Template:M summ 2002 ISDA 2(a)(iii)

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.