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Template:Flawed asset capsule: Difference between revisions
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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. | 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==== | ||
{{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. | |||
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 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''. | ||