By Satyajit Das, a former banker. His latest book is Age of Stagnation (published as A Banquet of Consequences in UK, Europe, Australia and NZ). His previous books include: Extreme Money and Traders, Guns and Money
In early May 2016, the US Federal Reserve’s (“Fed”) proposed new measures which would, if implemented, require derivative contracts to be altered requiring counterparties to waive their right to terminate open positions and claim amounts owed, for a period of up to 48 hours when a bank enters bankruptcy. The proposal is consistent with a voluntary protocol introduced by the International Swaps and Derivatives Association (“ISDA”), which represents the derivatives industry, in 2014 and subsequently amended in 2015.
‘Stay’ means: a delay, pause, stop or to suspend or postpone. It also means a device used as a brace or support, such as a corset made of two pieces laced together and stiffened by strips originally of whalebone. Interestingly, the proposal for a ‘stay’ encompasses all of the above meanings.
Rapidly Resolving Derivatives
The proposed measures are part of the rapid resolution regimes (“RRRs”) (also known as living wills) created to reduce systemic risk, where a default by a large and/ or well connected bank rapidly spreads through the financial markets and into the real economy.
The basic idea is to provide the State with the power to resolve a failed bank, without recourse to bankruptcy, liquidation or public bail-outs. Resolution would entail sale or transfer of assets, restructure of the entity (isolating bad assets) or recapitalisation (including a ‘bail-in’ to convert the bank’s quasi capital instruments or debt to equity). A principal objective is to avoid recourse to taxpayer funding and socialisation of the costs of failure.
Derivatives create certain issues for a RRR:
- The market is sizeable, though there are ongoing debates about the significance of its scale and the precise measure to be used.
- Derivatives link counterparties across markets and jurisdictions creating the risk of contagion allowing rapid transmission of financial shocks.
- Values (that is the amounts owing on closure of a contract) can change rapidly. As many contracts are secured by collateral, usually cash or government bonds, valuation effects can be transferred across market segments.
- Some contracts are complex and illiquid creating uncertainty.
- Where used for risk management, the failure of a counterparty can expose the hedging firm or institution to the underlying risk.
- Forced re-hedging or portfolio management may exacerbate volatility.
- Opacity about positions held by individual counterparties and the precise terms and conditions (including credit enhancement) can heighten uncertainty.
Where one or other party defaults, for example due to bankruptcy, the process of termination of contracts should be as follows:
- All contracts should terminate, triggering unwinding of all open transactions governed by the ISDA Master Agreement.
- The value of each transaction must be determined.
- Amounts owing or owed on individual transactions should be netted off to arrive at an aggregate sum that is owed by one party to the other (known as Close-out Netting).
- Any net amount owing should be paid. In case of a bankruptcy, this means that if an amount is owed to the bankrupt party then the amount is paid to the bankruptcy trustee or administrator. If an amount is owed by the bankrupt party, then that amount will rank as a debt to be paid out of recoveries or by application of collateral held as surety of the exposure.
The economic logic underlying the mechanics is that the non-defaulting party can close out its open positions at market rates. It can then enter new transactions in the market to establish replacement hedges to avoid risk of loss from potential changes in prices or rates.
There are several aspects of the above which are interesting,
- In some jurisdictions such as the US, derivatives enjoy special treatment under bankruptcy law. Safe harbour provisions exempt derivatives from the automatic stay or freezing of assets following a bankruptcy filing. This confers, at least in theory, two advantages: (i) when a bank fails derivatives counterparties can terminate their contracts and seize any collateral being held to settle any payment owed; and (ii) the ability to net amounts receivable and payable may prefer derivative creditors over other claimants.
- In practice, the processes envisaged, such as determination of termination values and re-hedging can be more difficult than the theory assumes as shown in the case of Lehman Brothers (see In the Matter of Lehman Brothers – Part 1: Breaking Up is Hard To Do and Part 2: Well Structured Messes).
Stay in the Name Of?
The stay is designed to create additional time to allow a regulator to determine and implement the appropriate course of action. The Financial Stability Board (“FSB”) summarised this as follows:
Effective temporary stays on early termination rights… are important to prevent the close-out of financial contracts in significant volumes. Such close-out action upon entry into resolution could disrupt the provision of critical functions, lead to the firm in resolution having an unbalanced book and undermine the objective of a resolution action that seeks to maintain the continuity of critical functions.
The 2014 ISDA Protocol amended the terms of existing Master Agreements and related documents in two areas: (i) ensuring that the parties’ rights only arose in circumstances that would be permitted under applicable resolution regimes; and (ii) specifically in the context of US resolution action, introducing limitations on certain cross-default rights which did not otherwise exist in domestic legislation. The ISDA November 2015 Universal Resolution Stay Protocol (the 2015 Protocol), developed with the FSB, extended the scope of covered agreements giving the adhering parties the ability to specify other agreements to be governed by the stay.
The ISDA proposal created a multi-lateral contractual mechanism to overcome the problems of cross border transactions and different national regulatory regimes. It facilitated cross-border recognition of the stay of termination rights under individual schemes such as those of the UK, France, Germany, Japan, Switzerland and the US.
Adherence to the ISDA Protocol is not mandatory. Parties that do not adhere cannot become subject to the Protocol by virtue of transacting under existing ISDA Master Agreements with adhering counterparties. Regulators must promulgate rules to mandate or encourage broader participation. The Fed’s proposal is part of this process.
The stay measure as proposed raises important issues.
First, the measures only suspend rather than eliminate the counterparties’ rights. As discussed below, more proactive steps may be necessary to achieved the sought after resolution of an insolvent institution.
Second, it is not clear why 48 hours will be adequate. In the case of Lehman’s, most derivative contracts were closed out over a period of 4-5 weeks but some complex contracts remained unresolved for significantly longer periods.
Third, the delay is not inconsequential in terms of valuation of open positions. It also affects availability of hedging options to cover transaction exposed by the termination. Changes in market value of contracts and also market liquidity can be material under condition of stress. It may also drive perverse behaviours whereby concerned counterparties may react to concerns about problems at a counterparty by terminating positions prematurely to avoid the effects of the stay. These actions may increase rather than decrease systemic risk.
Fourth, the measures do not necessarily apply to all participants, creating a two tier market. The ISDA Protocol operates voluntarily. To date, major banks and their affiliates have joined (a full list of the current adhering parties is available on the ISDA website). The Fed proposal would apply to eight systematically important US banks: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street and Wells Fargo.
Non banks, especially pension and mutual funds, face problems in adhering to the stay because of a fiduciary obligation to protect their beneficiaries’ assets. They may not be able to put systemic concern above that of the contractual obligations to investors. In effect, the proposals may be transferring the risk of loss from a systemically important institution onto pensioners and investors.
Fifth, it is not clear how the stay will affect transactions routed through central counter parties (“CCPs”). In theory, the stay only affects bi-lateral transactions. However, if a bi-lateral transaction is hedged with a CCP then a stay which affects only one leg of a matched pair of transactions could create an asymmetry which can increase risk.
Sixth, participants who did not wish to be subject to the stay may not have the choice of transacting elsewhere. More than 90% of all derivative contracts may be covered by the ISDA protocol or national regulations. Regulatory and bank pressures may make it difficult for investors not to adhere despite their fiduciary responsibility.
The measure highlights fundamental issues with the RRR itself.
First, the application of the RRR to institutions other than modest-sized banks with traditional banking activities was always ambitious. Laudable in theory, RRRs for large and complex institutions, which operate across multiple markets and legal jurisdictions, were always likely to be difficult in practice.
Second, the vexed issue of cross-border regulation and bankruptcy has proved difficult to address. Modern banking is multi-jurisdictional. Domestic legislation in the entity’s home jurisdiction may not be applicable to a contract with a counterpart located elsewhere governed by the law of a third country. It is difficult to ensure that relevant aspects of the home country’s regime and the regulator’s authority are effective in such a case. This would require a change of law in all relevant countries to ensure mutual recognition and enforcement of rights. Issues of sovereignty and also significant differences in legal approach make this difficult. Contractual recognition of such regimes and restrictions on respective rights, such as the protocols, are being used as a more immediate solution, creating the identified problems.
Third, the proposals of stays highlight a specific regulatory dialectic, evident in banking regulations generally but perhaps more marked in complex areas such as derivatives. Industry driven regulatory solutions such as the ISDA protocols are now increasingly embedded in national regulations. In effect, the technical complexity of the issues and lack of expertise of many regulators and legislators has led to law making being delegated to the industry being regulated. On this issue, bankers take the view once espoused by Italian Prime Minister Silvio Berlusconi: “If I, taking care of everyone’s interests, also take care of my own, you can’t talk about a conflict of interest”.
The present case is illustrative. The stay makes minimal concessions to regulators whilst subtly resisting any major change which could be more damaging to industry interests. It avoids re-consideration of the safe harbour provisions which confer, as some academics (such as Professor Stephen J. Lubben and others) have argued, anomalous advantages to derivative transactions. It also avoids discussion about the size and scale of as well as the motivation for derivative trading more generally. The implicit aim is to prevent challenges to valuable existing business franchises.
In reality, the stay is inconsequential. It delays but does not materially change early termination rights on derivatives or cross default rights. If derivatives and especially the insolvency of a major derivative counterparty are systematically concerning then why are more dramatic measures not being considered or legislated? Measures to assist in resolution could include under certain circumstances: rights to override contractual provisions, modify contracts, alter netting, set-off and collateral rights; bail-in payments under derivatives agreements; and ability to transfer contracts as required. Such changes would materially strengthen resolution options, minimisng contagion risks and reducing the exposure of tax payers.
Fourth, the debate highlights the fact that despite nearly 8 years of debate and voluminous new regulations the too big to fail issue remains and the resolution methodology is not clear. The fact that US regulators recently sent back all 11 living wills received from banks for revision highlights this failure.
Asked about government assistance to firms considered too big to fail, George Schultz, secretary of the Treasury under President Nixon, reputedly snapped: “If they are too big to fail, make them smaller.” That simple advice remains pertinent today.
© 2016 Satyajit Das