Talk:Cross default
Cross Default is designed to cover the unique risks that come from lending money to people who have also borrowed heavily from other people, likely on better terms than you. The basic vibe is: if any of this other borrowing becomes theoretically payable then I want the right to terminate my ISDA as well.
Sounds simple, doesn’t it. Well: ride with me a while.
Cross default’s origins in the loan market
Cross default is an ancient concept. It grew out of the traditional loan market and was transplanted into the swaps market 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 big institutional bank — and an identifiable borrower — usually a small business or an individual. They are in a formalised relationship of dominance and subservience, and this power structure and their roles will not change. The bank is, always, the risk taker: it is giving away its money against nothing but the borrower’s earnest promise to later give it back.
- Secondly, therefore a loan represents the outright allocation of a large amount of capital from the bank to the customer: there is an intrinsic creation of credit risk. A large part of the bank’s business is assessing whether the borrower is likely to give the money back and implementing terms in its loan contract to force the borrower to give the money back if things do not go according to plan. The bank therefore keeps its “weapons” trained on the borrower. Conversely, once thre borrower has the money, it is not at risk to the bank. The borrower does not need to point any weapons at the bank.
- Thirdly, this allocation of capital is time-constrained. Unless the borrower defaults, the bank cannot get its money back before the specified term. All it is entitled to is interest on the amount loaned.
- Fourthly, as a consequence, during the term of the loan, the borrower will not often have to pay any money to the borrower. Usually, only periodic interest, and that might only be quarterly or even semi-annually. All the borrower’s financial obligations are “rear-loaded”. They all come at the end of the loan contract.
The bank is at significant risk, therefore, if the customer’s creditworthiness deteriorates during the term of the loan. This is what its weapons are there to manage: The bank will want to be able to call a default as soon as it thinks the customer will not be able to repay later. It will not want to wait and see.
But what default events can it look to in the loan contract? A “failure to pay” or a “breach of agreement” won’t do, because the customer might not have any payment or performance obligations due under the loan. The bank will not want to wait six months for the next interest payment.
The borrower may have taken out loans with other banks. It may owe money to other lenders before it owes anything to the bank. This will make the bank nervous: other lenders are also exposed to that borrower’s solvency. If the borrower becomes financially distressed, everyone will want to use their weapons. There is plainly an advantage to being the first lender to pull the trigger. If another lender shoots — if another lender even becomes entitled to shoot — then the bank will want to be entitled to shoot, too.
Hence, the concept of “cross default”: should a borrower be in material default under a different contract with a third-party lender, a cross default right permits the bank to call in its loan, too, even though the borrower has not missed any payments to the bank. Even if none were even due.
This is a drastic measure: it puts the bank and the borrower’s other lenders into a kind of Mexican standoff: if you know your borrower has given up a cross-default right to other lenders then all lenders have twitchy trigger fingers. All will want to accelerate their loans as soon as anybody else is entitled to.
There is a curious phenomenon here: a kind of systemantics: though {{{{{1}}}|Cross Default}} is designed as credit-risk mitigant, its very existence makes a credit default more likely. The cruel games we play
The loan market therefore developed some “thresholds” around the cross-default concept: 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.
Remember that {{{{{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.
Also, to reiterate: cross-default is a one-way right. A borrower has no cross-default right against a lender. (Why would it? That would be silly.)
The ISDA evolved from the loan market
We have seen elsewhere that the ISDA Master Agreement evolved in the 1980s out of innovations in the loan market. Early swaps were offsetting loans. They were documented by lawyers who were, by training and disposition, banking specialists: they were used to thinking of the world in terms of lending.
When it came to drawing up early versions of the ISDA Master Agreement it was only natural that the lawyers who drafted it would include the usual suite of banking weaponry to manage the risk of default. That included {{{{{1}}}|Cross Default}}.
Swaps are not like outright loans
But swaps are not very much like outright loans. They are not, by nature, lending arrangements. Swaps are, in a sense, financing arrangements: the swap dealer finances assets, but does not engage in the outright allocation of capital, as a lender does. Financing and lending are fundamentally different activities. They present different risks.
Swaps, also, are by their nature fully bi-directional. Unlike in the loan market, roles are not fixed. There is no pre-determined lender and borrower: under a swap, either party can owe money. Who is “in-the-money” can change at any time.
This means the range of default events 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. The bilateral nature of the {{{{{1}}}|Cross Default}} in the ISDA Master Agreement applies equally to banks as it does to customers. This presents some rather curly conceptual challenges, as we will see.
But in another sense, swaps sort of are like loans. Swap dealers manage their books to be “flat” market risk, whereas swap customers enter swaps to take on market risk. Swap dealers have a quasi-banking role: they may not be allocating capital, but they are arranging it.
The rationale for cross default is not present in a swap
In any case, the features of loans that {{{{{1}}}|Cross Default}} was developed to address are broadly not present in swap transactions:
- Firstly, swaps are not primarily instruments of uncollateralised indebtedness. Swaps are implied financings where, on day 1, the customer is not indebted to the dealer or vice versa. (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).
- Secondly, swap notionals tend to be relatively small compared to the loan facilities in which you might expect to see a cross default.
- Thirdly, swap payments are frequent and flow in both directions, especially under an ISDA Master Agreement having multiple unrelated transactions, with individual payment dates and tenors.
- Fourthly, at least nowadays, 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 ISDA customers will not have significant unmargined third-party indebtedness: most heavy users of swaps like investment funds invest on margin and not by means of outright uncollateralised loan. 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.
How does it 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 any of loans A B or C in a total sum over the specified {{{{{1}}}|Threshold Amount}}, the cross-default provision in your ISDA will entitle you to accelerate all outstanding Transactions under your ISDA.
“Capable of acceleration” versus failure to pay
A bit fussily, Section {{{{{1}}}|5(a)(vi)}} distinguishes between the general acceleration of {{{{{1}}}|Specified Indebtedness}} — a general event of default of any kind at any time during the tenor of any {{{{{1}}}|Specified Indebtedness}} such as the borrower’s bankruptcy, a breach of its reps and warranties, a non-payment of interest, any repudiatory breach of the contract of indebtedness, really — and a failure to pay: a borrower’s failure to fulfil, in full, final repayment of the debt itself when due.
Does not a “failure to pay” count as an acceleration event? This drafting seems redundant? 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.
“Default”
“Default” is described widely and (at least in the 2002 ISDA) is not restricted to payment defaults. A breach of representations or a technical breach of loan covenants would count as an actionable {{{{{1}}}|Cross Default}} as long as it entitled the third-party lender to accelerate the loan.
The lender does not have to accelerate
The lender need not actually accelerate the loan. The cross-default right arises when the lender becomes entitled to accelerate. See below for our discussion of cross acceleration — a weakened version of {{{{{1}}}|Cross Default}} that requires the loan to be actually called in.
Needless to say, this makes the {{{{{1}}}|Cross Default}} a very powerful and sensitive tool. Too powerful. Too sensitive.
Most favoured nation
It also introduces an unusual variability to the ISDA universe: While the {{{{{1}}}|Events of Default}} described in the ISDA Master Agreement are for the most part standardised and inviolate, default events under a bilaterally-negotiated loan facility may well be tweaked. 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.
“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. Clearly it takes in formal loan arrangements; it’s not clear whether trade credit terms would be included — Firth on derivatives thinks not — but in light of the small relative size of those arrangements, it probably doesn’t make much difference in any case.
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
A type of {{{{{1}}}|Specified Indebtedness}} that would not upset cross defaults in the loan market but has the potential to do so in the swaps market is the bank deposit. Deposits are plainly borrowed money, and they mightily add up: as we will see, aggregation is important when calculating the {{{{{1}}}|Threshold Amount}}.
Only banks are allowed to accept bank deposits, and in the traditional loan market banks are lenders and therefore are not subject to cross default terms, so deposits are not in play.
But ISDA {{{{{1}}}|Cross Default}} is bilateral, so could — unless you fix it, would— catch a bank swap dealer’s customer deposit base. 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 tend to exclude retail deposits from the definition of {{{{{1}}}|Specified Indebtedness}}. This is sensible, and they will not resile from this position, so buy-side agitants, when you are picking your ditch to die in, I would not make it this one.
Public indebtedness
The last thing to note about {{{{{1}}}|Specified Indebtedness}} is that typically, borrowed money tends to arise under private contracts and the circumstances in which it is in default will not be known to the market. The only exception to this are public bond issuances. Beyond that, generally speaking, the market will not have real-time information about the level of a given counterparty’s overall 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.
“Threshold Amount”
The {{{{{1}}}|Threshold Amount}} is the level over which accumulated defaults in Specified Indebtedness comprise an actionable {{{{{1}}}|Event of Default}} under the ISDA Master Agreement.
It is usually defined as 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.
This accumulation feature means that relatively trivial amounts of indebtedness can be problematic particularly where the default is technical, systemic or operational. As mentioned above, should a system outage prevent the bank from honouring its deposits — almost certainly a sum greater than 2% of its shareholder equity — it might instantly trigger a cross-default right on all its ISDA Master Agreements. This would be catastrophic if acted upon. That is a big if, it is true — but commending the institution’s soul into the hands of rapacious hedge fund swap counterparties is not a gambit most prudent banks would willingly take.
Because of the snowball effect that a cross default clause can have, the {{{{{1}}}|Threshold Amount}} for every contract 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 end users (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.
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.
Why banks should worry about Cross Default
{{{{{1}}}|Cross Default}} thus imports the default rights from some contract the counterparty has agreed with some third party random — in fact all default rights it has given away to any third party randoms, as long as they add up to the {{{{{1}}}|Threshold Amount}} — into the present ISDA Master Agreement.
Think about this for a moment from the Borrower’s perspective: if you technically breach a covenant in your term loan with a bank, an different swap dealer could close out all your derivatives with it, even though you weren’t otherwise in default under your ISDA with that dealer, and even though your bank took no action under the term loan.
This ought to strike a fair-minded person as startling. It typically does not strike a swap dealer’s credit officers as startling. They tend to think it is groovy.
This, we think, is because credit officers tend to be unusually focused on the credit risk presented by their customers and not the liquidity risk an ill-considered contractual term might present to the dealer. As we have mentioned, the arsenal of default events set out in a normal bank customer contract point all in one direction. In the ISDA, they point in both directions.
Cross default is a lender remedy. But the ISDA Master Agreement is not, from a customers’ perspective, primarily a lending contract. Especially not now everything is, by regulation, daily margined to a zero threshold. There is no material indebtedness.
So, if you are a swap dealer, the boon of having a {{{{{1}}}|Cross Default}} right against your customer — which might not have a lot of public indebtedness — may be a lot smaller than the bane of having given away a {{{{{1}}}|Cross Default}} against yourself. Because you have a ton of public indebtedness.
Cross default is unusually dangerous, in theory, to a prudentially regulated banking institution, precisely because it has so much indebtedness, and it must calculate its liquidity buffer by reference to theoretical capital outflows rather than practically likely ones. Giving away a low cross-default threshold or widening cross-default to include technical defaults on derivatives and other non borrowing contracts dramatically increases the theoretical possibility of a bank triggering a {{{{{1}}}|Cross Default}}. There is a “snowball effect”.
The snowball effect: worked example.
Here is a fun game: Imagine you have a standard cross-default threshold of £100M. 50,000 contracts have a threshold of £100M or more. You have forty contracts with low {{{{{1}}}|Threshold Amount}}s. How easily could your whole ISDA book be triggered via snowball?
- Ten contracts have a {{{{{1}}}|Threshold Amount}} of £10M.
- Ten contracts have a {{{{{1}}}|Threshold Amount}} of £1M.
- Ten contracts have a {{{{{1}}}|Threshold Amount}} of £100,000.
- Ten contracts have a {{{{{1}}}|Threshold Amount}} of £10,000.
In each case the amount due under the contracts is no less than its stated {{{{{1}}}|Threshold Amount}}.
What kind of default would you need to trigger {{{{{1}}}|Cross Default}} across every ISDA?
The answer is a single default of £10,000 (or, if you like, 100 defaults of £100 each). That would be enough to trigger the ten £10,000 contracts, which together would trigger the ten £100,000 contracts, which together would trigger the ten £1,000,000 contracts, which together would trigger the 10 £10,000,000 contracts, which together would trigger the 10 £100,000,000 contracts, which toeghether would trigger the rest of your portfolio.
A whole banking conglomerate taken down for the sake of £10,000.
But the bank risk departments which engage in ISDA onboarding specialise in managing the credit risk of end user counterparties. Often they have no mandate to consider the credit implications on their own institutions of the terms they impose on their customers. They will tend to be satisfied with symmetry of obligations. This seems a bit regrettable.
Alternatives
DUST
Default under specified transaction: DUST is like cross default, but just between you and me, on derivative transactions and without a {{{{{1}}}|Threshold Amount}}. There is meant to be a mutual exclusivity between dust and {{{{{1}}}|Cross Default}}: dust applies only between the two parties to the ISDA agreement and only references specified transactions which in the ordinary course are financing transactions like stock lending and repo arrangements, and not loans as such. {{{{{1}}}|Cross Default}}, on the other hand, by default references only outright lending arrangements with third parties and by default excludes financing transactions that do not explicitly envisage unsecured indebtedness.
This is not to say that credit departments will not ever fiddle around with the definitions and confuse them, of course. It is enduringly surprising how different the approaches of different swap dealers to this question will be.
Differences between Cross Default and DUST
Ideally, cross default and DUST should be mutually exclusive. They are meant to dovetail with each other, not cross over. This will not stop mission creep from over-zealous credit departments, who will try to expand the scope of each, leading to all kinds of cognitive dissonances and righteous indignation from the counterparty’s negotiator. As ammunition for your fruitless attempts to persuade the credit department to live in the real world for once, try these:
| Subject | Cross Default | DUST |
|---|---|---|
| Exposure types | outright indebtedness and contracts for borrowed money | Trading exposures and asset financings |
| Threshold | Requires material (solvency threatening) indebtedness | None: Exposure size not relevant; what matters is default. |
| Counterparty | Any third party lender | Only your ISDA counterparty |
| Default status | Theoretical default, whether or not acted upon | Actual acceleration. |
Cross Acceleration
Cross acceleration: {{{{{1}}}|Cross Acceleration}} is not an actual ISDA Event of Default, but it is what happens to an actual ISDA Event of Default — {{{{{1}}}|Cross Default}} — only if you can persuade your credit department to water it down to something kinder and gentler: a world in which people wait for third party indebtedness to be actually accelerated before closing out their ISDAs.
Cross Acceleration is only an Event of Default once the Defaulting Party’s third-party lenders have actually accelerated Specified Indebtedness in an amount exceeding the {{{{{1}}}|Threshold Amount}}. That is a much a less sensitive trigger — worse, a credit officer might say, but bear with me — and avoids that weird scenario when the actual lender has not itself exercised its default rights, but you have exercised your, even though your counterparty hasn’t otherwise breached your contract. (This ought to make a dispositionally benign third-party lender less inclined to be benign, for fear you will still its lunch).
Cross acceleration also avoids the need to muck around waiting for grace periods to expire, granting indulgences for administrative and operational error and all that dreck: if the counterparty has actually accelerated the loan, the grace periods and operational errors must have expired and therefore no longer matter. It is too late. The game is up.
Remove it
You may detect a thread running through this article that {{{{{1}}}|Cross Default}} is more trouble than it is worth in an ISDA Master Agreement. You may be tempted to try your credit department with the idea of doing without {{{{{1}}}|Cross Default}} altogether.
If so, I salute you and wish you well, but I don’t expect to hear from you any time soon. Should you find yourself banished to Siberia or pushed out the window of a Moscow apartment building for expressing incautious political opinions, you should accept your fate with the cold comfort that you were right, but the world is a stupid place.
Arguments for Cross Default
So what are the usual justifications for insisting on {{{{{1}}}|Cross Default}}?
- It’s an early warning system: while other events of default might eventually occur, {{{{{1}}}|Cross Default}} can be triggered first. While this is theoretically true, Practical experience is that {{{{{1}}}|Cross Default}} occurs almost contemporaneously with failure to pay and bankruptcy. Take Lehman Brothers: if there was a cross-default – no one is quite sure – it preceded a failure to pay by a matter of hours: in the time it would take to convene and brief the necessary risk committee with a mandate to close out one of the biggest swap dealers on the planet for a speculative third-party default, Lehman had failed to pay and declared bankruptcy.
- It prevents cherry picking: We have seen it argued that {{{{{1}}}|Cross Default}} prevents a counterparty from selectively defaulting on some obligations while maintaining others. This is a curious objection impliedly in that case the counterparty would be selectively maintaining the present ISDA, choosing to default instead on other obligations. It seemed counterintuitive to dissuade a distressed counterparty from prioritising the performance of your own ISDA.
- It provides negotiation leverage: Even if it is rarely triggered the existence of a {{{{{1}}}|Cross Default}} right provides a non-defaulting counterparty with important negotiating leverage and can force its distressed counterparty to the table to address financial issues holistically. This is a favourite argument of credit officers, although strangely the sight of a brave credit officer grimly holding a recalcitrant counterparty’s feet to the fire with the threat of incipient {{{{{1}}}|Cross Default}} is rare indeed. Often talked about, seldom seen.
- It’s market standard: It is absolutely standard and removing it could be seen as weird behaviour by other market participants. Fair play, you’ve got me on this one: it is true that {{{{{1}}}|Cross Default}} is there, it’s a fact of life, and it is not going anywhere but this still does not derogate from the significant blowback risks it presents to a regulated financial institution, and in JC’s Opinion one should look to pare back and defang {{{{{1}}}|Cross Default}} as far as possible notwithstanding its ubiquity in the market.
Comparison with securities financing
Stock lending and repo have no cross default: Neither the 2010 GMSLA nor the Global Master Repurchase Agreement have, as standard, either a cross default or a default under specified transaction provision. Unless some bright spark thinks it is a good idea to negotiate one in.
Changes to {{{{{1}}}|Threshold Amount}} over the years
The 1992 ISDA contemplates default “in an aggregate amount” exceeding the {{{{{1}}}|Threshold Amount}}: that is to say, the value of the failed payment, and not the whole principal amount of the loan, contributes to the {{{{{1}}}|Threshold Amount}}. So if a lender failed on a small interest payment on a large facility only the payment value would count towards the {{{{{1}}}|Threshold Amount}} even though the whole facility could be accelerated.
This was a drafting oversight — or, I don’t know, perhaps it was meant to be that way — but in any case, by 2002 ISDA’s crack drafting squad™ had thought the better of it and corrected it. The 2002 ISDA contemplates an event of default under agreements whose “aggregate principal amount” is greater than the {{{{{1}}}|Threshold Amount}}: that is to say the whole principal amount of the agreement is picked up, not just the payment value.
Also, in the 2002 ISDA, {{{{{1}}}|Cross Default}} can be triggered by any event of default, not just a payment default, whereas the 1992 ISDA’s requirement for “an Event of Default ... in an amount equal to...” impliedly limited the clause to payment defaults only since other defaults — failure to provide annual reports and so on — would not be “in an amount” of anything)
How to change Cross Default to Cross Acceleration
If you want to downgrade from {{{{{1}}}|Cross Default}} to {{{{{1}}}|Cross Acceleration}}, then simply include the following in Part 1 of your Schedule:
Section 5(a)(vi) is amended by deleting “, or becoming capable at such time of being declared,” from subsection (1).
Is “downgrading” wise?
In which JC picks an argument with his elders and betters.
There are two schools of thought: the sensible, pragmatic, wise, noble, fearless and brave one you will find in these pages:
“Yes. Cross default is misplaced in a modern daily-collateralised ISDA. Anything you can do either to restrict its scope, or simply to avoid being dragged into a tedious argument about its scope, is worth doing.”
The learned one, from the learned author of that terrible FT book about derivatives: “
No: one should only soften Cross Default reluctantly. Because other counterparts might not be so weak.
The FT derivatives book’ view, in our view, mischaracterises what is going on.
“With cross acceleration the innocent third party actually has to start proceedings against the defaulting counterparty before you can trigger your transaction termination rights ...”
But it doesn’t have to sue: just call its debt in. This seems to be the right point to allow a dealer to close out an otherwise performing ISDA.
“If the third party is your counterparty’s main relationship bank it may take some time to review its position...”
Indeed: it probably will. But while it is doing that it is not accelerating its claim against your counterparty. It is granting its customer, and your counterparty, an indulgence. Your position is, therefore, not worsened in the meantime.
“... and may propose a compromise which does not suit you.”
You, bear in mind, are the owner of a fully collateralised ISDA Master Agreement which the counterparty has, in the meantime, continued faithfully to perform. If one of your co-creditors has granted an indulgence on outstanding indebtedness — even in return for some other surety or compromise — which avoids that debt being accelerated in full, how can that by itself make your position worse?
“I believe such downgrade requests should only be considered favourably if specific foreseeable circumstances justify them [...] or if your counterparty gives written confirmation that cross acceleration applies to all its agreements and will do so in the future. This is because if even one counterparty has {{{{{1}}}|Cross Default}} it would be in pole position to trigger its termination rights.”
On this last point, the learned author is, technically, correct: you are marginally worse off if you have conceded cross acceleration and other swap counterparties have not. They can beat you, and your counterparty’s main relationship bank, to the punch, assuming they are cowboys who view a relationship contract like an ISDA Master Agreement as something that it should be a race to close out. Dealers don’t tend to think that way. They have compliance officers who will quail at the thought of not treating their customers fairly. In any case, the fact that this could happen just illustrates how stupid the concept of cross-default is. Especially in our enlightened age of zero-threshold, daily margined non-exotic swap contracts. Especially given the extreme conceptual difficulty of even gathering enough information to work out whether you even can exercise your cross default right.
Initial margin failure?
What of a failure to pay an {{{{{1}}}|Independent Amount}}?
Technically this is not a payment of indebtedness, and if the Initial Margin payer is up-to-date on variation margin payments, there may not be any indebtedness at all.
Indeed, once the Initial Margin payer has paid the required Initial Margin, under a title transfer arrangement, the Initial Margin receiver becomes indebted to the payer for its return — so while it certainly comprises a Failure to Pay or Deliver when due, its contribution to the {{{{{1}}}|Threshold Amount}} might be nil, or even negative.