Regulators are pushing ISDA and derivatives market participants really hard to incorporate a stay on derivatives trades of failing SIFIs. As I wrote a couple of weeks ago, this is a problem if bankruptcy law involving derivatives is not changed because the prospect of having contracts stayed, and thus the right of termination abridged, could lead counterparties to run from a weak counterparty before it actually defaults. This is possible if derivatives remain immune from fraudulent conveyance or preference claims.
Silla Brush, who co-wrote an article about the issue in Bloomberg, asked me a good question via Twitter: why should derivatives counterparties run, if they are confident that their positions with the failing bank will be transferred to a solvent one during the resolution process?
I didn’t think of the answer on the fly, but upon reflection it’s pretty clear. If counterparties were so confident that such a transfer will occur, a stay would be unnecessary: they would not terminate their contracts, but would breathe a sigh of relief and wait patiently while the transfer takes place.
If regulators think a stay is necessary, it is because they fear that counterparties would prefer to terminate their contracts than await their fate in a resolution.
So a stay is either a superfluous addition to the resolution process, or imposes costs on derivatives counterparties who lack confidence in that process.
If this is true, the logic I laid out before goes through. If you impose a stay, if market participants would prefer to terminate rather than live with the outcome of a resolution process, they have an incentive to run a failing bank, and find a way to get out of their derivatives positions and recover their collateral.
This can actually precipitate the failure of a weak bank.
I say again: constraining the actions of derivatives counterparties at the time of default can have perverse effects if their actions prior to default are not constrained.
This means that you need to fix bankruptcy rules regarding derivatives in a holistic way. And this is precisely the problem. Despairing at their ability to achieve a coherent, systematic fix of bankruptcy law in the present political environment, regulators are trying to implement piecemeal workarounds. But piecemeal workarounds create more problems than they correct.
But of course, the regulators pressing for this are pretty much the same people who rushed clearing mandates and other aspects of Frankendodd into effect without thinking through how things would work in practice.