A new industry standard governing the treatment of derivatives contracts in insolvency raises hackles amongst banks’ clients and, critics argue, may even increase systemic risk.
In October the International Swaps and Derivatives Association (ISDA), the trade body for the $700 trillion global derivatives market, announced that 18 major global banks had agreed to a temporary suspension of the rights they enjoy when a counterparty to derivatives trades gets into trouble.
The new ISDA “resolution stay” protocol, due to come into effect from January 2015, will impose a 48-hour hiatus on the protocol signatories’ rights to the early termination of trades, a period intended to give regulators time to “resolve” a troubled bank.
The stay, introduced at the behest of the G-20 nations’ Financial Stability Board (FSB), the policy body charged with maintaining the safety of the global financial system, also represents a small but potentially significant shift in the privileged status of the large financial institutions that dominate the derivatives market.
Via a series of amendments to bankruptcy law in the U.S., Europe and elsewhere, beginning in the 1980s, counterparties to trades in so-called qualifying financial contracts, including derivatives, swaps, repo trades and forwards, were exempted from the normal rules affecting insolvencies.
Under these so-called safe harbor provisions, these financial counterparties could terminate contracts with a failing firm immediately, seizing in full any collateral that they had pledged to back trades, rather than waiting for the decision of a court and a likely write-down of their claims, the fate of most creditors of a bankrupt entity.
While other legal initiatives, says ISDA, including the U.S. Dodd-Frank Act and the EU Bank Recovery and Resolution Directive, also aim to impose a stay on the early termination rights of counterparties to a failing bank, these statutory regimes typically don’t address cross-border exposures.
For a major investment bank, these global exposures can be enormous: Lehman, for example, which failed in 2008, had 209 registered subsidiaries in 21 countries. According to consultant and author Satyajit Das, the bank had 1.2 million in derivatives contracts outstanding at the time of its bankruptcy filing, worth $39 trillion in notional value.
By addressing such potential cross-border claims via a voluntary, bank-led agreement, the new protocol “is a major component of a regulatory and industry initiative to address the too-big-to-fail issue, therefore ensuring taxpayer money is never again needed to prop up a failing institution,” ISDA said in October.
“Regulators want the new ISDA protocol because bank insolvencies in the future will be addressed by a resolution arrangement: you create a so-called good bank and you transfer the performing assets and the creditors you want to protect to it, while bailing in other creditors. That’s supposed to happen over a weekend,” says Simon Firth, partner at law firm Linklaters.
However, a major category of derivatives users is notable by its absence from the list of co-signatories to the ISDA protocol: buy-side firms, including asset managers, insurance companies and other non-bank counterparties.
In the largest segment of the derivatives market—interest rate swaps (IRS)—non-banks are involved in nearly nine out of every ten trades, according to credit rating agency Fitch, citing data from the Depository Trust & Clearing Corporation (DTCC).
In a letter sent to FSB Chairman Mark Carney on November 4, a group of six industry bodies representing derivatives users, led by the U.S. Managed Funds Association (MFA), said it disagreed with the regulators’ proposal to limit the protections enjoyed by derivatives counterparties in bankruptcy, saying that, for buy-side firms, the move was contrary to the goal of protecting investors. The ISDA protocol also puts the functioning of the financial markets in jeopardy, argued the MFA letter’s authors.
The co-signatories accused the global regulator of having failed to follow due process when introducing the protocol and of having consulted only a small group of market participants prior to its introduction.
“The buy side is livid about the protocol: they are freaking out about it,” says Craig Pirrong, professor of finance at the University of Houston. “They are particularly concerned that the banks are going to sell them down the river in some way.”
In mid-November, over a month after the protocol had been announced, ISDA issued an emollient media comment, stating that it understood investors’ concerns and maintaining that it had sent buy-side firms all drafts of the protocol, having encouraged them to voice their opinions throughout the process.
Buy-side firms “argued they have a fiduciary duty to their clients that prevents them from voluntarily signing away advantageous contractual rights. And they’re right,” ISDA said.
But non-bank derivatives users may have little choice in the matter of whether or not to retain their ability to exit trades early.
“Regulators have committed to develop new regulations in their jurisdictions in 2015 that will promote broader adoption of the stay provisions beyond the G-18 banks,” ISDA stated when announcing the signing of the protocol.
“If the regulators say to banks that they can’t enter into further transactions with counterparties who haven’t signed up to the protocol, the counterparties won’t have any choice if they want to carry on doing business in the derivatives market,” explains Linklaters’ Firth.
Nor would the ISDA protocol apply only from a point in time, says Firth, leaving existing contracts untouched.
“By signing up, the protocol would apply to the whole ISDA master agreement, including historic and future transactions,” he adds.
Meanwhile, legal and derivatives market experts raise two other principal objections to the new ISDA protocol: whether the resolution of a large bank can realistically happen in a two-day timeframe, and whether bankruptcy law is becoming less consistent, with potentially dangerous knock-on effects.
“The idea that people can spend a weekend doing due diligence on failing bank’s derivatives portfolio, come up with a purchase price and move it somewhere is a fantasy. It’s more likely that people will wait a couple of days and then litigate for years, just as has happened with Lehman,” says Anne Beaumont, partner at law firm Friedman, Kapler, Seiler and Adelman.
Litigation over Lehman’s estate has continued for over six years, costing over $2 billion in legal fees and expenses.
Das is another skeptic about regulators’ resolution powers.
“The U.S. Federal Deposit Insurance Corporation (FDIC) has an article on its website claiming it could have resolved Lehman over a weekend and the creditors would have got back more money. If Lehman had been a community bank in Idaho with two branches, this might have been feasible. But I don’t think this works with large complex institutions,” says Das. “Nothing really gets done in two days.”
Firth is more optimistic.
“If regulators are doing their job properly, they should be able to identify problems before an event of default occurs and, once they’ve decided that something needs to be done, move fairly quickly,” he says.
Meanwhile, the ISDA resolution stay protocol creates potentially dangerous inconsistencies in bankruptcy law, argues Pirrong.
“For better or for worse, at least the safe harbor provisions make sense and fit with one another,” says Pirrong.
“My objection to the new ISDA protocol is that bankruptcy law has to be joined up. Restricting rights in bankruptcy creates perverse incentives in the run-up to a potential insolvency. This is a piecemeal fix when you need something more holistic,” he adds. “In the event of a crisis, run risk could be amplified. People might prefer to get out while they can instead of waiting for a stay of two days and seeing whether this new, untried mechanism actually works.”
And regulators haven’t yet clarified how the new stay protocol would apply to an increasingly important part of the post-crisis financial system infrastructure, central counterparty clearinghouses (CCPs).
According to Fitch, about 61% of the IRS market is dealer-to-CCP.
“It is likely that, given the focus that regulators will apply to CCP resolutions over the near-to-medium term, CCPs would logically come under future agreement with the resolution stay,” Fitch said in October.
This extension in the protocol’s scope could create a new source of systemic risk, argues Das.
“Most derivatives trades are now supposed to be going through a CCP,” Das adds. “If regulators apply the resolution stay protocol to a CCP, this creates a whole new dynamic as CCPs are better off closing out positions as quickly as possible. Market moves after an insolvency event can create exposures for a CCP. The ISDA document didn’t address this, which is problematic.”
More broadly, argues Das, the current approach to reforming arcane but important areas of financial market law threatens an accident.
“Complex regulation is being created by silos of people who don’t necessarily understand what’s happening elsewhere.”
–Paul Amery
ISDA Protocol Raises Fairness And Risk Concerns
A new industry standard governing the treatment of derivatives contracts in insolvency raises hackles amongst banks’ clients and, critics argue, may even increase systemic risk.