Cross default

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

As a standard term in master trading agreements

For specific provisions see:

• Cross Default (ISDA)
• Cross Default (FBF)
• Stock lending and repo have no cross default: Neither the 2010 GMSLA nor the Global Master Repurchase Agreement have, as standard, either a cross default or a default under specified transaction provision. Unless some bright spark thinks it is a good idea to negotiate one in.

Compare and contrast

• Default under specified transaction: DUST is like cross default, but just between you and me, on derivative transactions and without a Threshold Amount;
• Cross acceleration: like cross default, only for a kinder, gentler world where people wait for indebtedness to be actually accelerated before closing out their exposures.

History

Cross default in the loan market

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 — months; quarters; even years — where the borrower was not scheduled to make any payments to the lender at all.

Now a borrower that is not due to pay anything, can hardly fail to pay.

This presented our lender with a risk: if, in the meantime, the borrower failed to pay under a loan from another lender, our lender would be in a difficult spot: it has good reason to think the borrower is in trouble, but the borrower hasn’t missed any payments. (How could it? None were due.) Waiting for the next payment to see if the borrower will pay won’t do. Our borrower wants to accelerate its loan now — while the going is still tolerably good.

Whence came the notion of a cross default: If you default under a loan you have borrowed from someone else, you default under your loan with me.

But this is a drastic measure. It means the borrower and its various lenders are in a Mexican stand-off: The lenders will all tend to be trigger happy: they will want to accelerate before some other blighter does. Therefore some thresholds were put around it: The size of the loan being defaulted on would need to be material enough to threaten the borrower’s very solvency.

Note the key vulnerabilities that cross default clause is designed to protect against:

• Material indebtedness: Our lender has significant credit exposure to the borrower;
• Infrequent payments: Our lender is owed infrequent payment obligations and cannot necessarily rely on a failure to pay.
• Material default: The borrower has taken on other indebtedness in a size big enough to threaten its own viability.

Cross default in the ISDA Master Agreement

In their infinite wisdom (or jest), the framers of the 1987 ISDA Interest Rate and Currency Exchange Agreement (cro-magnon man to the 2002 ISDA’s metropolitan hipster) thought it wise to include a cross default, perhaps because, in those pioneering days, credit support annexes weren’t run-of-the-mill, and may not even have been invented.

Subsequent generations of derivative lawyers, being the creatures of habit they are, especially when sequestered into an ISDA working group, never thought to take it out, and even our artisanal coffee-swilling 2002 ISDA boasts a tedious Cross Default provision, an embarrassing relic of its bogan parentage. It’s like that tattoo you got when you were a drunk, but physically attractive, 19 year-old.

You see the thing is, for a derivative master agreement, cross default is a complete nonsense.

A counterparty to an ISDA Master Agreement, particularly one with a zero-threshold daily CSA and many transactions under it, suffers none of those weaknesses it is designed for:

• Little indebtedness: An ISDA Master Agreement is not a contract of indebtedness, and any mark-to-market exposure that may resemble indebtedness is zeroed daily by means of a collateral call;
• Frequent payments: particularly where there are many transactions, or where the net mark-to-market position is shifting, there are payment obligations flowing every day, and if there are not that means there is no net indebtedness at all to the counterparty.

Additionally, regulated credit institutions have (or should have) enormous concerns about giving away cross default, because it can affect their liquidity buffer calculations.

Yet still we persist in our sophistry.

Then the lawyers and credit officers start fiddling with things

Cross default is a bad enough idea in a derivatives master agreement in the first place, before risk managers start having a go at it. Misguided things they can do include the following:

• Widening it to include default under agreements which aren’t in the nature of indebtedness: for example, derivatives, or even “any payment obligation”.

• This is problematic because of the accretive nature of the threshold: A single technical or operational failure may mean one is technically in default on payments which, if aggregated, could quickly exceed even a large threshold (especially in a heavily traded derivative master agreement).

• Not, in the case of banks, excluding retail deposits, where operational failure or even governmental action (like a moratorium or currency controls) could lead to technical default on a large amount of indebtedness. (Bank deposits are a form of indebtedness, and will almost certainly be a significant source of indebtedness for any trading bank).
• Adding in grace periods or other preconditions, excuses, permission to skip PE class and so on, before a party may invoke a cross default;
• Arguing the toss about threshold amounts (should it be shareholders funds or cash? or both? lower or higher of? Is my threshold higher than yours? Is it too big? Is it too small? Does my Threshold Amount look big in this? Honestly it is so tedious).

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 right effectively imports into the ISDA all the default termination rights under any Specified Indebtedness owed by a party:

• It dramatically (and indeterminately) widens the definition of Event of Default.
• It entitles a Counterparty to accelerate the ISDA whether or not the Specified Indebtedness itself has been accelerated.
• Depending on the market value of the transactions under the ISDA it may cause an immediate capital outflow (though is less likely to in these days of compulsory variation margin).

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 a bank counterparty’s creditworthiness (for example, political action in a single jurisdiction which affects the bank's ability to pay on its local deposits)
• Note that repo is not considered Specified Indebtedness: see borrowed money. But don’t let your inner anal retentive amending the definition in your Schedule so that it is (even though repo is more properly dealt with by DUST).

Derivatives as Specified Indebtedness

Be wary of including derivatives or other non-debt-like money payment obligations in the definition of Specified Indebtedness, no matter how high a Threshold Amount. We would say never do it, but the wise minds of the credit department may well be beyond your calming influence, so you may not have a choice. But if you have a choice, don’t do it.

In its unadulterated formulation, Cross Default aggregates up all Transaction-level defaults, so even though a single ISDA Master Agreement would be unlikely to have a net out-of-the-money MTM of anywhere near the Threshold Amount, a large number of individual Transaction MTMs, if aggregated, may — particularly if you’re selective about which Transactions you’re counting — which Cross Default entitles you to be.

Thus, where you have a large number of small failures, you can still have a big problem. (This is why banks should also carve out deposits: operational failure or regulatory action can create an immediate problem).

Now it is true that you can require the Specified Indebtedness of a master trading agreement to be calculated by reference to its net close-out amount, but this only really points up the imbalance between buy-side and sell-side. Sure, fund managers may have fifty or even a hundred ISDA Master Agreements, but they will be split across dozens of different funds., each a different entity with its own Threshold Amount. Broker-dealers, on the other hand, will have literally hundreds of thousands of master agreements, all facing the same legal entity. Credit dudes: you are the wrong side of this risk, fellas.

Now seeing as most master trading agreements are fully collateralised, and so don’t represent material indebtedness on a netted basis anyway, it may be that even with hundreds of thousands of the blighters, no-one’s Threshold Amount will ever be seriously threatened. But if no Threshold Amount is ever at risk from an ISDA Master Agreement, then why are you including the ISDA Master Agreement in Specified Indebtedness in the first place?

O tempora. O paradox.

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.