers may have ten, twenty or even fifty ISDA Master Agreements, but they will be split across dozens of different funds, each a different entity with its own {{{{{1}}}|Threshold Amount}}. Swap dealers, on the other hand, will have literally hundreds of thousands of master agreements, all facing the same legal entity. Dealers are the wrong side of this risk.

Now, you could manage this by careful negotiation — but there is a better way: excluding financing transactions altogether, for the perfectly sensible reason that they are not “borrowed money.

Cross default as a “most favoured nation” clause

While the ISDA {{{{{1}}}|Events of Default}} are standardised, bilaterally-negotiated default events under private loans will be highly customised.

Especially since Section {{{{{1}}}|5(a)(vi)}} Is loose about what counts as a qualifying default:

“a default, event of default or other similar condition or event (however described) in respect of such party”.

This is loose and could for example include potential events of default (those which will become an event of default on expiry of a grace period).

This turns {{{{{1}}}|Cross Default}} into a “most favoured nation” clause, dragging into the ISDA every single “default or similar event” from the counterparty’s {{{{{1}}}|Specified Indebtedness}}. This is wide, swingeing term and Is likely to be much more severe against bank and dealer counterparties than end users, since banks will have a lot more indebtedness.

  1. In this I include hedge funds, mutual funds, index funds, ETFs, pension funds, life insurance plans, private equity funds and sovereign wealth funds.
  2. See elsewhere.