July 30 (Bloomberg) -- Wall Street and global financial regulators, trying to squash the lingering perception that banks remain “too big to fail,” are looking to an obscure change in derivatives contracts to solve the problem.
The main industry group for the $700 trillion global swaps market is rewriting international protocols to impose a “stay” or pause designed to prevent trading partners from calling in collateral all at once when a bank nears failure.
U.S. and international banking regulators are considering making use of the new protocols mandatory, according to two people who spoke on condition of anonymity to discuss private meetings. The International Swaps and Derivatives Association is aiming to release the revised contract guidelines by November, the people said.
The change is designed to prevent a recurrence of one of the most vexing problems revealed by the 2008 financial crisis: When Lehman Brothers Holdings Inc. failed, counterparties trying to unwind derivatives contracts touched off a panic that triggered a worldwide credit crisis.
The new protocol “puts another nail in the coffin of ‘too big to fail,’” Wilson Ervin, a senior adviser at Credit Suisse Group AG and the bank’s chief risk officer during the 2008 crisis, said in an e-mail. “Most banks want to get this done and are working hard for a good solution.”
Derivatives are complex financial instruments whose value is tied to another asset, such as a loan or stock. In normal times, derivatives can be used to offset or hedge potential losses on those assets. During the 2008 financial crisis, however, derivatives had the effect of spreading and intensifying the crisis triggered by escalating mortgage foreclosures.
ISDA’s protocols are used worldwide to draft contracts for derivatives trades. The group includes the world’s largest dealers, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Deutsche Bank AG, as well as asset managers and other firms that are traditional buyers, including BlackRock Inc. and Pacific Investment Management Co.
In the U.S., the regulators most directly involved in supervising and dismantling large financial firms are the Federal Deposit Insurance Corp. and the Federal Reserve. FDIC spokesman Andrew Gray confirmed that the agency is working with regulators from other countries to “explore contractual solutions to prevent disorderly termination of derivative portfolios.” He declined to discuss the process in further detail. Barbara Hagenbaugh, a Federal Reserve spokeswoman, declined to comment.
U.S., U.K. and European regulators, still wrestling with the aftermath of the financial crisis, have held months of discussions aimed at buttressing the new and untested system for dismantling failing banks that was built by the Dodd-Frank Act and similar efforts in other countries. Some lawmakers and many participants in the market remain skeptical that regulators are really prepared to let a systemically large firm fail.
In addition to the regular bankruptcy process, Dodd-Frank created a separate “liquidation” authority that the FDIC could use to seize and take apart a firm if a bankruptcy would shake the wider financial system.
However, as a U.S.-focused law, Dodd-Frank didn’t have the authority to solve the question of how to treat derivatives contracts as part of that process, in part because so many of them are international. Derivatives were already exempt from the stay that normally applies during bankruptcy; financial firms had successfully argued for decades that the financial system would be more stable and risks would be contained if traders could immediately end deals with a failing institution.
Lehman’s failure exposed that argument as flawed. When it filed for bankruptcy, Lehman had more than 900,000 derivatives positions and its counterparties moved immediately to terminate trades and demand collateral.
“When Lehman went down, there was no stay in effect for derivatives and that had an enormous impact on the market,” Harvey Miller, partner at Weil, Gotshal & Manges LLP and a bankruptcy lawyer for Lehman, said in an interview. “If you have an entity such as Lehman, which is interconnected with so many other contracts and global in scope, the markets will invariably fall.”
The new terms for the ISDA contracts would bar a firm from ending swap trades with a bank being put into liquidation for 24 or 48 hours, depending on which country’s laws apply. That would give regulators time to move the contracts to a new company, limiting contagion to the larger financial system.
The protocol would initially affect only the largest globally significant banks, said one of the people.
“A contractual solution is being developed,” Nick Sawyer, a spokesman for ISDA, said in an e-mail. The temporary stay under discussion would be controlled by the legal system in place in the failing bank’s home jurisdiction.
The FDIC and regulators in the U.K., Germany and Switzerland pressed ISDA in a letter last year to change the contracts, particularly as they apply to cross-border trades. Since then, ISDA has been in frequent talks with regulators and is aiming to finish the new protocols before regulators and central bankers meet in mid-November at a Group of 20 summit in Brisbane, Australia.
Regulators in the U.S. and Europe are also examining how they can mandate use of the new contracts, the people said. A regulatory requirement could also help buyers comply; asset managers are wary of giving up their ability to terminate deals because they could be broaching their fiduciary duties to their clients, one of the people said.
In some categories of swaps, virtually all of the trading is done between firms in different countries. With conflicting rules in each jurisdiction, questions arise that regulators and bankers like Ervin say they hope are answered by this effort.
“It’s of utmost importance. Every major bank’s portfolio is global,” Philipp Paech, law professor at the London School of Economics, said in a phone interview. “It’s just not enough to stop the local counterparties from terminating.”
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