Specified Indebtedness - 1992 ISDA Provision
Content and comparisons
Specified Indebtedness is a simple and innocuous enough provision. Almost redundant, you’d think — why go to the trouble of defining “borrowed money” as another term? (Answer: because many firms, in their wisdom, will wish to change the definition in the Schedule to include derivatives, other trading exposures, things owed to their affiliates, or even any payment obligations of any kind, and for those people, “Specified Indebtedness” is a (somewhat) less loaded term.
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.
Stock loans and repo as Specified Indebtedness
In any case, what should one make of “borrowed money”? Could it include repo and stock loan obligations under securities financing transactions? Amounts owed to trade creditors? (In each case no, according to Simon Firth - see here).
What of a failure to pay an Independent Amount? Technically this is not a payment of indebtedness, and if the IM payer is up-to-date on variation margin payments, there may not be any indebtedness at all. Indeed, once the IM payer has paid required IM, the IM receiver becomes indebted to the payer for the return of the initial margin — so while it certainly comprises a failure to pay when due, the value of the Specified Indebtedness that failure contributes to the Threshold Amount might be nil, or even negative. This, your risk people will say, is why one should widen Specified Indebtedness to include all payment obligations, but that, for a host of reasons you can find here — is whopping great canard a l’orange in this old contrarian’s opinion.