Template:Cross default in securities financing agreements

There is no cross default in a securities financing transaction

There’s no need for cross default in any master trading agreement, actually — this is the JC’s considered view, about which you can read at length elsewhere — but the 2010 GMSLA and Global Master Repurchase Agreement are a particularly bad candidates for cross default because their transactions are by definition short term (in the case of repo) and callable at any time (in the case of stock loans) and fully collateralised, so the “mischief” cross default is designed to fix — large credit exposure under long tenor transactions with few regular cash-flows — does not exist.

Remember that:

• Large credit exposure
• Long term exposure with no break rights
• Infrequent cashflows

Cross default is designed for transactions with all of these features. A standard SFT has none of these features.

Cross default is a banking concept. It is designed to protect lenders who have unsecured credit exposure to borrowers under fixed rate loans where the only payments will be period interest payments, which might be only quarterly, half-yearly or even yearly. For your average credit officer, a year between scheduled payments is a long time between drinks. If she knows the borrower has defaulted in a big way to some other lender — some random — she will not want to wait nine months to for a failure to pay on her own facility. She will want to hit DEFCON 5 straight away; ideally, even before that other random lender has.

Hence, she will seek a cross default right: If random guy can pull you down, I can pull you down.

There’s no need to put one in. Even if you are doing term loans.

All the talk of borrowers and lenders in securities financing transactions makes a fellow giddy. But remember: SFTs are not contracts of indebtedness. Even though they’re called “Loans”, they are not actually, you know, loans. Lenders aren’t — legally or economically —lenders. Thus, there is no cross default in any standard SFT agreements. This was not a mistake. It was deliberate. You don’t need one.

Now, there is a certain stripe of credit officer who will not be convinced of this, and will want to put one in anyway. Does it do any harm? Well yes, actually: it creates contingent liquidity issues for your own treasury department, whom credit will routinely ignore when making their credit requests. And yes, from the perspective of production waste in the negotiation process: insisting on a cross default is, par excellence, the waste of over-processing.

Yeah, but why not, just to be on the safe side?

Why not put one in for good measure? SFTRs are collateralised daily, so:

• Neither party has material exposure;
• There will usually be payments flowing each way daily as loaned Securities and Collateral values move around, creating collateral transfers; and
• Even if there aren’t, either party can recall the loans on any day

Ok, how about set-off. I’ve got you there, haven’t I?

With set-off you truly open yourself up to the risk of a negotiation oubliette: A naturally-occurring subterranean cavern which forms when legal eagles gather to argue about trifles. Given enough nest-feathering, posturing and guano, even the most robust transaction will tend to fray and weaken and may in time collapse: those discussing suddenly find themselves in a dungeon on their own making, not knowing how they got there, but rather enjoying it all the same. While alarming for the commercial counterparties themselves, their negotiators will carry on, oblivious, sometimes for months or even years.

Oubliettes are often prompted by the lawyer’s equivalent of the “clabby” conversation: one struck up by an agent to appear busy while avoiding difficult work, wasting time and provoking maximum forward confusion.

Thus, they have a cosmological quality to them; like any black hole, they are impossible to see directly. We detect them only by their signature detritus: crushed aspirations of clarity and elegance, swirling around an event horizon of nothingness like so many gossamer dreams of greatness, gurgling around a galaxy-sized plughole. We enter these space-tedium singularities often, but always unwittingly, and it is only when scrabbling desperately for a way back out that we realise just what we have fallen into.

In any case, set-off is a furry and misunderstood thing. consider two scenarios: one where you have independent close-out rights under both agreements that allow you to terminate both, but no written contractual right of set-off, and one where you do not: Your 2010 GMSLA has blown up, but your counterparty doggedly hangs on under your other master agreements like Harold Lloyd dangling from a clock tower, refusing to let go, heroically continuing to perform, defying the circling vultures of default.

Where both master agreements have independently terminated, there is a common-law set-off right. It might not get to the level of comfort to ameliorate your financial reporting team’s capital calculators, but you would need a fully weaponised master netting agreement and separate netting opinion for that anyway. But, in practice you have off-setting obligations, in the same currency, due immediately (and therefore at the same day) and under English common law there is a set-off right. This may be interfered with by your counterparty’s insolvency regime — but then so would an explicit set-off clause, unless you had a F.W.M.N.A. as described above — but in many cases would not: English insolvency set-off is compulsory. This is to do no more than recognise that possession is nine-tenths of the law: I may owe you fifteen, but you owe me ten, so I will paying five and we will be square. Since no insolvency regime sophisticated enough to contemplate post-insolvency set-off would deny its efficacy, we must assume the law will be silent, and it will be a resourceful insolvency practitioner indeed who can construct an equitable argument to overcome that. (If you owe me twenty I will be a sport and call it quits if you pay me five: until that time you can whistle for it).

Where only one master agreement has actually defaulted — the Harold Lloyd scenario — it is even easier. By your own theory of the game, your counterparty, though broken, battered, bruised and perhaps expiring in a heap behind the dumpsters in the alley next to the kitchen, is still with us. Here we are contemplating an arrangement rather like “settlement netting”. I owe you, you owe me, and I am simply going to serially discharge you from your indebtedness to me by neglecting to pay you, and declaring that inaction a satisfaction of your corresponding debt to me. If it would be hard for an insolvency practitioner to argue against that kind of practical withholding, imagine how hard it will be for a solvent counterparty. Especially one on the bones of it arse, that can’t afford a decent lawyer. If if could, it would have just paid you in the first place, right?

No doubt purists will rail that this is a grubby, speckled and imperfect analysis. It is not true in all worlds, for all times, and it snubs its snotty nose at the proprieties of modern financial services legal practice. It is not accompanied by opinions. It is a bit too visceral; a bit too swooned by the earthy appeal of the mundane and every-day; it doesn’t acknowledge the primacy of the legal music of the spheres to which the philosopher kings of our industry like to tap their feet.

Guilty as charged: The JC’s philopsher king is Voltaire, and those who seek the perfect will still be formulating their close-out notices and preparing statements of claim, while we pragmatic folk have settled up caught a cab.