Template:Isda 5(a)(vi) summ

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 characteristics of loans that {{{{{1}}}|Cross Default}} address, broadly, no not hold for swap transactions:

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>

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.

Thirdly, swap payments are therefore usually frequent and flow in both directions, especially under an ISDA Master Agreement with multiple Transactions.

Fourthly, ISDA Master Agreements are typically daily margined to a zero Threshold, so even though it is conceptually possible for indebtedness to arise under an ISDA, in practice, it mostly does not.

Lastly, many customers will not have significant unmargined third-party indebtedness: swap users like investment funds 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 therefore expect to have to use {{{{{1}}}|Cross Default}} often to close 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.

And this is the general experience: {{{{{1}}}|Cross Default}} is much talked about seldom seen.

How does Cross Default work?

Imagine swap counterparty X who, alongside its ISDA Master Agreement with you, has “{{{{{1}}}|Specified Indebtedness}}” - outstanding loan obligations 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.

“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. ISDA’s crack drafting squad™’s drafting simply catches the distinction between a default event happening before the termination date and that final fundamental repayment failure.

“Specified Indebtedness”

What counts as “{{{{{1}}}|Specified Indebtedness}}” is a topic of hot debate.

The ISDA itself restricts “{{{{{1}}}|Specified Indebtedness}}” to “borrowed money” without further elaborating on what that means.

Financing arrangements

Financing arrangements are not caught in the standard wording, as discussed elsewhere. They do not involve uncollateralised “indebtedness” as such but rather are margined transformations of owned assets.

This does not stop credit officers 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.

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

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.

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.

For this reason, banks usually exclude retail deposits from the ambit of {{{{{1}}}|Specified Indebtedness}}. This is sensible and they will not lightly resile from it, so buy-side legal eagles looking for a ditch to die in are advised to avoid this one.

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.

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 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.

“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:

“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”

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.

Snowball

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 ISDA Master Agreements.

Because of the snowball effect that a cross default clause can have the {{{{{1}}}|Threshold Amount}} for should be big: like, 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.

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.

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 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.

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 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.

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”.

Now seeing as most master trading agreements 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.

But if no {{{{{1}}}|Threshold Amount}} is ever likely to be breached, then why are you including Specified Indebtedness in the first place?

O tempora. O paradox.