Template:Isda Automatic Early Termination summ

{{{{{1}}}|Automatic Early Termination}} is an odd and misunderstood concept which exists in Section {{{{{1}}}|6(a)}} {{{{{1}}}|Right to Terminate Following Event of Default}} of the ISDA Master Agreement. As is so much in the ISDA Master Agreement, it’s as much to do with managing regulatory capital implications — in particular, vouching safe close-out netting — as it is about substantive credit risk mitigation.

Where the bankruptcy rules in a counterparty’s jurisdiction permit insolvency administrators to suspend contractual terms once the counterparty is formally insolvent, the idea is to have the ISDA break the exact moment — or even before — that suspension kicks in. Therefore, the regulatory capital boon afforded by close-out netting works.

{{{{{1}}}|AET}} It was introduced in the 1987 ISDA, but was not labelled “{{{{{1}}}|Automatic Early Termination}}” in that agreement, possibly because it was not conceived as an optional election to be used with caution where needed: it just sat there and applied across the board.

{{{{{1}}}|AET}} is thus only triggered by certain events under the {{{{{1}}}|Bankruptcy}} event of default — formal bankruptcy procedures — and not by economic events that tend to indicate insolvency (such as an inability to pay debts as they fall due, technical insolvency or a creditor’s mere exercise of default rights or enforcement of security. Though, interestingly, those events (captured in limbs (2) and (7) of the {{{{{1}}}|Bankruptcy}} definition) did trigger automatic early termination in the 1987 ISDA. This is just one more reason not to use that edition, if there are any Burmese Junglers out there looking for one.

{{{{{1}}}|AET}} does not apply to other {{{{{1}}}|Events of Default}}.

It is now an election

Though the 1987 ISDA} triggered automatic termination upon any type of {{{{{1}}}|Bankruptcy}} event for any counterparty in any jurisdiction, it has since turned out that the mischief against which {{{{{1}}}|AET}} guards does not really arise in most jurisdictions: only those a history of Teutonic jurisprudence.

In those (e.g., Germany, Austria and Switzerland) immediately upon commencement of formal bankruptcy proceedings a bankruptcy administrator would be entitled “cherry-pick” those {{{{{1}}}|Transaction}}s it wishes to honour (typically, those that are in-the-money to the {{{{{1}}}|Defaulting Party}} whose estate it is administering) and those it wished would just conveniently vanish from the financial record (namely those where the {{{{{1}}}|Defaulting Party}} is out-of-the-money).

Since the whole point of the {{{{{1}}}|Single Agreement}} and the close-out netting concept is to get to a market exposure as close as possible to zero before launching any recovery actions, this kind of cherry-picking would completely demolish the entire capital theory on which the ISDA Master Agreement is founded. Hence, Automatic Early Termination!

In any case, since the 1992 ISDA {{AET has been an election that you toggle on or off for each counterparty in Part 1 of the {{{{{1}}}|Schedule}}.

It only has limited use

{{{{{1}}}|AET}} is only really useful:

(1) to a regulated financial institution, which
(2) would incur a capital charge if it doesn’t have a netting opinion, and
(3) where it wouldn’t get that netting opinion for a particular counterparty without {{{{{1}}}|AET}} being switched on in its ISDA Master Agreement.

There are only a few counterparty types where these conditions prevail: the German and Swiss corporates mentioned above, for example. There may be others, but not many, because {{{{{1}}}|AET}} is a good-old-days, regulators-really-are-dopey-if-they-fall-for-this kind of tactic. It only really survives these days because it is so part of the furniture no-one has the chutzpah to question it, despite the trail of destruction and confusion it has left across the commercial courts of the US an the UK.

I mean, really? Deeming your ISDA to have magically terminated, without anyone’s knowledge or action, the instant before that termination would become problematic as a result of your insolvency? Come on. Is any sophisticated insolvency regime going to buy that kind of magical thinking? (No slight meant on Germany or Switzerland here: the “Teutonic” AET does not deliver netting where unequivocally it would otherwise be forbidden, but rather buttresses residual doubt about the effectiveness of netting during insolvency as a result of looseness in insolvency regulations that aren’t categorical that you can net. The view is generally it should be okay in insolvency, but there are just some freaky discretions that may make life awkward if used maliciously. This is not legal advice.)