Template: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, “{{{{{1}}}|AET}}”, but not to be confused with “{{{{{1}}}|ATE}}” or “{{{{{1}}}|ETA}}” — is an odd, feared and misunderstood concept buried at the back end of Section {{{{{1}}}|6(a)}} ({{{{{1}}}|Right to Terminate Following Event of Default}}).

Acclimatisation

In a document stuffed with arcanities, {{{{{1}}}|AET}} 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.
• Single Agreement: The unbearable weirdness of ISDA’s single agreement concept.
• Regulatory capital: The rules on how much capital a regulatred financial instrument is required to hold, and how it is calculated.
• Closing out an ISDA: The law and lore of closing out an ISDA
• Flawed asset: ISDA’s notorious “flawed asset” provision: Section {{{{{1}}}|2(a)(iii)}}.

Overview

{{{{{1}}}|Automatic Early Termination}} provision is triggered when a party to whom it applies suffers an in-scope {{{{{1}}}|Bankruptcy}} {{{{{1}}}|Event of Default}}. If it is triggered, all outstanding {{{{{1}}}|Transaction}}s are instantly and automatically terminated, without the need for any action by — or even the knowledge of — the {{{{{1}}}|Non-Defaulting Party}}. This usually means instantly, but in one case, it is even quicker than that.

If the {{{{{1}}}|Bankruptcy}} event is the presentation to the court by a creditor of a formal petition seeking the entity’s bankruptcy under Section {{{{{1}}}|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 {{{{{1}}}|Non-Defaulting Party}}’s hands, AET subverts the normal order of things under the ISDA Master Agreement. Normally, the {{{{{1}}}|Non-Defaulting Party}} is in control. It may, but need not, call an {{{{{1}}}|Event of Default}} if the circumstances justifying one exist. AET is, well, automatic. It even obliterates the {{{{{1}}}|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 {{{{{1}}}|NDP}} pre-waive in anticipation? See “Anticipatory waiver?” in the premium section.)

JC’s view is that {{{{{1}}}|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.

It’s not about risk: it’s about capital calculations

Triago: Herewith, hereinafter and hereinbefore-confirmed:
A custom aperture. Wall-inlaid,
Well-glazed and fringed by lintel stone.
A device to shed upon us light!

Regolamento: Oh, a window?

Triago: Good heavens, No! Not that!
(Whispering) There are ways and means of saying ’t, ser —
Prithee, gird thy verbiage about with care
Lest th’Exchequer’s like for “levies upon transparency”
Untimely drains th’excess from our meagre chancelry—
Catcheth thou the drift?

Regolamento: It is not a window, then? These sound like solid facts?

Nuncle: ’Tis not so much a window
As a means of dodging tax.

—Büchstein, Talentdämmerung

Automatic Early Termination is as much to do with managing regulatory capital — in particular, vouching safe close-out netting — as it is about substantive credit risk mitigation.

If you don’t have to hold regulatory capital — as a rule, swap dealers do, end users don’t — you could be forgiven for being a little sanguine: the risk AET addresses that is that:

• Your counterparty goes bankrupt without an intervening Failure to Pay and
• It is significantly net out-of-the-money on a collateralised basis when it does so and
• Its receiver cherry-picks its in-the-money Transactions and gets a local judgment against you for those and
• Your home courts enforce the foreign judgment even though the netting is robust in your jurisdiction.

This risk is low. It does not seem to have happened yet, in the 43-year history of the global OTC derivatives market.

Against that contingency pit the present risk that you are, without notice, prematurely catapulted out of adequately margined {{{{{1}}}|Transactions}} you were happy to remain in, that were perhaps even out-of-the-money to you, and for which you might have preferred to roll the dice in the optimistic hope that reasonableness and consensus might yet prevail at a time of lower volatility, thereby reducing the risk of off-market loss for both parties.

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 an insolvency 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 {{{{{1}}}|Transactions}} to honour, it would help the {{{{{1}}}|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.

A bankruptcy regime could affect an innocent counterparty’s rights in at least two ways:

1. Discretionary termination right itself: Firstly, bankruptcy rules may prevent the {{{{{1}}}|Non-Defaulting Party}} closing out {{{{{1}}}|Transactions}} at all. They may give the administrator the discretion to affirm or avoid individual {{{{{1}}}|Transactions}}. This bigly messes with the fundamental philosophy of the ISDA Master Agreement:

   A swap counterparty to a portfolio of swap transactions scheduled to mature over the next five years may have no present obligation to pay any cash under those {{{{{1}}}|Transaction}}s even if, from a mark-to-market perspective, the net present value of that portfolio is significantly negative. Who knows? Things may come right.

   All those hopes and dreams would be crushed if the {{{{{1}}}|Transactions}} were terminated on grounds of {{{{{1}}}|Bankruptcy}}. The {{{{{1}}}|Defaulting Party}} would immediately be liable to pay that full mark-to-market value in cash. A bankruptcy suspension right prevents the {{{{{1}}}|Non-Defaulting Party}} from crushing the bankrupt party’s dreams. Well, its other unsecured creditors’ dreams, at any rate.
2. Netting right: Beyond that, having exercised its early termination right, the “single agreement” operates to net all {{{{{1}}}|Transaction}} exposures down to a single sum. Since a bankruptcy administrator may have a right to enforce some contracts and set aside others. that netting right is prejudiced.

History

Automatic Early Termination was introduced in the 1987 ISDA, but was not labelled “{{{{{1}}}|Automatic Early Termination}}”: it just sat there and applied across the board. Unlike in later editions, it was not conceived as an election to be used cautiously and only when needed against counterparties in jurisdictions vulnerable to bankruptcy shenanigans.

While under the Modern ISDAs {{{{{1}}}|AET}} is only triggered by certain events under the {{{{{1}}}|Bankruptcy}} event of default, in the 1987 ISDA any Bankruptcy Event triggered it, against any counterparty in any jurisdiction. This is just one more reason not to use the 1987 ISDA, if there are any Burmese Junglers still out there looking for a way back to civilisation.

By 1992, ISDA’s crack drafting squad™ had realised that the risk of “bankruptcy shenanigans” largely arose in formal bankruptcy procedures and not as a result of “soft” economic events tending to indicate mere insolvency. As we note elsewhere, the ISDA’s {{{{{1}}}|Bankruptcy}} definition somewhat jumbles the distinct concepts of “bankruptcy” and “insolvency”.

In any case, a Counterparty’s “cashflow insolvency”, its “balance-sheet insolvency” or a creditor’s enforcement of security — is no more of a risk to close-out netting than any other {{{{{1}}}|Event of Default}}, so the 1992 ISDA reduced the scope of AET by excluding these soft “insolvency” events captured in limbs (2) and (7) of the {{{{{1}}}|Bankruptcy}} definition.

It is now an election

Though the 1987 ISDA triggered automatic termination upon any {{{{{1}}}|Bankruptcy}} event happening to any counterparty in any jurisdiction, it has since turned out that the mischief against which {{{{{1}}}|AET}} guards does not arise at all in most jurisdictions, and where it does, only to certain counterparty types and certain Bankruptcy events.

The ’squad corrected this in 1992. Since the 1992 ISDA, {{{{{1}}}|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

Automatic Early Termination is only really useful to a regulated institution: one, like a bank or an insurer, that must hold regulatory capital against its ISDA exposures. Basel rules allow a bank to treat its ISDA exposures against a counterparty as “net” only if it can find a law firm that will give an opinion that in all conceivable circumstances including on the counterparty’s bankruptcy, those exposures would net down on close-out. In a very few cases, the legal opinion will say something like:

“Well, if your Counterparty goes bankrupt and then you try to close out, it won’t work. Unless you activate that sneaky AET trigger. If you do that, you’ll be fine, because it will magically close at at the point of calamity, and you will never actually have a live ISDA versus a bankrupt counterparty. So, yes: in that case your close-out will always work.”

If you don’t hold regulatory capital, you won’t get hit with a reg cap charge, and you may take the view that your counterparty’s bankruptcy is a risk worth running.

A shade cynical?

This may strike you as a cynical view, but it is not really.

Actual, direct bankruptcy losses are a deep tail risk. Only a very small portion of your portfolio will ever go bankrupt, its trajectory towards that forsaken state will usually be well-telegraphed and, your credit guys being the vigilant professionals they are, most likely they will have long-since trimmed lines, managed down positions and closed the counterparty out, well ahead of formal bankruptcy. And even if they haven’t, the practical chance that the adminstrator tries on, let alone succeeds with, the worst case cherry-picking scenario is low. It has not, yet, happened in the financial markets.

A regulatory capital charge against that risk, on the other hand, is an immediate, present running cost to your business. It applies against every affected counterparty whether or not it eventually goes bankrupt. Given that the disaster scenarios the capital charge contemplates,the regulatory capital charge — not necessarily the risk itself — would make the business uneconomic for the bank.

These considerations do not apply if you do not have to hold regulatory capital.

Few and far between

There are only a few counterparty types in a few jurisdictions where the conditions for {{{{{1}}}|AET}} prevail. There are not many because — let’s be clear, here — {{{{{1}}}|AET}} is a bit of try on: any self-respecting netting-hostile bankruptcy regime would see straight through it. It’s a bit cute, in other words. Now this sort of cuteness passed for sport in the eighties and nineties — I’ll be gone; you’ll be gone and all that — but post the GFC we are reformed characters now. AET only really passes muster these days because it’s so deeply ingrained into the documents and our way of doing things that no-one has the gorm to know any better.

A piece of time-travelling contractual magic — deeming an ISDA 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, purely so that the termination would not be problematic for one creditor under discretionary rules designed to ensure fairness and avoid just that kind of preference seems a bit optimistic.

The benign view is still a bit hopeful: {{{{{1}}}|Automatic Early Termination}} delivers netting not where otherwise it would be forbidden, but rather it helps buttress a permitted outcome, dispelling residual doubt as to ambiguous or untested regulatory guidance following the phase transition to bankruptcy.

The pragmatic view is blunter: ISDA Master Agreements once were weird innovations that bamboozled and outraged bankruptcy administrators. Now, they are not. Everyone knows what ISDAs are, why they net, and why the single agreement is a sensible plank in the capital structure of the financial system, and why cherry-picking TSDA Transactions would not lead to a fair result for anyone.

I rest my case on this: no single single agreement has been successfully challenged in 40 years.

The question is whether, unwittingly, {{{{{1}}}|Automatic Early Termination}} creates more practical risk now than ever it avoided in the derivative dark ages of superstition, fear and nightmare.

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

Why not just switch it on, to be on the safe side?

Master trading agreements are unusual in that upon an {{{{{1}}}|Event of Default}}, there is no guarantee the {{{{{1}}}|Non-Defaulting Party}} will actually be owed any money. If it is net out-of-the-money, it might have to pay.

The last thing an innocent swap counterparty would want is to realise mark-to-market losses by accelerating a bunch of badly performing swaps. Indeed, the “flawed asset” provisions of the ISDA Master Agreement are designed precisely to allow it to just suspend performance of Transactions — therefore not make its position any worse — without crystallising its {{{{{1}}}|Transaction}} exposures.

So having {{{{{1}}}|Transaction}}s automatically accelerate is undesirable: one would only choose that if the alternative was catastrophically worse.

In the minds of those who framed the early ISDAs, mendacious application of discretions by foreign bankruptcy administrators was just such a catastrophic worseness.

But — time’s passed, water’s flowed and tempers have mellowed with age and wisdom: surely now there are better things for the world’s risk officers to fret about.