Rating-Triggered Termination Rights

Rating-triggered termination rights (RTTs) allow one party to terminate transactions if the counterparty’s credit rating falls below a predefined threshold.

Relevance Depends on Collateralisation

The economic importance of RTTs is highly regime-dependent:

• Under a well-functioning two-way CSA (with daily variation margin and appropriately calibrated initial margin):
• Mark-to-market exposure is largely eliminated
• Residual risk is limited to gap risk and operational frictions
• As a result, RTTs have minimal economic relevance

In uncollateralised or weakly collateralised structures (including one-way CSAs):

• Exposure persists and can become large in stress scenarios
• RTTs become economically material, as they truncate tail exposure

Direction of Optionality

The direction of the embedded optionality depends on who holds the termination right:

In typical dealer-client relationships, the dealer may hold the RTT, creating:

• A reduction in CVA, FVA, and KVA for the dealer
• An embedded option to terminate when the client’s credit deteriorates

In supranational and SSA contexts, the structure is often reversed:

• The client (supranational) may retain stronger contractual protections, including RTTs

In these cases, the dealer is the party effectively short the option

• This distinction is critical—there is no universal “dealer-favourable” interpretation.

Economic Interpretation

Where RTTs are relevant (i.e. outside a fully collateralised framework), they:

• Truncate exposure in adverse credit states
• Reduce tail losses and capital requirements for the party holding the right
• Embed a form of credit-contingent optionality

However, once a two-way CSA removes exposure, this optionality becomes largely redundant.

Negotiation Implications

The primary objective should be robust collateralisation, not reliance on RTTs

In a two-way CSA framework, RTTs should not be a central pricing lever

In uncollateralised or one-way structures:

• RTTs have real economic value
• That value should be explicitly recognised and negotiated

Particular attention should be paid to:

• Direction (who holds the right)
• Trigger levels
• Cure periods and grace mechanisms

Conclusion

RTTs are second-order terms in a properly collateralised derivatives framework, and first-order only where exposure is allowed to persist.

They should not be viewed as a substitute for collateral, but rather as a legacy credit protection mechanism whose relevance diminishes sharply in modern CSA-based markets.