Events of Default (Early Termination Payments) - ISDA Provision
See also 6(e)(i) - 1992 ISDA provision for the equivalent provision under the 1992 ISDA.
The effect of this is that in closing out an ISDA, the first step is to terminate all transactions to arrive at a Close-out Amount[1] for each one, then figure out if there were any Unpaid Amounts that were due under Transactions but had not been paid at the time the Transactions terminated. The close out happens under Section 6(e) of the ISDA Master Agreement itself and the recourse is to a net sum. Netting does not happen under the Transactions — on the theory of the game there are no outstanding Transactions at the point of netting; just payables.
Therefore, if your credit support (particularly guarantees or letters of credit) explicitly reference amounts due under specific Transactions, you may lose any credit support at precisely the point you need it.
Which would be a bummer.
Further commentary on the Guarantee page.
Relevance of Section 6 to the peacetime operation of the Credit Support Annex
The calculation of {{{{{1}}}|Exposure}} under the CSA is modelled on the Section 6(e)(ii) termination methodology following a Termination Event where there is one Affected Party, which in turn tracks the Section 6(e)(i) methodology following an Event of Default, only taking mid-market valuations and not those on the Non-Defaulting Party’s side.
This means you calculate the {{{{{1}}}|Exposure}} as:
- (a) the Close-out Amounts for each Terminated Transaction plus
- (b) Unpaid Amounts due to the Non-defaulting Party; minus
- (c) Unpaid Amounts due to the Defaulting Party.
There aren’t really likely, in peacetime, to be Unpaid Amounts loafing about — an amount that you are due to pay today or tomorrow wouldn’t, yet, qualify as “unpaid”, but would be factored into the Close-out Amount calculation.
There is a little bit of a dissonance here, since “{{{{{1}}}|Exposure}}” is a snapshot calculation that treats all future cashflows, whether due in a day, a month or a year from today, the same way: it discounts them back to today, adds them up and sets them off. Your {{{{{1}}}|Delivery Amount}} or {{{{{1}}}|Return Amount}}, as the case may be, is just the difference between that Exposure and whatever the existing {{{{{1}}}|Credit Support Balance}} is. The future is the future: unknowable, unpredictable, but discountable, whether it happens in a day or a thousand years.
All the same, this can seem kind of weird when your CSA you have to pay him an amount today when he owes you an even bigger amount tomorrow. It’s like, “hang on: why am I paying you margin when, tomorrow, you are going to be in the hole to me? Like, by double, if I pay you this margin and you fail to me tomorrow.”
The thing which, I think, causes all the confusion is the dates and amounts of payments under normal Transactions are deterministic, anticipatable, and specified in the Confirmation, whereas whether one is required under a CSA on any day, and how much it will be, depend on things you only usually find out about at the last minute. CSA payments are due “a regular settlement cycle after they are called” — loosey goosey, right? — (or even same day if you are under a VMV CSA and you are on the ball with your calls) whereas normal swap payments are due (say) “on the 15th of March”
So, a scenario to illustrate:
- Day 1: Party A has an {{{{{1}}}|Exposure}} — is out of the money — to the tune of 100. Its prevailing {{{{{1}}}|Credit Support Balance}} is 90, so (let’s say, for fun, after the {{{{{1}}}|Notification Time}} on the {{{{{1}}}|Demand Date}}) Party B has called it for a {{{{{1}}}|Delivery Amount}} of a further 10, which it must pay, but not until tomorrow.
- Day 2: Meanwhile, Party A has a Transaction payment of 10 that falls due to Party B, also tomorrow. The arrival of this payment will change Party A’s Exposure to Party B so it is 90. Assuming Party A also pays the Delivery Amount, by knock-off time tomorrow it will have posted a {{{{{1}}}|Credit Support Balance}} of 100, and its Exposure to Party B will only be 90. This means it will be entitled to call Party B for a {{{{{1}}}|Return Amount}} of 10.
This seems rather a waste of operational effort, and will also take years off your credit officer’s life and may even cause his hair to catch fire. Can Party A just not pay the further Delivery Acount in anticipation of what will happen tomorrow?
Fun times in the world of collateral operations.
See also
References
- ↑ The Close-out Amont is basically the replacement cost for the Transaction, and will therefore assume past payments have all been made. Hence the converse concept of “Unpaid Amounts”, being amounts that should have been paid or delivered under the Transaction by termination, but weren’t (hence, we presume, why good sir is closing out the ISDA Master Agreement in the first place). Note that, to avoid the fear of double-counting, the definition of “Close-out Amount” explicitly ignores the effect of any Unpaid Amounts under a Transaction.