I’ve been meaning to write about how derivatives are treated in bankruptcy, but it’s a big topic and I haven’t been able to get my hands around it. But this article from Bloomberg merits some comment, because it suggests that market participants, led by ISDA, are moving to a partial change that could make things worse if the bankruptcy code treatment of derivatives remains the same.
Derivatives benefit from a variety of “safe harbors” in bankruptcy. They are treated very differently than other financial contracts. If a firm goes bankrupt, its derivatives counterparties can offset winning against losing trades, and determine a net amount. In contrast, with normal debts, such offsets are not permitted, and the bankruptcy trustee can “cherry pick” by not performing on losing contracts and insisting on performance on winning ones. Derivatives counterparties can immediately access the collateral posted by a bankrupt counterparty. Other secured debtors do not have immediate access to collateral. Derivatives counterparties are not subject to preference or fraudulent conveyance rules: the bankruptcy trustee can claw back cash taken out of a firm up to 90 days prior to its bankruptcy, except in the case of cash taken by derivatives (and repo) counterparties. Derivatives counterparties can immediately terminate their trades upon the bankruptcy of a trading partner, collect collateral to cover the bankrupt’s obligations, and become an unsecured creditor on the remainder.
It is this ability to terminate and grab collateral that proved so devastating to Lehman in 2008. Cash is a vital asset for a financial firm, and any chance Lehman had to survive or be reorganized disappeared with the cash that went out the door when derivatives were terminated and collateral seized. It is this problem that ISDA is trying to fix, by writing a temporary stay on the ability of derivatives counterparties to terminate derivatives contracts of a failed firm into standard derivatives contract terms.
That sounds wonderful, until you go back to previous steps in the game tree. The new contract term affects the calculations of derivatives counterparties before a tottering firm actually declares bankruptcy. Indeed, as long as preference/fraudulent conveyance safe harbor remains, the new rule actually increases the incentives of the derivatives counterparties to run on a financially distressed, but not yet bankrupt, firm. This increases the likelihood that a distressed firm actually fails.
The logic is this. If the counterparties keep their positions open until the firm is bankrupt, the stay prevents them from terminating their positions, and they are at the mercy of the resolution authority. They are at risk of not being able to get their collateral immediately. However, if they use some of the methods that Duffie describes in How Big Banks Fail, derivatives counterparties can reduce their exposures to the distressed firm before it declares bankruptcy, and crucially, get their hands on their collateral without having to worry about a stay, or having the money clawed back as a preference or fraudulent conveyance.
Thus, staying derivatives in a bankrupt firm, but retaining the safe harbor from preference/fraudulent conveyance claims, gives derivatives counterparties an incentive to run earlier. Under the contracts with the stay, they are in a weaker position if they wait until a formal insolvency than they are under the current way of doing business. They therefore are more likely to run early if derivatives are stayed.
This means that this unbalanced change in the terms of derivatives contracts actually increases the likelihood that a financial firm with a large derivatives book will implode due to a run by its counterparties. The stay may make things better conditional on being in bankruptcy, but increase the likelihood that a firm will default. This is almost certainly a bad trade-off. We want rules that reduce the likelihood of runs. This combination of contract terms and bankruptcy rules increases the likelihood of runs.
This illustrates the dangers of piecemeal changes to complex financial systems. Strengthening one part can make the entire system more vulnerable to failure. Changing one part effects how the other parts work, and not always for the better.
Rather than fixing single parts one at a time, it is essential to recognize the interdependencies between the pieces. The bankruptcy rules have a lot of interdependencies. Indeed, the rules on preferences/fraudulent conveyance are necessary precisely because of the perverse incentives that would exist prior to bankruptcy if claims are stayed in bankruptcy, but creditors can get their money out of a firm before bankruptcy. Stays alone can make things worse if the behavior of creditors prior to a formal filing is not constrained. All the pieces have to fit together.
The Bloomberg article notes that the international nature of the derivatives business complicates the job of devising a comprehensive treatment of derivatives in bankruptcy: harmonizing bankruptcy laws across many countries is a nightmare. But the inability to change the entire set of derivatives-related bankruptcy rules doesn’t mean that fixing one aspect of them by a contractual change makes things better. It can actually make things worse. It is highly likely that imposing a stay in bankruptcy, but leaving the rest of the safe harbors intact, will do exactly that.
ISDA appears to want to address in the worst way the problems that derivatives can cause in bankruptcy. And unfortunately, it just might succeed. ISDA should stay its hand, and not derivatives in bankruptcy, unless other parts of the bankruptcy code are adjusted in response to the new contract term.