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 A “[[flawed asset]]” provision allows the “innocent” party to a financial transaction to suspend performance of its own obligations if its counterparty suffers certain default events ''without'' finally terminating or closing out the transaction. Should the defaulting side cure the default scenario, the transaction resumes and the suspending party must perform all its obligations including the suspended ones. For so long as it ''not'' cured, the innocent party may close the Master Agreement out at any time, but is not ''obliged'' to.}}
-====Rationale====
+====Rationale: avoiding a cleft stick====
-{{drop|W|hy would a}} party ever want to ''not'' close out a defaulting counterparty? It all comes down to ''[[moneyness]]''. The “[[The bilaterality, or not, of the ISDA|bilaterality]]” of most derivatives arrangements means that either party may, net, be “[[out of the money]]” — that is, net across all outstanding transactions, would ''owe'' money, if all transactions were terminated. This is a notional debt that is not “due” as such, so it is money a solvent counterparty might not want to have pay out just because its counterparty has failed to perform its end of the bargain. On the other hand, the innocent counterparty doesn’t want to have to continue stoically paying away to a bankrupt counterparty that isn’t reciprocating.
+{{drop|W|hy would a}} party ever want to ''not'' close out a defaulting counterparty? It all comes down to ''[[moneyness]]''.
-The flawed asset provision allows the innocent party the best of these both worlds. It can stop, and sit on its hands, thereby not thereby crystallising the [[mark-to-market]] loss implied by its [[out-of-the-money]] position. The defaulting party’s “asset” – its right to be paid, or delivered to under the transaction – is “flawed” in the sense that its rights don’t apply for so long as ''the [[conditions precedent]] to payment are not fulfilled''.
+The “[[The bilaterality, or not, of the ISDA|bilaterality]]” of most derivatives arrangements means that either party may, net, be “[[out of the money]]” — that is, across all outstanding transactions, it would have to ''pay'' a net sum of money if all transactions were terminated. This is a notional debt that only becomes “due” as such if you designate an {{{{{1}}}|Early Termination Date}} under the Master Agreement. So an [[out-of-the-money]] {{{{{1}}}|Non-defaulting Party}} has a good reason therefore ''not'' to close out the ISDA. Why should it have to pay out just because a {{{{{1}}}|Defaulting Party}} has failed to perform its end of the bargain? On the other hand, if it forebears from terminating against a bankrupt counterparty the {{{{{1}}}|Non-defaulting Party}} doesn’t want to have to continue stoically paying good money away to a bankrupt counterparty who isn’t reciprocating.
-Conceivably you could invoke a flawed asset provision even if you were [[in-the-money]], but you would be mad to.
+An [[out-of-the-money]] {{{{{1}}}|Non-defaulting Party}} seems, therefore, to be in a bit of a cleft stick.
+Section 2(a)(iii) allows the {{{{{1}}}|Non-defaulting Party}} the best of both worlds. The [[conditions precedent]] to payment not being satisfied it can just stop performing, and sit on its hands, and thereby not thereby crystallising the [[mark-to-market]] loss implied by its [[out-of-the-money]] position. The {{{{{1}}}|Defaulting Party}}’s “asset” – its right to be paid, or delivered to under the {{{{{1}}}|Transaction}} – is “flawed” in the sense that its rights don’t apply for so long as ''the [[conditions precedent]] to payment are not fulfilled''.
+Conceivably you ''could'' invoke a flawed asset provision even if you were [[in-the-money]], but you would be mad to.
 =====Which events?=====
-Exactly ''which'' default events can trigger a flawed asset clause will depend on the contract. Under an {{isdama}} it {{{{{1}}}|Events of Default}} and even {{{{{1}}}|Potential Events of Default}}, but not {{{{{1}}}|Termination Event}}s or {{{{{1}}}|Additional Termination Event}}s — which, given the “culpability” and “event-of-defaulty-ness” of [[ATE]]s, is something of dissonance in itself.
+Exactly ''which'' default events can trigger a flawed asset clause will depend on the contract. Under the {{isdama}} it {{{{{1}}}|Events of Default}} and even {{{{{1}}}|Potential Events of Default}} do, but {{{{{1}}}|Termination Event}}s and {{{{{1}}}|Additional Termination Event}}s do not. {{{{{1}}}|Termination Event}}s are softer, “hey look, it’s no-one’s fault, it’s just one of those things” kind of close outs, so that makes some sense — but on the other hand this is not really true of {{{{{1}}}|Additional Termination Event}}s, which tend to be credit-driven and with more “culpability” and “event-of-defaulty-ness” about them. This is, a bit dissonant, but there are far greater dissonances, so we park this one and carry on.
+=====2(a)(iii) in a time of Credit Support=====
+Flawed assets entered the argot in a simpler, more (''less''?) peaceable time when two-way, zero-threshold, daily-margined collateral arrangements were a fantastical sight. It was therefore reasonably likely that a {{{{{1}}}|Non-defaulting Party}} might be nursing a large unfunded [[mark-to-market]] liability which it would not want to have to pay out on just because the clot at the other end of the contract had driven his fund into a ditch. A large uncollateralised position is a less likely scenario in these days of mandatory [[regulatory margin]] in which counterparties generally cash-collateralise their net market positions to, or near, zero each day.
-=====Collateral=====
+Nor, we think, did it occur to dealers, who typically insisted on the flawed assets clause, that they might be on the wrong end of it. The events of [[Global financial crisis|September 2018]] were, therefore, quite the chastening experience.
-Flawed assets entered the argot in a simpler, more peaceable time when two-way, zero-threshold, daily-margined collateral arrangements were a fantastical sight. It was reasonably likely that a counterparty might be nursing a large unfunded mark-to-market liability which it would not want to have to fund just because the clot at the other end of the contract had blown up. This is a lot less likely in these days of mandatory regulatory margin. Nor did it occur to dealers, who typically insisted on the flawed assets clause, that they might be on the wrong end of it. The events of September 2018 were, therefore, quite the chastening experience.