Cross Default - ISDA Provision
See Also
Cross Default under the 1992 ISDA
The text of Section 5(a)(vi) the 1992 ISDA Master is as follows:
- 5(a)(vi) Cross Default. If “Cross Default” is specified in the Schedule as applying to the party, the occurrence or existence of
- (1) a default, event of default or other similar condition or event however described) in respect of such party, any Credit Support Provider of such party or any applicable Specified Entity of such party under one or more agreements or instruments relating to Specified Indebtedness of any of them (individually or collectively) in an aggregate amount of not less than the applicable Threshold Amount (as specified in the Schedule) which has resulted in such Specified Indebtedness becoming, or becoming capable at such time of being declared, due and payable under such agreements or instruments, before it would otherwise have been due and payable or
- (2) a default by such party, such Credit Support Provider or such Specified Entity (individually or collectively) in making one or more payments on the due date thereof in an aggregate amount of not less than the applicable Threshold Amount under such agreements or instruments (after giving effect to any applicable notice requirement or grace period);
Cross Default under the 2002 ISDA
The text of Section 5(a)(vi) the 2002 ISDA Master provides:
(vi) Cross-Default. If “Cross-Default” is specified in the Schedule as applying to the party, the occurrence or existence of:― (l) a default, event of default or other similar condition or event (however described) in respect of such party, any Credit Support Provider of such party or any applicable Specified Entity of such party under one or more agreements or instruments relating to Specified Indebtedness of any of them (individually or collectively) where the aggregate principal amount of such agreements or instruments, either alone or together with the amount, if any, referred to in clause (2) below, is not less than the applicable Threshold Amount (as specified in the Schedule) which has resulted in such Specified Indebtedness becoming, or becoming capable at such time of being declared, due and payable under such agreements or instruments before it would otherwise have been due and payable; or (2) a default by such party, such Credit Support Provider or such Specified Entity (individually or collectively) in making one or more payments under such agreements or instruments on the due date for payment (after giving effect to any applicable notice requirement or grace period) in an aggregate amount, either alone or together with the amount, if any, referred to in clause (1) above, of not less than the applicable Threshold Amount;
Introduction
A cross default provision in an agreement allows a non-defaulting party, on a default by the other party under any separate contract it may have entered for borrowed money, to close out the agreement containing the cross default provision. Compare this with a cross acceleration provision, where the lender of the borrowed money must actually have taken steps to accelerate the borrowed money as a result of the default before the default becomes available as a termination right under the first agreement.
Cross Default is a potentially very damaging clause, as this picture to the right amply illustrates. To the extent it doesn't:
Cross Default
a cross default provision against a party imports into the ISDA all of the termination rights upon default under any Specified Indebtedness owed by that party:
- It has the effect of dramatically (and indeterminately) widening the definition of Event of Default.
- Cross default entitles a Counterparty to accelerate the ISDA whether or not the Specified Indebtedness in question itself has been accelerated.
- Depending on the market value of the transactions under the ISDA at the time of termination, therefore exercise of a cross default may lead to an immediate capital outflow.
Specified Indebtedness
Specified Indebtedness means, generally, any borrowings that, in aggregate, exceed a designated Threshold Amount. Because of the aggregation right, even comparatively trivial agreements can trigger the provision where they are relatively homogenous and affected by the same local circumstances (for example, retail deposits). A low Threshold Amount, therefore, presents three challenges:
- It allows a more varied (and difficult to monitor) range of potential termination rights, because a greater number of agreements will qualify as Specified Indebtedness.
- It “lowers the bar” so failures to comply with comparatively trivial financial commitments could be aggregated to trigger the Cross Default.
- By not excluding bank deposits, it raises the possibility of being triggered by localised events unrelated to BBPLC’s credit (for example, political action in a single jurisdiction which affects BBPLC’s ability to pay on its local deposits)
- Note that repo is not considered specified indebtedness: see borrowed money.
Derivatives as Specified Indebtedness
Derivatives should never be included in the definition of Specified Indebtedness, no matter how hight the Threshold Amount. the Cross Default language aggregates up all individual defaults, so even though a single ISDA would be unlikely to have a net out-of-the-money MTM of anything like 3% of shareholder funds, a large number of them taken together may, particularly if you’re selective about which ones you’re counting. Which the cross default language entitles you to be.
Thus, where you have a number of small failures, you can still theoretically have a big problem. This is why we don’t include deposits: operational failure or regulatory action in one jurisdiction can create an immediate problem.
The same could well be true for derivatives. Individual net MTMs under derivative Master Agreements can be very large. We have a lot of Master Agreements (18000+).
Say we have an operational failure (triggering a regulatory announcement, therefore public) or a government action in a given jurisdiction preventing us from making payments on all derivatives in that jurisdiction. We could have technical events of default on a large number of agreements at once – unlikely to be triggered, but for a cross default, that doesn’t matter.
The net MTM across all those agreements may well not be significant. But an opportunistic counterparty could tot up all the negative mark to markets, ignore the positive ones, and reach a large number very quickly.
Cross Default is a banking concept intended to reference borrowed money - indebtedness etc - and it really doesn’t make economic sense to apply it to derivatives – the fact that there’s a cross default in derivatives documentation at all is something of a historical accident. There are good points made below about the difficulty of calculating it and knowing what to apply it to (MTM? Termination Amount? Payments due on any day?) – bear in mind these values are not nearly as deterministic as amounts due wrt borrowed money: on a failure of a derivative contract the valuation of the termination amount (off which Cross Default would calculate) is extremely contentious. The market is still in dispute with Lehman, for example.
Credit Mitigation
Cross Default is intended to be a tool for mitigating credit exposure. It should be set at a level which reflects a material credit concern in the context of the entire enterprise. By convention, the market generally imposes a Threshold Amount equating to between 2 and 3 percent of shareholders’ funds (as at 2009 annual report, 2% of [Counterparty] Shareholders’ funds would be £1.1bn).
Credit Support Annex
There are other ways of mitigating credit exposure (such as a zero threshold 1995 CSA). If a Counterparty's positive exposure to [Counterparty] will be fully collateralised on a daily basis, meaning its overall exposure to [Counterparty] at any time will be intra-day movement in the net derivatives positions (a failure to post collateral itself is grounds for immediate termination).
Contagion risk
It is important to maintain minimum standards which are reflective of genuine credit concerns against the bank so as to limit a “snowball” effect: were we to allow a £50mm Threshold Amount, we would potentially be open to a large number of derivative counterparties simultaneously (and opportunistically) closing out out-of-the-money derivatives positions, which in itself could have massive liquidity and capital implications.
ISDA Master Agreement
Under the ISDA Master Agreement, if the cross default applies, the occurrence with respect to a party of a payment default under, or other circumstance that could result in the early termination of, Specified Indebtedness above an agreed Threshold will give the other party the right to terminate transactions under the ISDA Master.
Specified Indebtedness is usually defined to any claim against a party (by any third party) for borrowed money (e.g. bank debt; deposits etc.) and the Threshold which triggers it is usually defined as a cash amount or a percentage of shareholder funds. For BBPLC, see Cross default - Treasury policy, which and note in particular the requirement to carve out deposits in certain circumstances).
If the cross default applies, the terms of any Specified Indebtedness owed by the counterparty above the Threshold are, in effect, indirectly incorporated into the ISDA Master Agreement. For example, the breach of a financial covenant in a qualifying loan facility, even if not acted upon by the lender of that facility would give a swap counterparty the right to terminate transactions under the ISDA Master even though the ISDA Master itself contains no financial covenants.
Cross Aggregation
The 2002 ISDA Master amends the 1992 ISDA Master cross-default provision so that if the outstanding amount under the 2 limbs of cross-default added together breach the Threshold Amount, then that will trigger cross default. Normally, under the 1992 ISDA, cross-default is only triggered if an amount under one or the other limbs is breached.
As per the above, the two limbs are:
- a default or similar event under financial agreements or instruments that has resulted in indebtedness becoming capable of being accelerated and terminated by a Non-defaulting Party
- a failure to make any payments on their due date under such agreements or instruments after notice or the expiry of a grace period.