Cross default

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This is a page about the general concept of cross default.

Before we start

As a standard term in master trading documents

For specific provisions see:

Compare and contrast

History

The concept of cross default developed in the loan market. If a lender advanced a large sum to a borrower with only periodic interest or principal repayments, there would be long periods between interest payments — potentially months, quarters or even years where the Borrower had no repayment obligations to the lender at all. Now it stands to reason that borrower with no payment obligations, can hardly fail to pay (Failure to Pay being the cleanest of all events of default).

However, if in the mean time the Borrower failed to make a payment under a materially sized loan from another Lender B, Lender A is in a difficult position, unless it can accelerate its loan in response. Cross Default was introduced to give Lender A an out in that circumstance. To make sure it was a material default, a threshold of indebtednexss triggering that cross default right was usually included.

Note two key "vulnerabilities" of a lender that a cross default clause is designed to protect against: (a) the fact the borrower has incurred material indebtedness, and (ii) the Lender A has infrequent payment obligations by which to measure the Borrower's capacity to repay.

An ISDA, particularly one with a zero threshold daily CSA and multiple transactions under it, has neither of those weaknesses. It is not a contract of indebtedness – the nearest thing to indebtedness is MTM exposure, and that is zeroed daily by means of a collateral call – and there are payment obligations arising almost every day (such as margin calls).

So the two main reasons for inserting a cross default aren't really there in an ISDA or any other collateralised trading agreement. For a bank, there are key treasury concerns about giving away a cross default, because it can affect our liquidity buffer calculations, but credit to date has not been persuaded to worry about these.

DUST, on the other hand, is between just the two parties, and here any direct failure to us under any transaction, whether or not under the ISDA should allow us to close out the ISDA (just as a payment default under the ISDA itself would). The better your dust, the less need, in fact, you have for a cross default. Dust doesn’t need to cover indebtedness because it’s covered already by default, but you’re right – it’s slightly odd that indebtedness between parties is excluded from specified transactions – but there you have it.


Introduction

A cross default provision in an agreement allows a non-defaulting party, on a default by the other party under any separate contract it may have entered for borrowed money, to close out the agreement containing the cross default provision. Compare this with:

  • a cross acceleration provision, where the lender of the borrowed money must actually have taken steps to accelerate the borrowed money as a result of the default before the default becomes available as a termination right under the first agreement; and
  • default under specified transaction which references default under financial contracts which do not represent indebtedness, but only as between the two counterparties to the present contract.

Cross default is potentially a very damaging clause, as this picture to the right amply illustrates. Or would do, if there were a picture to the right. To the extent it doesn't:

Cross Default

a cross default provision against a party imports into the ISDA all of the termination rights upon default under any Specified Indebtedness owed by that party:

  • It has the effect of dramatically (and indeterminately) widening the definition of Event of Default.
  • Cross default entitles a Counterparty to accelerate the ISDA whether or not the Specified Indebtedness in question itself has been accelerated.
  • Depending on the market value of the transactions under the ISDA at the time of termination, therefore exercise of a cross default may lead to an immediate capital outflow.

Specified Indebtedness

Specified Indebtedness means, generally, any borrowings that, in aggregate, exceed a designated Threshold Amount. Because of the aggregation right, even comparatively trivial agreements can trigger the provision where they are relatively homogenous and affected by the same local circumstances (for example, retail deposits). A low Threshold Amount, therefore, presents three challenges:

  • It allows a more varied (and difficult to monitor) range of potential termination rights, because a greater number of agreements will qualify as Specified Indebtedness.
  • It “lowers the bar” so failures to comply with comparatively trivial financial commitments could be aggregated to trigger the Cross Default.
  • By not excluding bank deposits, it raises the possibility of being triggered by localised events unrelated to BBPLC’s credit (for example, political action in a single jurisdiction which affects BBPLC’s ability to pay on its local deposits)
  • Note that repo is not considered specified indebtedness: see borrowed money.

Derivatives as Specified Indebtedness

Derivatives should never be included in the definition of Specified Indebtedness, no matter how hight the Threshold Amount. the Cross Default language aggregates up all individual defaults, so even though a single ISDA would be unlikely to have a net out-of-the-money MTM of anything like 3% of shareholder funds, a large number of them taken together may, particularly if you’re selective about which ones you’re counting. Which the cross default language entitles you to be.

Thus, where you have a number of small failures, you can still theoretically have a big problem. This is why we don’t include deposits: operational failure or regulatory action in one jurisdiction can create an immediate problem.

The same could well be true for derivatives. Individual net MTMs under derivative Master Agreements can be very large. We have a lot of Master Agreements (18000+).

Say we have an operational failure (triggering a regulatory announcement, therefore public) or a government action in a given jurisdiction preventing us from making payments on all derivatives in that jurisdiction. We could have technical events of default on a large number of agreements at once – unlikely to be triggered, but for a cross default, that doesn’t matter.

The net MTM across all those agreements may well not be significant. But an opportunistic counterparty could tot up all the negative mark to markets, ignore the positive ones, and reach a large number very quickly.

Cross Default is a banking concept intended to reference borrowed money - indebtedness etc - and it really doesn’t make economic sense to apply it to derivatives – the fact that there’s a cross default in derivatives documentation at all is something of a historical accident. There are good points made below about the difficulty of calculating it and knowing what to apply it to (MTM? Termination Amount? Payments due on any day?) – bear in mind these values are not nearly as deterministic as amounts due wrt borrowed money: on a failure of a derivative contract the valuation of the termination amount (off which Cross Default would calculate) is extremely contentious. The market is still in dispute with Lehman, for example.

Credit Mitigation

Cross Default is intended to be a tool for mitigating credit exposure. It should be set at a level which reflects a material credit concern in the context of the entire enterprise. By convention, the market generally imposes a Threshold Amount equating to between 2 and 3 percent of shareholders’ funds.

Credit Support Annex

There are other ways of mitigating credit exposure (such as a zero threshold 1995 CSA). If a Counterparty's positive exposure to [Counterparty] will be fully collateralised on a daily basis, meaning its overall exposure to [Counterparty] at any time will be intra-day movement in the net derivatives positions (a failure to post collateral itself is grounds for immediate termination).

Contagion risk

It is important to maintain minimum standards which are reflective of genuine credit concerns against the bank so as to limit a “snowball” effect: were we to allow a £50mm Threshold Amount, we would potentially be open to a large number of derivative counterparties simultaneously (and opportunistically) closing out out-of-the-money derivatives positions, which in itself could have massive liquidity and capital implications.

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