Template talk:Isda Automatic Early Termination summ

HAL 9000: Just a moment — just a moment — I just picked up a fault in the AET-87 Unit.

Frank Poole: What is it?

HAL 9000: It’s a device for optimising regulatory capital, but that’s not important right now.

David Bowman: What’s the problem, HAL?

HAL 9000: It’s going to go one hundred per cent. failure, within 72 hours.

Poole: Surely, you can’t be serious?

HAL 9000: I am serious. And don’t call me “Shirley”.

Bowman: (sticking to the script) I don’t know what you’re talking about, HAL?

Cue musical introduction

HAL9000: Well, I’ll tell you.

Chorus: He’s going to tell!
He’s going to tell!
He’s going to tell!
He’s going to tell! —

Poole: Stop that! Stop that! No singing!

Carries on for three hours in this vein

—Monty Python and the Magnetic Anomaly from Airplane!

Automatic Early Termination — colloquially, “AET”, but not to be confused with “ATE” (Additional Termination Event) or “ETA” (Early Termination Amount) — is an odd, feared and misunderstood concept buried at the back end of Section 6(a) (Right to Terminate Following Event of Default).

In a document stuffed with arcanities, Automatic Early Termination is especially abstruse, so if you are hitting this article cold then, firstly: what the hell are you doing; and secondly some background reading is in order:

Recommended background reading

• Bankruptcy phase transition: The difference between insolvency and bankruptcy and why the phase transition between them is a weird dreamtime that freaks derivatives lawyers out.
• Bankruptcy shenanigans and why they present a unique problem for derivatives counterparties that normal creditors are less bothered about.
• Single Agreement: The unbearable weirdness of ISDA’s single agreement concept.
• Regulatory capital: The rules on how much capital a regulated financial institution is required to hold, and how that is calculated.
• Closing out an ISDA: The law and lore of closing out an ISDA
• Flawed asset: ISDA’s notorious “flawed asset” provision: Section 2(a)(iii).

Automatic Early Termination provision is triggered when a party to whom it applies suffers an in-scope Bankruptcy Event of Default. If it is triggered, all outstanding Transactions are instantly and automatically terminated, without the need for any action by — or even the knowledge of — the Non-Defaulting Party. This usually means instantly, but in one case, it is even quicker than that.

If the Bankruptcy event is the presentation to the court by a creditor of a formal petition seeking the entity’s bankruptcy under Section 5(a)(vii)(4) — let us call this a “bankruptcy petition”, some creative warping of lexophysical swaptime is required. We will discuss this at some length and with wistful pedantry, in the premium content section.

In taking things out of the Non-Defaulting Party’s hands, AET subverts the normal order of things under the ISDA Master Agreement. Normally, the Non-Defaulting Party is in control. It may, but need not, call an Event of Default if the circumstances justifying one exist. AET is, well, automatic. It even obliterates the Non-Defaulting Party’s right to waive designation of an Event of Default, since by the time it is in a position to do so, the Event Default has already been declared.

(Could a NDP pre-waive in anticipation? See “Anticipatory waiver?” in the premium section.)

JC’s view is that Automatic Early Termination is a bad solution to an unlikely problem, but since it is embedded in every ISDA on the planet, and remains present in the minds of those who mandate capital calculations, we are stuck with it.

The theory

“Formal bankruptcy is a “phase transition”: the whole “legal context” surrounding a company changes. Erstwhile certainties vanish: normal rules of contract, debt and credit are suspended; in their place arise uncontrollable vagaries. The court appoints a bankruptcy administrator and invests her with wide, nightmarish discretions to do as she pleases, within reason, to sort out who gets what while ensuring the right thing is done by all the bankrupt’s creditors, customers, employees and, if there is anything left, shareholders. All, therefore, must fall upon her mercy”

—The phase transition of bankruptcy

Where a Defaulting Party’s bankruptcy regime allows its administrator to suspend its contractual terms or cherry-pick which of its Transactions to honour, it would help the Non-Defaulting Party if the ISDA were to automatically terminate before that phase transition occurred. To be safe, termination should happen at the exact moment — or even an infinitesimal moment before — that bankruptcy regime comes to life.

Bankruptcy shenanigans could affect a Non-Defaulting Party’s rights in at least two ways: Firstly, it may prevent it closing out Transactions at all. The bankruptcy administrator may have the discretion to affirm or avoid individual Transactions. This bigly messes with the fundamental philosophy of the ISDA Master Agreement.

Secondly, it may impact netting rights: a party having exercised its close-out right, ISDA’s “single agreement” operates to net all Transaction exposures down to a single sum. If a bankruptcy administrator is allowed to enforce some Transactions and set aside others — that is, to “cherry-pick” — that netting right is compromised, especially if the administrator has tactically DK’d only your profitable trades.

History

We rarely look back to the 1987 ISDA these days; few Burmese Junglers remain out there fighting the good fight, but sometimes the fossil record gives us purchase on the state of modern biology all the same. So it is with Automatic Early Termination which was introduced, uncredited, in the 1987 ISDA.

Bear in mind the broad sweep of three historical trends that converged in the 1980s.

Financialisation

First, the rapid onset of financialisation of, well, everything, due to parallel developments in information technology. Through the Seventies and Eighties, Western markets acquired the mental habits and technical systems they needed to look at financial risk in a much more detailed, segmentable way: as “substrate-neutral” derivatives of real-world propositions.

Financial instruments traded electronically. Increasingly, institutions modelled their risk with computers. They unbundled big, organic, ineffable risks into discrete tradable components: first, market risk and credit risk. Then into more esoteric measures: volatility. Liquidity. Convexity. Correlation. Credit and debt value.

At the same time, the market developed the legal and contractual tools to implement this new way of thinking about risks. Principle among them was a new class of bilateral financial contracts unlike anything the world had seen before, in which the usual master-slave relationship between creditors and debtors and between bankers and their customers were rendered — apparently — moot. There was no lender or borrower. The parties were equals: traders.

The ISDA Master Agreement was at the vanguard of these new bilateral contracts.

At the same time, powered by the same irrepressible forces of modernity, the market internationalised. Reducing financial instruments to electronic impulses made cross-border trade easier. While central banks could manage prudential supervision in their own jurisdictions, it was difficult for them to do it across global financial markets where different regulatory regimes presented all kinds of arbitrage opportunities.

New capital regulation

These developments in banking and market technology called for a more sophisticated framework for managing institutional risk in the global markets. Banks were increasingly interconnected, both across exchanges and in private over-the-counter markets, and the speed at which they traded, and at which trading values fluctuated, meant there was heightened systemic risk should major institutions get into trouble. The Latin American debt crisis was a case in point. Even smaller participants could have a disproportionate effect on system stability. We saw this, a bit later, when the brainbox-stuffed pioneering relative value arbitrage hedge fund Long Term Capital Management blew up and almost took Western banking civilisation with it. Some would say that would have been no bad thing.

At the same time the innovative financial instruments, which tended to be leveraged and shared few of the characteristics of traditional financial instruments, meant effective capital ratios at financial institutions declined over the 1980s. It became apparent that the worst-case loss scenario for a master trading agreement like the ISDA was orders of magnitude greater than that presented by exposure to, for example, a syndicated loan. As a result, the Basel Committee on Banking Supervision introduced harmonised global standards for the capital treatment of financial instruments, including these new swap contracts. These rules, now known as Basel I, were first published in 1986. The following year, the 1987 ISDA arrived.

Corporate resolution didn’t change

While there was a good deal of harmony in the international capital markets, many domestic bankruptcy regimes — which were targeted at small and medium-sized enterprises and typically did not have such an international focus — did not similarly change or update.

Swaps remained an arcane part of the international capital markets. They were not relevant to the SMEs. Companies regulators, assignees and administrators did not well understand them, or how they worked. Having local tax and employment liabilities and “trade credit” arrangements in mind, Bankruptcy regimes tended to confer broad discretions on receivers and liquidators to ensure fair outcomes for all claimants upon a company’s resolution.

But broad discretion means lack of certainty, and financial markets do not like uncertainty. Especially not for highly unusual, levered arrangements like swaps, which are not by nature creditor-debtor arrangements. Should an administrator try to “cherry-pick” the in-the-money transactions in a swap portfolio, the implications for swap dealers — who had only entered into them at all on the assumption that all exposures, positive and negative, would net down to a single number — could be far worse, and far more volatile, than the corresponding risks presented by an ordinary loan or trade invoice.

Basel I addressed this “local insolvency risk” by requiring swap dealers to obtain written and reasoned legal opinions that, under local bankruptcy rules, their master agreements could not be cherry-picked in this way. that the “single agreement” concept would work, and their rights to apply close-out netting would be respected.

And this is where the phase transition into bankruptcy becomes important. Typically, while a company is still solvent and trading in the ordinary course, its master trading agreements may be enforced, and netted, according to their terms. It is only at the point of formal bankruptcy that the phantom shenanigans of wide-ranging equitable discretion hove into view. In some jurisdictions, the point at which everything changes is a split second, and getting the right side of it makes all the difference.

Insolvency versus bankruptcy

As we note elsewhere, there is common confusion between the accounting status of “insolvency”, which has no formal legal status and therefore makes no particular difference to the effectiveness of netting, and the legal status of “bankruptcy”, which does. Mere insolvency may lead to bankruptcy, but need not: they are different concepts and have different legal implications (in that bankruptcy has some, insolvency does not). Only once you are into formal bankruptcy are bankruptcy shenanigans on the cards.

ISDA’s definition of “Bankruptcy” somewhat jumbles the concepts up. Some ISDA Bankruptcy events (especially cashflow/balance sheet insolvency and composition with creditors) are “pre-phase transition events”, are not really observable, nor are they accompanied by formal changes in the application of laws of contract and should not trigger Automatic Early Termination.

1987: a blunt instrument

In the 1987 ISDA they do anyway. Automatic Early Termination applies across the board, to all Bankruptcy events, and all counterparties: it is not even an optional election, to be engaged judiciously when needed. It just sits there and applies across the board if any Bankruptcy Event of Default should be declared. You could engineer your Schedule to disable it, but this would require initiative.

This presented a real risk of indeterminacy, where the facts triggering an insolvency-style Bankruptcy were not public or even easily determinable. How are you meant to know whether your counterparty is balance sheet insolvent? Even for the company’s own accountants, this is more a matter of art than science. If mere insolvency triggered AET, it would be impossible to know whether a given ISDA was alive or dead. And that is before you even consider the impact of Section 2(a)(iii).

There is this weird thing: Automatic Early Termination could be triggered without notice, action or knowledge, and that would trigger a section 2(a)(iii) suspension, also without notice, action or knowledge. In that case, it is hard to see what to make of unexplained non-performance by your counterparty under the contract. Was it bankrupt? Or did it think you were bankrupt?

1992: Slow reverse-ferret

The history since 1987 has been to slow-walk AET back — not nearly fast enough, in this commentator’s opinion — from that highly unsatisfactory epistemological state. By 1992, AET excluded the “soft” economic insolvency events and was limited to circumstances with a live risk of bankruptcy shenanigans.

The 1992 ISDA also converted AET into an optional election in Part 1 of the Schedule. For most parties, in most jurisdictions, it stays off.

2002: grace periods tighten

In 2002 a further refinement was implemented in the definition of “bankruptcy petition”. ISDA’s crack drafting squad™ split Section 5(a)(vii)(4) in two: a bankruptcy petition instituted by a regulator is not subject to a grace period; one instituted by anyone else — such as a creditor — would only mature into an Event of Default if ordered by the Court, or not otherwise discharged within a 15-day grace period — down from the 30 days in the 1992 ISDA.

If a regulator is taking formal action against you, the game is certainly up. A grace period here serves no real purpose. A mere creditor doing so may be little more than a rather brusque debt-collection tactic: it may not indicate any genuine concern about a party’s ability to pay its debts, but rather be a pointed hurry-up. In that case, a bankruptcy petition can be fairly easily discharged. Hence the grace period.

Few and far between

As it stands there are only a few counterparty types in a few jurisdictions where the conditions for AET prevail. There are not many because — let’s be clear, here — AET is a bit of try on: any self-respecting netting-hostile bankruptcy regime ought to see straight through it.

It is, after all, a piece of time-travelling contractual magic — it deems Transactions to have terminated, without anyone’s knowledge or action, the instant before the event that, on expiry of a grace period would later trigger it, to avoid the ambit of discretionary rules designed to ensure fairness and prevent just that kind of preference. Expecting this to work very often seems a bit optimistic.

There is a more benign view, but it is still a bit hopeful: Automatic Early Termination helps deliver the appropriate outcome, dispelling residual doubt about ambiguous or untested regulatory provisions that were never intended to allow bankruptcy shenanigans, but that were crafted without the sui generis use case of the master trading agreement in mind. On this view, AET is a sort of “better be safe than sorry” gambit.

Then there is a pragmatic view. This is blunter: ISDA Master Agreements once were weird innovations that bamboozled and (wrongly) outraged bankruptcy administrators. Nowadays, they are not. Everyone knows what ISDAs are, why they net, why the “single agreement” concept is a sensible plank in the capital structure of the financial system, and why the bankruptcy shenanigans AET seeks to avoid would not produce a fair result for anyone.

This is all well and good. But if, unwittingly, Automatic Early Termination now creates practical risks where once it avoided theoretical ones, it still should be a source of concern. In JC’s view, it does.

We will talk about that at great length in the premium section.