Template:Isda 2(a)(iii) summ: Difference between revisions

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===Technical nuts and bolts===
====The problem with bilateral agreements====
Leaving for a few moments when in this day and age you would ever need or even want to invoke {{{{{1}}}|2(a)(iii)}} other than in the strangest of days, let’s consider the mechanics. You will notice there ''are none''. Section {{{{{1}}}|2(a)(iii)}} just ''sits'' there, and has effect, without anyone’s particular by-or-leave. No notice is required: no-one need look out for envelopes being delivered to the physical address the firm occupied seventeen years ago when someone filled out Part IV of the schedule. Section {{{{{1}}}|2(a)(iii)}}doesn’t even say an {{{{{1}}}|Innocent Party}} is ''entitled'' to withhold payment: rather the conditions are not met and ''payment is not therefore due''. It just happens.
As we have remarked before, most financing contracts are decidedly one-sided.  One party — the dealer, broker, bank: we lump these various financial service providers together as ''The Man'' — provides services, lends money, creates risk outcomes; the other — the customer — consumes them. Generally, the customer presents risks to The Man and not vice versa. All the weaponry is therefore pointed in one direction: the customer’s. It almost goes without saying that should the customer “run out of road”, the Man stands to ''lose'' something.


This poses some rather intriguing questions:
Even though the ISDA is also, in practice, a “risk creation contract” having these same characteristics, it is not, in theory, designed like one. Seeing the dealer and the customer for what they are involves seeing a rather bigger picture. In the small picture — the ISDA agreement proper — either party can be out of the money, and either party can blow up. The weaponry points both ways.


Firstly a conceptual one: at what point do we know — when even do ''I'' know  — whether I have “suspended” my payment and not just simply ''failed'' on it? Is there a difference? The payment arrangements under a modern ISDA are a blizzard of electronic impulses, across multiple booking systems, product silos and other arrangements. The various operatives will have no idea of the status of other payments — sometimes these things fail for explainable reasons. So if, for some reason {{{{{1}}}|2(a)(iii)}} applies, the conditions precedent do not exist, but I make my payment anyway, then what? Is that a mistaken payment? Is it supported by [[consideration]]? Is there a potential claim for [[money had and received]]?
This presented the First Men with an unusual scenario when they were designing the {{isdama}}: what happens if ''you'' blow up when ''I'' owe money to you? Here I might not want to crystalise my contract: since it will involve me paying you a mark-to-market amount I hadn’t budgeted for I might not even be able to. (This is less of a concern in these days of mandatory bilateral variation margin, but the {{isdama}} was forged well before this modern era).


What, for the purpose of close-out valuations, is the status of payments that ''were'' made, but that were not ''required'' to be made? Are these some kind of negative energy in the close-out spacetime; dark matter, a kind of inverted {{isdaprov|Unpaid Amount}}?<ref>Okay I am having a bit of fun with you here I confess.</ref>
The answer the [[First Men]] came up with was the “flawed asset” provision of Section {{{{{1}}}|2(a)(iii)}}. This allows an innocent, but out-of-the-money, party faced with its counterparty’s default not to close out the ISDA, but to just freeze its obligations, and do nothing until the situation is resolved.  


The other one is practical. In times of market dislocation all kinds of things can go wrong. People suddenly instigate to manual processes. They start frisking all money payments on their way out the door. For all you know ''your correspondent bank may be doing this without your knowledge''. Payments you thought you had made may not have got to your counterparty.<ref>This is not nearly as unlikely as it seems: in a widespread market dislocation, for example, where sanctions are involved (hello Ukraine conflict!) expect ''everyone'' to be terrified of getting anything wrong. ''Everything'' will slow down.</ref>  Counterparties make oral arrangements to check payments in before sending anything out — expect all kinds of paranoia, fear & loathing. It’s great. Sometimes payments — going in either direction — can get hung up, stuck, blocked, sanctioned, or — who knows? — waived, or suspended by mutual consent, or even suspended by ''implication'': the parties may agree (or ''think'' they have agreed) to net settle payments usually made gross. If there is a misunderstanding —
There is an argument it wasn’t a good idea then; there is a better argument it isn’t a good idea now, but like so many parts of this sacred form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it.
====Flawed assets generally====
{{Flawed asset capsule|{{{1}}}}}


In short, it is not always certain whether payments have, in fact, been made, or missed. You would think this sort of thing would be determinate, but it isn’t. And this kind of uncertainty is more likely ''exactly at a time of stress''.  
====Does not apply to {{{{{1}}}|Termination Events}}====
Since most {{isdama}}s that reach the life support machine in an ICU get there by dint of a {{{{{1}}}|Failure to Pay}} or {{{{{1}}}|Bankruptcy}} this does not, in point of fact, amount to much, but it is worth noting that while {{{{{1}}}|Event of Default}}s — and even events that are not yet but with the passing of time might ''become'' {{{{{1}}}|Events of Default}} — can, without formal action by the {{{{{1}}}|non-Defaulting Party}} trigger a {{{{{1}}}|2(a)(iii)}} suspension, a mere Section {{{{{1}}}|5(b)}} {{{{{1}}}|Termination Event}} — even a catastrophic one like an {{{{{1}}}|Additional Termination Event}} (such as a [[NAV trigger]], [[Key person clause|key person event]] or some such) — cannot, until the {{{{{1}}}|Transaction}} has been formally terminated, at which point it really ought to go without saying.  


This can lead to some unfortunate surprises: the counterparty who, faced with a massive counterparty failure, and diligently files its notice of {{{{{1}}}|Failure to Pay or Deliver}}, only to find that, last week some clot in Collateral Ops mis-keyed a small yen payment or just effected a net settlement that the counterparty didn’t match, meaning that none of the “failing payments” were actually due in the first place. Expect a race back in time to see who committed the earliest unremedied non-payment.
This might rile and unnerve [[credit officer]]s — by nature an easily perturbed lot — but given our arguments below for what a train wreck the whole {{{{{1}}}|2(a)(iii)}} thing is, those of stabler personalities will consider this in the round a good thing.


None of this you will enjoy when, as it will, it happens just as the world has lost its head and is blaming it on you.
Nevertheless the [[JC]] has seen valiant efforts to insert {{{{{1}}}|Additional Termination Events}} to section {{{{{1}}}|2(a)(iii)}}, and — ''quel horreur'' — ''Potential'' {{{{{1}}}|Additional Termination Event}}s, a class of things that does not exist outside the laboratory, and must therefore be defined. All this for the joy of invoking a clause that doesn’t make any sense in the first place.


===...These days?===
“Some things are better left unsaid,” said no [[ISDA ninja]] ever.
The overriding mischief that a [[flawed asset]] provision addresses arises when a solvent swap counterparty with a long-dated [[out-of-the-money]] portfolio, finds its counterparty has, against the run of play, gone bust. If I am in the hole to you to the tune of $50 million, but that liability isn’t due to mature for ten years, in which time it might well come right and even go positive, I don’t want to crystallise it now, at the darkest point, just because ''you'' sir have gone tits-up.  
====“No Early Termination Date ... has occurred”...====
New in the {{1992ma}} was the second condition precedent, that “...no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”.


Answer: insert a flawed asset provision. This lets me suspend my performance on your default, ''without'' closing you out, until you have got your house in order and paid all the transaction flows you owe me. So the portfolio goes into suspended animation. Like Han Solo in ''The Empire Strikes Back''.
This is tidy-up material to bring ''triggered'' {{{{{1}}}|Termination Event}}s into scope. There is a period between notice of termination and when the {{{{{1}}}|Early Termination Date}} is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the {{{{{1}}}|Transaction}} is still on foot and going, albeit headed inexorably at a brick wall.
 
Now if, heaven forfend, you ''can’t'' thereafter get your house in order — if what was once your house is presently a smoking crater —then the game is up anyway, isn’t it? You will be wandering around outside your building in a daze clutching an [[Iron Mountain]] box cycling hurriedly through the stages of grief, wondering where it all went so wrong, wishing you had pursued that music career after all, but in any case casting scant thoughts for your firm’s unrealising mark-to-market position on that derivative portfolio with me.
 
This seems cavalier in these enlightened times, but in the old days people did think like this. But, with the gruesome goings-on of 2008, those are largely bygone days, though older [[legal eagle]]s may wistfully look into the middle distance and reminiscing about these kinder, happier times. Those who didn’t wind up desperately rekindling their music careers in 2009, anyway.
 
In the aftermath of the [[Lehman]] collapse regulators showed some interest in curtailing the [[flawed asset]] provision. The Bank of England suggested a “use it or lose it” exercise period of 30 days. Ideas like this foundered on the practical problem that repapering tens of thousands of {{isdama}}s was not wildly practical, especially without a clear consensus on what the necessary amendment might look like. So the initiative withered on the vine somewhat.
 
In the meantime, other regulatory reform initiatives overtook the debate. These days flawed asset provision is largely irrelevant, seeing as brokers don’t tend to take massive uncollateralised directional bets. Compulsory [[variation margin]] means for the most part they ''can’t'', even if the Volcker rule allowed them to.
 
Since all swap counterparties now must pay the cash value of their negative [[mark-to-market]] exposures every day, the very thing the flawed asset seeks to avoid — paying out negative positions — has happened, there is a lot more to be said for immediately closing out an {{isda}}, whether or not it is [[out-of-the-money]].
 
For [[synthetic prime brokerage]] fiends, there is another reason to be unbothered by Section 2(a)(iii): you shouldn’t ''have'' a losing position, since you are meant to be perfectly delta-hedged. Right?
===Flawed assets generally===
{{Flawed asset capsule}}

Revision as of 10:03, 25 March 2024

The problem with bilateral agreements

As we have remarked before, most financing contracts are decidedly one-sided. One party — the dealer, broker, bank: we lump these various financial service providers together as The Man — provides services, lends money, creates risk outcomes; the other — the customer — consumes them. Generally, the customer presents risks to The Man and not vice versa. All the weaponry is therefore pointed in one direction: the customer’s. It almost goes without saying that should the customer “run out of road”, the Man stands to lose something.

Even though the ISDA is also, in practice, a “risk creation contract” having these same characteristics, it is not, in theory, designed like one. Seeing the dealer and the customer for what they are involves seeing a rather bigger picture. In the small picture — the ISDA agreement proper — either party can be out of the money, and either party can blow up. The weaponry points both ways.

This presented the First Men with an unusual scenario when they were designing the ISDA Master Agreement: what happens if you blow up when I owe money to you? Here I might not want to crystalise my contract: since it will involve me paying you a mark-to-market amount I hadn’t budgeted for I might not even be able to. (This is less of a concern in these days of mandatory bilateral variation margin, but the ISDA Master Agreement was forged well before this modern era).

The answer the First Men came up with was the “flawed asset” provision of Section {{{{{1}}}|2(a)(iii)}}. This allows an innocent, but out-of-the-money, party faced with its counterparty’s default not to close out the ISDA, but to just freeze its obligations, and do nothing until the situation is resolved.

There is an argument it wasn’t a good idea then; there is a better argument it isn’t a good idea now, but like so many parts of this sacred form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it.

Flawed assets generally

Flawed asset
/flɔːd ˈæsɛt/ (n.)
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: avoiding a cleft stick

Why would a party ever want to not close out a defaulting counterparty? It all comes down to moneyness.

The “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.

An out-of-the-money, {{{{{1}}}|Non-defaulting Party}} seems to be, therefore, in a bit of a cleft stick.

Section {{{{{1}}}|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 crystallise 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 the ISDA, {{{{{1}}}|Events of Default}} and even Potential {{{{{1}}}|Events of Default}} do, but {{{{{1}}}|Termination Event}}s and {{{{{1}}}|Additional Termination Event}}s do not.

This is because most Termination Events are softer, “hey look, it’s no-one’s fault, it’s just one of those things” kind of closeouts — but this is not really true of {{{{{1}}}|Additional Termination Event}}s, which tend to be credit-driven and girded with more “culpability” and “event-of-defaulty-ness”.

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 an unusual sight. Nor, in those times, were dealers often of the view that they might be on the wrong end of a flawed assets clause. They presumed if anyone was going bust, it would be their client. Because — the house always wins, right? The events of September 2018 were, therefore, quite the chastening experience.

In any case without collateral, a {{{{{1}}}|Non-defaulting Party}} could, be nursing a large, unfunded mark-to-market liability which it would not want to pay out just because the clot at the other end of the contract had driven his fund into a ditch.

That was then: in these days of mandatory regulatory margin, counterparties generally cash-collateralise their net market positions to, or near, zero each day, so a large uncollateralised position is a much less likely scenario. So most people will be happy enough just closing out: the optionality not to is not very valuable.

Does not apply to {{{{{1}}}|Termination Events}}

Since most ISDA Master Agreements that reach the life support machine in an ICU get there by dint of a {{{{{1}}}|Failure to Pay}} or {{{{{1}}}|Bankruptcy}} this does not, in point of fact, amount to much, but it is worth noting that while {{{{{1}}}|Event of Default}}s — and even events that are not yet but with the passing of time might become {{{{{1}}}|Events of Default}} — can, without formal action by the {{{{{1}}}|non-Defaulting Party}} trigger a {{{{{1}}}|2(a)(iii)}} suspension, a mere Section {{{{{1}}}|5(b)}} {{{{{1}}}|Termination Event}} — even a catastrophic one like an {{{{{1}}}|Additional Termination Event}} (such as a NAV trigger, key person event or some such) — cannot, until the {{{{{1}}}|Transaction}} has been formally terminated, at which point it really ought to go without saying.

This might rile and unnerve credit officers — by nature an easily perturbed lot — but given our arguments below for what a train wreck the whole {{{{{1}}}|2(a)(iii)}} thing is, those of stabler personalities will consider this in the round a good thing.

Nevertheless the JC has seen valiant efforts to insert {{{{{1}}}|Additional Termination Events}} to section {{{{{1}}}|2(a)(iii)}}, and — quel horreur — Potential {{{{{1}}}|Additional Termination Event}}s, a class of things that does not exist outside the laboratory, and must therefore be defined. All this for the joy of invoking a clause that doesn’t make any sense in the first place.

“Some things are better left unsaid,” said no ISDA ninja ever.

“No Early Termination Date ... has occurred”...

New in the 1992 ISDA was the second condition precedent, that “...no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”.

This is tidy-up material to bring triggered {{{{{1}}}|Termination Event}}s into scope. There is a period between notice of termination and when the {{{{{1}}}|Early Termination Date}} is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the {{{{{1}}}|Transaction}} is still on foot and going, albeit headed inexorably at a brick wall.

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