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.
• 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 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.

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: Firstly, it may prevent the {{{{{1}}}|Non-Defaulting Party}} closing out {{{{{1}}}|Transactions}} at all. The bankruptcy administrator may have the discretion to affirm or avoid individual {{{{{1}}}|Transactions}}. This bigly messes with the fundamental philosophy of the ISDA Master Agreement.

Secondly, it may impact netting rights: having exercised its early termination right, ISDA’s “single agreement” operates to net all {{{{{1}}}|Transaction}} exposures down to a single sum. If a bankruptcy administrator is allowed to enforce some contracts and set aside others, that netting right is prejudiced, 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 {{{{{1}}}|Automatic Early Termination}} which was introduced, uncredited, in the 1987 ISDA.

Bear in mind three historical contingencies which converged in the 1980s.

Financialisation

First, the rapid onset of financialisation due to parallel developments in information technology. Through the Seventies and Eighties, Western markets acquired the mental habits and systems needed to look at financial risk in a much more detailed, segmentable, way, as substrate-neutral derivatives of real-world propositions. Financial instruments were traded electronically. Increasingly, institutions modelled their risk with computers. They unbundled big, organic, ineffable risks into discrete tradable components: volatility. Liquidity. Convexity. Correlation. Credit and debt value.

At the same time, the market developed the legal and contractual tools to go with this new way of thinking about risks. Principle among them was a new class of bilateral financial contracts unlike anything bank regulators had seen before, in which the usual relationships between debtors and creditors and between customers and banker were — apparently — moot. The ISDA Master Agreement was at the vanguard of these new contracts.

And 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 increasingly difficult to do so across global financial markets where different prudential and regulatory regimes gave rise to arbitrage opportunities.

New capital regulation

These developments in banking and market technology called for a more sophisticated and globally consistent framework for managing bank risk in the financial markets. Banks were increasingly interconnected both across exchanges and in private over-the-counter networks, and the speed at which instruments traded and their values changed meant there was heightened systemic risk should major market participants fail, and even minor participants could have a disproportionate effect on system stability.

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

Corporate resolution didn’t change

While there was a good deal of harmony in the international capital markets, local bankruptcy regimes of individual jurisdictions — which typically had a much greater domestic focus — did not similarly change or update.

Swaps remained an arcane part of the international capital markets. They were not relevant to the small and medium-sized enterprises at whom a local companies regime was targeted. Companies regulators, assignees and administrators did not well understand them. Bankruptcy regimes tended to confer broad discretions on receivers and liquidators to ensure fair outcomes for all stakeholders in a company’s resolution. Should a receiver try to “cherry-pick” valuable Transactions in a swap portfolio while setting aside loss-making ones, the implications for bank counterparties could be far worse, and far more volatile, than the corresponding risks presented by an ordinary corporate loan.

The Basel Rules addressed this “local insolvency risk” by requiring banks to obtain reasoned legal opinions that, under local bankruptcy rules, master agreements could not be cherry-picked in this way.

And this is where the phase transition into bankruptcy becomes important. Typically, while a company is solvent and trading, its swap contracts may be enforced according to their terms in the ordinary course. It is only at the point of formal bankruptcy that the phantoms 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 contracts, 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 shenaniganson the cards.

ISDA’s definition of “{{{{{1}}}|Bankruptcy}}” somewhat jumbles the concepts up. Some ISDA {{{{{1}}}|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 {{{{{1}}}|Automatic Early Termination}}.

1987: The Schrodinger’s Cat ISDA

In the 1987 ISDA they do anyway. {{{{{1}}}|Automatic Early Termination}} applies across the board, to all {{{{{1}}}|Bankruptcy}} events, and all counterparties: it is not even an optional election, to be engaged judiciously when needed against counterparties in jurisdictions vulnerable to bankruptcy shenanigans. It just sits there and applies across the board, if any {{{{{1}}}|Bankruptcy}} {{{{{1}}}|Event of Default}} should be declared.

This presented a real risk of “Schrodinger’s Cat” ISDAs, where the facts determining an insolvency-style {{{{{1}}}|Bankruptcy}} were not public or even easily determinable (balance sheet insolvency, in particular, is more a matter of art than science) and if automatically triggered, it would be impossible to know whether a given ISDA were alive or dead, or whether one had suspended one’s obligations under the flawed asset provision or not.

There is this weird thing: {{{{{1}}}|Automatic Early Termination}} could be triggered without notice, action or knowledge, and that would trigger a section {{{{{1}}}|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 has been to walk AET back — not fast enough, in this commentator’s opinion — from that highly unsatisfactory epistemological state. By 1992, ISDA’s crack drafting squad™ limited AET to circumstances with a live risk of bankruptcy shenanigans and excluded the “soft” economic insolvency events. The 1992 ISDA also converted {{{{{1}}}|AET}} into an optional election in Part 1 of the {{{{{1}}}|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 {{{{{1}}}|5(a)(vii)(4)}} in two: a bankruptcy petition instituted by a regulator was not subject to a grace period. A bankruptcy petition instituted by anyone else — such as a creditor — would only mature into an {{{{{1}}}|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 is a fairly ordinary debt-collection tactic: it may not indicate a genuine inability to pay debts, but in that case can be fairly easily discharged. Hence the grace period.

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.

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, to avoid the ambit of discretionary rules designed to ensure fairness and prevent just that kind of preference seems — a bit optimistic?

There is a more benign view, but it is still a bit hopeful: {{{{{1}}}|Automatic Early Termination}} helps buttress what is really a permitted outcome, dispelling residual doubt about ambiguous or untested regulatory provisions that come into force following the phase transition to bankruptcy. Sort of a “better be safe than sorry”.

Then there is a pragmatic view. This 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 the bankruptcy shenanigans they seek to avoid would not produce a fair result for anyone.

But, still: this is all well and good. But if, unwittingly, {{{{{1}}}|Automatic Early Termination}} now creates practical risk where once it avoided theoretical ones, it still should be a source of concern.

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