What is the significance of the maximumnotice period of 20 days that one may use to close out the ISDA Master Agreement? Poor defaulted Counterparty is in pieces, on its knees, bleeding out, but really, as long as it gets some notice, does it really care how much? Surely, the longer the period, the more hope you have? While the agreement remains in termination but un-terminated, en route to that crater in the ground but not there yet — the chance remains, however remote, that things will come right; that you, its counterparty, will see sense, or unexpectedly discover the one compassionate bone in your body that, until now, has gone wholly unnoticed and, in a cloying bout of clemency, will change your mind and withdraw your notice of termination? Well, a little hedge fund can dream, can’t it? So why deprive it, and yourself, of that option?
Now, this is deep ISDA lore. It is of the First Men[1] — yea, even the Children of the Forest. As such — since they didn’t have a written tradition back in 1986 and legends were passed down orally from father to son[2] and much has been lost to vicissitude and contingency — it is not a subject on which there is much commentary: That dreadful FT book about derivatives sagely notes that, usually, much less notice is given than 20 days (I mean, you don’t say) but doesn’t give a reason for this curious outer bound, in the same way it doesn’t give a reason for much else in the ISDA Master Agreement despite costing a monkey and that being its express purpose. Nor, for that matter, does the official ISDA User’s Guide to the 2002 ISDA Master Agreement.
One is just expected to know. Yet, in point of fact, no-one seems to. And no-one wants to risk looking stupid by asking, right?
Well, companions, just not knowing things is not how we contrarians roll. We like looking stupid. Compared with plain old ignorance, it speaks to having at least put in some effort, even if wasted: noble but futile toil is flattering in some lights. So, in the absence of a credentialised, plausible reason,[3] let us speculate.
Remember the ISDA Master Agreement was invented by banking folk: people who who view the cosmos chiefly through the prism of indebtedness[4]. A lender whose borrower has defaulted will not dilly dally: she will bang in a default notice and seize whatever assets she can get her hand in poste haste. I lend, you owe. I don’t muck about. Breakage costs on a loan are easy to calculate and they are not especially volatile. There is nothing to be gained by waiting around: The longer I take to terminate my exposure , the larger it is likely to be.
But, but, but. ISDAs are different. They are not, principally,[5] a contract of indebtedness, and while a large uncollateralised mark-to-marketexposure[6] is economically the same as indebtedness, the contract is bilateral, and who is indebted at any time is dependent on the net exposure: it can and does swing around.
Also, the mark-to-market exposure on swaptransaction is a wildly volatile thing: With a loan, less so: you know you have (a) principal, (b) accrued interest and (c) break costs — the last of which might be significant for a long term fixed rateloan[7], but generally will pale in comparison to the principal sum owed.
So a swap counterparty who terminates might be out of the money, and disinclined to terminate just now, hoping that a more benign market environment might be just around the corner to dig it out of its hole so that when it does pull its trigger, the Close-Out Amount will be favourable. This is still taking quite the market punt on a bust counterparty — by means of a European option[8] — of course, and not the sort of thing a prudent risk manager would do[9], but I don’t suppose banking folk can be expected to have understood this in 1986.
Actually, even that makes little sense, since such a counterparty wouldn't be obliged to close out at all, but could just suspend its obligations under Section 2(a)(iii) — something which it can (or could, at any rate, when the notice period was devised, in 1987) do indefinitely. To be sure, a 2(a)(iii) suspension is just that — a suspension; should one come eventually to terminate the Transaction, those as-yet unperformed obligations will come back to haunt you as Unpaid Amounts, but at least here you retain control of the process and timing of close-out: it is an American option, not a European one. If you see the market moving against you, you can cash in your chips. So, ask yourself which is a bigger punt: that, the mark-to-market value you determine in 20 days — in a market that is likely to be a flaming wreck, by the way — better suits your book than the one you can actually trade on today, or on any day between now and that distant Early Termination Date.
So we get back to an alternative, more tedious explanation. It is pure flannel.
↑I know, I know — or women, but that spoils the Game of Thrones reference, you know?
↑And we have done our due diligence, you know: in coming to this conclusion the JC has consulted Magic circle law firm partners, managing directors, inhouseGCs and even a former general counsel of ISDA, all of whom swore me to secrecy but were as nonplussed as, let’s face it, you are about this baffling clause.
↑Hence, a Cross Default clause in the ISDA. Well — can you think of another reason for it?
↑Such as the sort you could have if it were 1987 and the credit support annexhadn't been invented.
↑But are there such things in this day and age? Serious question.
↑A correspondent writes pointing out — quite correctly — that, once an Event of Default has happened, the option to send a 6(a) Notice is American. So it is — thanks to Section 2(a)(iii), a potentially open ended one — until you convert it into something like a European option by sending the notice and specifying a date in the future on which it takes place.
↑The silly FT book is right about this, to be fair.
