Cross Default - ISDA Provision
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2002 ISDA Master Agreement
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Crosscheck: 5(a)(vi) in a Nutshell™
Original text
See ISDA Comparison for a comparison between the 1992 ISDA and the 2002 ISDA.
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Comparisons
The 2002 ISDA updates the 1992 ISDA’s Cross Default so that if the combined amount outstanding under the two limbs of Cross Default exceed the Threshold Amount, then it will be an Event of Default. Normally, under the 1992 ISDA, Cross Default requires one or the other limbs to be satisfied — you can’t add them together. This was a bit of a snafu.
The two limbs are:
- a default under a financial agreement that would allow a creditor to accelerate any indebtedness that party owes it;
- a failure to pay on the due date under such agreements after the expiry of a grace period.
Cross default in securities financing arrangements
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.
Comaprison with cross acceleration
Cross acceleration is essentially cross default only tweaked such that it is only triggered on actual acceleration of 3rd party indebtedness rather than the mere potential for acceleration. This is enough of a difference to make it worth its own page so if you're interested in that please see Cross Acceleration.
Basics
Cross Default is designed to cover the unique risks that come from lending money to people who have also borrowed heavily from other people, likely on better terms than you. The basic vibe is: if any of this other borrowing becomes theoretically payable then I want the right to terminate my ISDA as well.
Sounds simple, doesn’t it? Well: ride with me a while.
Cross default’s origins in the loan market
Cross default is an ancient concept. It grew out of the traditional loan market and was transplanted into the swaps market at the dawn of the Age of Swaps. Consider a traditional unsecured loan. Its characteristics are as follows:
- Firstly, there is an identifiable lender — usually a big institutional bank — and an identifiable borrower — usually a small business or an individual. They are in a formalised relationship of dominance and subservience, and this power structure and their roles will not change. The bank is, always, the risk taker: it is giving away its money against nothing but the borrower’s earnest promise to later give it back.
- Secondly, therefore a loan represents the outright allocation of a large amount of capital from the bank to the customer: there is an intrinsic creation of credit risk. A large part of the bank’s business is assessing whether the borrower is likely to give the money back and implementing terms in its loan contract to force the borrower to give the money back if things do not go according to plan. The bank therefore keeps its “weapons” trained on the borrower. Conversely, once thre borrower has the money, it is not at risk to the bank. The borrower does not need to point any weapons at the bank.
- Thirdly, as a consequence, during the term of the loan, the borrower will not often have to pay any money to the borrower. Usually, only periodic interest, and that might only be quarterly or even semi-annually. All the borrower’s financial obligations are “rear-loaded”. They all come at the end of the loan contract.
- Fourthly, this allocation of capital is time-constrained. Unless the borrower defaults, the bank cannot get its money back before the specified term. All it is entitled to is interest on the amount loaned.
An outright lender is at significant risk, therefore, if the customer’s creditworthiness deteriorates during the term of the loan. This is what its weapons are there to manage: The bank will want to be able to call a default as soon as it thinks the customer will not be able to repay later. It will not want to wait and see.
But what default events can it look to in the loan contract? A “failure to pay” or a “breach of agreement” won’t do, because the customer might not have any payment or performance obligations due under the loan. The bank will not want to wait six months for the next interest payment.
The borrower may have taken out loans with other banks. It may owe money to other lenders before it owes anything to the bank. This will make the bank nervous: other lenders are also exposed to that borrower’s solvency. If the borrower becomes financially distressed, everyone will want to use their weapons. There is plainly an advantage to being the first lender to pull the trigger. If another lender shoots — if another lender even becomes entitled to shoot — then the bank will want to be entitled to shoot, too.
Hence, the concept of “cross default”: should a borrower be in material default under a different contract with a third-party lender, a cross default right permits the bank to call in its loan, too, even though the borrower has not missed any payments to the bank. Even if none were even due.
This is a drastic measure: it puts the bank and the borrower’s other lenders into a kind of Mexican standoff: if you know your borrower has given up a cross-default right to other lenders then all lenders have twitchy trigger fingers. All will want to accelerate their loans as soon as anybody else is entitled to.
There is a curious phenomenon here: a kind of systemantics: though Cross Default is designed as credit-risk mitigant, its very existence makes a credit default more likely. The cruel games we play
The loan market therefore developed some “thresholds” around the cross-default concept: you could only invoke Cross Default if the borrower’s default exceeded a certain monetary value. Cross Default should only apply to events material enough to threaten the borrower’s solvency.
Remember that Cross Default is meant to protect against the risk of material uncollateralised indebtedness, on terms containing infrequent payment obligations, where the borrower also has significant indebtedness to other lenders in the market.
Also, to reiterate: cross-default is a one-way right. A borrower has no cross-default right against a lender. (Why would it? That would be silly.)
The ISDA evolved from the loan market
We have seen elsewhere that the ISDA Master Agreement evolved in the 1980s out of innovations in the loan market. Early swaps were offsetting loans. They were documented by lawyers who were, by training and disposition, banking specialists: they were used to thinking of the world in terms of lending.
When it came to drawing up early versions of the ISDA Master Agreement it was only natural that the lawyers who drafted it would include the usual suite of banking weaponry to manage the risk of default. That included Cross Default.
Swaps are not like outright loans
But swaps are not very much like outright loans. They are not, by nature, lending arrangements. Swaps are, in a sense, financing arrangements: the swap dealer finances assets, but does not engage in the outright allocation of capital, as a lender does. Financing and lending are fundamentally different activities. They present different risks.
Swaps, also, are by their nature fully bi-directional. Unlike in the loan market, roles are not fixed. There is no pre-determined lender and borrower: under a swap, either party can owe money. Who is “in-the-money” can change at any time.
This means the range of default events under the ISDA Master Agreement must be symmetrical and bi-directional: if there is to be a Cross Default right, it must point in both directions. The bilateral nature of the Cross Default in the ISDA Master Agreement applies equally to banks as it does to customers. This presents some rather curly conceptual challenges, as we will see.
But in another sense, swaps sort of are like loans. Swap dealers manage their books to be “flat” market risk, whereas swap customers enter swaps to take on market risk. Swap dealers have a quasi-banking role: they may not be allocating capital, but they are arranging it.
The rationale for cross default is not present in a swap
In any case, the features of loans that Cross Default was developed to address are broadly not present in swap transactions:
- Firstly, swaps are not primarily instruments of uncollateralised indebtedness. Swaps are implied financings where, on day 1, the customer is not indebted to the dealer or vice versa. (A “financing” is an arrangement where a customer raises cash against a margined asset, a “loan” is where a customer raises cash against its own un-margined promise to repay).
- Secondly, swap notionals tend to be relatively small compared to the loan facilities in which you might expect to see a cross default.
- Thirdly, swap payments are frequent and flow in both directions, especially under an ISDA Master Agreement having multiple unrelated transactions, with individual payment dates and tenors.
- Fourthly, at least nowadays, ISDA Master Agreements are typically daily margined to a zero Threshold so even though it is conceptually possible for indebtedness to arise under an ISDA, in practice, it mostly does not.
- Lastly, many ISDA customers will not have significant unmargined third-party indebtedness: most heavy users of swaps like investment funds invest on margin and not by means of outright uncollateralised loan. As we will see, asset financing arrangements tend not to have cross default terms in them — the one exception being the ISDA.
You would not therefore expect to have to use Cross Default often to close out an ISDA Master Agreement. Usually, there would long since have been a Failure to Pay or Deliver or Bankruptcy, and both of those events are a much more deterministic, identifiable and therefore safe means of bringing an ISDA arrangement to an end. And this is the general experience.
How does it work?
Imagine swap counterparty X who, alongside its ISDA Master Agreement with you, has “Specified Indebtedness” - outstanding loan obligations to lenders A, B and C.
Should X default under any of loans A B or C in a total sum over the specified Threshold Amount, the cross-default provision in your ISDA will entitle you to accelerate all outstanding Transactions under your ISDA.
“Capable of acceleration” versus failure to pay
A bit fussily, Section 5(a)(vi) distinguishes between the general acceleration of Specified Indebtedness — a general event of default of any kind at any time during the tenor of any Specified Indebtedness such as the borrower’s bankruptcy, a breach of its reps and warranties, a non-payment of interest, any repudiatory breach of the contract of indebtedness, really — and a failure to pay: a borrower’s failure to fulfil, in full, final repayment of the debt itself when due.
Does not a “failure to pay” count as an acceleration event? This drafting seems redundant? The distinction is technical: with a loan, the lion’s share of the borrower’s payment obligation falls on the maturity date, at which point the loan cannot logically be “accelerated” because it is already due. ISDA’s crack drafting squad™’s drafting simply catches the distinction between a default event happening before the termination date and that final fundamental repayment failure.
“Specified Indebtedness”
What counts as “Specified Indebtedness” is a topic of hot debate.
The ISDA itself restricts “Specified Indebtedness” to “borrowed money” without further elaborating on what that means. Clearly, it takes in formal loan arrangements; it’s not clear whether trade credit terms would be included — Firth on derivatives thinks not — but in light of the small relative size of those arrangements, it probably doesn’t make much difference in any case.
Financing arrangements
Financing arrangements are not caught in the standard wording, as discussed elsewhere. They do not involve uncollateralised “indebtedness” as such but rather are margined transformations of owned assets.
This does not stop credit officers fiddling with the definition of Specified Indebtedness to bring them into scope — a favourite tweak is to include derivatives and securities financing arrangements as Specified Indebtedness without stopping to clarify how the “borrowed money” under them (hint, under a margined ISDA, there will not be any) is to be measured.
For reasons we will come to, this is a grave mistake.
Bank deposits
A type of Specified Indebtedness that would not upset cross defaults in the loan market but has the potential to do so in the swaps market is the bank deposit. Deposits are plainly borrowed money, and they mightily add up: as we will see, aggregation is important when calculating the Threshold Amount.
Only banks are allowed to accept bank deposits, and in the traditional loan market banks are lenders and therefore are not subject to cross default terms, so deposits are not in play.
But ISDA Cross Default is bilateral, so could — unless you fix it, would— catch a bank swap dealer’s customer deposit base. It is not out of the question that a bank could be prevented from repaying deposits through operational error, IT outage or geographical incident and therefore technically be in default on a large number of its deposits at once.
For this reason, banks tend to exclude retail deposits from the definition of Specified Indebtedness. This is sensible, and they will not resile from this position, so buy-side agitants, when you are picking your ditch to die in, I would not make it this one.
Public indebtedness
The last thing to note about Specified Indebtedness is that typically, borrowed money tends to arise under private contracts and the circumstances in which it is in default will not be known to the market. The only exception to this are public bond issuances. Beyond that, generally speaking, the market will not have real-time information about the level of a given counterparty’s overall indebtedness, much less whether it has defaulted on it. This makes practical policing and enforcement of a Cross Default right fraught, where it is even possible.
“Default”
“Default” is described widely and (at least in the 2002 ISDA) is not restricted to payment defaults. A breach of representations or a technical breach of loan covenants would count as an actionable Cross Default as long as it entitled the third-party lender to accelerate the loan.
The lender does not have to accelerate
The lender need not actually accelerate the loan. The cross-default right arises when the lender becomes entitled to accelerate. See below for our discussion of cross acceleration — a weakened version of Cross Default that requires the loan to be actually called in.
Needless to say, this makes the Cross Default a very powerful and sensitive tool. Too powerful. Too sensitive.
Most favoured nation
It also introduces an unusual variability to the ISDA universe: While the Events of Default described in the ISDA Master Agreement are for the most part standardised and inviolate, default events under a bilaterally-negotiated loan facility may well be tweaked. Section 5(a)(vi) references “a default, event of default or other similar condition or event (however described) in respect of such party”. This is loose and could for example include potential events of default (those which will become an event of default on expiry of a grace period).
In any case, Cross Default is a “most favoured nation” clause importing into the ISDA every single “default or similar event” from the counterparty’s other third-party loan contracts: any defaults rights you have given away to any other material lender you must also give to me. This is wide, and, as noted elsewhere acts as much as anything else to destabilise the creditworthiness of the counterparty.
“Threshold Amount”
The Threshold Amount is the level over which accumulated defaults in Specified Indebtedness comprise an actionable Event of Default under the ISDA Master Agreement.
It is usually defined as a cash amount or a percentage of shareholder funds, or both, in which case — schoolboy error hazard alert — be careful to say whether it is the greater or lesser of the two.
This accumulation feature means that relatively trivial amounts of indebtedness can be problematic particularly where the default is technical, systemic or operational. As mentioned above, should a system outage prevent the bank from honouring its deposits — almost certainly a sum greater than 2% of its shareholder equity — it might instantly trigger a cross-default right on all its ISDA Master Agreements. This would be catastrophic if acted upon. That is a big if, it is true — but commending the institution’s soul into the hands of rapacious hedge fund swap counterparties is not a gambit most prudent banks would willingly take.
Because of the snowball effect that a cross default clause can have, the Threshold Amount for every contract should be big: like, life-threateningly big. So, expect a swap dealer to accept little less than 2-3% of shareholder funds, or sums in the order of hundreds of millions of dollars.
For end users (especially for thinly capitalised investment vehicles) the Threshold Amount may be a lot lower than that — like, ten million dollars or so — and, of course, for fund entities will key off NAV, not shareholder funds.
Bear in mind, too, that if even one of your ISDA contracts has a lower Threshold Amount, that can create a chain reaction: because the exposure under that ISDA, once it has been triggered by a Cross Default, then contributes to the total amount of defaulted Specified Indebtedness and may itself lead to Threshold Amounts being triggered in other ISDAs. And each of those then contributes … you get the idea.
There is one last problem with including ISDAs within Specified Indebtedness: what is the “indebtedness” you are measuring? You can look at individual transaction exposures and aggregate them. Nothing requires you to apply a Single Agreement concept or any kind of cross-transactional netting to those exposures. (Why would it? ISDA contracts are designed to be out of scope for Cross Default). If you bring them into scope you could, in theory, cherry-pick all out-of-the-money Transactions, total them up and cross a Threshold Amount fairly easily.
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 dealers and their customers. Sure, big 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. Swap dealers, on the other hand, will have literally hundreds of thousands of master agreements, all facing the same legal entity. Dealers are the wrong side of this risk.
This can of course be managed by careful negotiation, but JC would say there is a much better means of managing this risk: excluding transactions under collateralised master trading agreements altogether, for the perfectly sensible reason that they should not be considered as “borrowed money”.
Now seeing as most master trading agreements are fully collateralised, and so don’t represent material indebtedness on a net basis anyway, it may be that — if correctly calibrated to catch the net mark-to-market exposure, no-one’s Threshold Amount will ever be seriously threatened.
But if no Threshold Amount is ever likely to be breached, then why are you including Specified Indebtedness in the first place?
O tempora. O paradox.
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See also
- Cross default in general
- Cross acceleration — cross default gone runny at the edges
- Indebtedness
- Capital structure