Streetwise Professor

July 30, 2014

ISDA Should Stay Its Hand, Not Derivatives In Bankruptcy

Filed under: Derivatives,Economics,Financial crisis,Regulation — The Professor @ 8:39 pm

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.

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  1. Stays on the capacity of counterparties to terminate future obligations and net obligations (asset loaned against asset borrowed) is not new.

    The capacity to terminate and net appears as a standard clause in master netting agreements (close-out netting clauses) such as those based on ISDA documents that are used for derivatices exposures, swaps, repos and securities lending. A number of jurisdictions, including the US (FDIC), have the capacity to place a temporary stay on excercise of such clauses. Typically this is to preclude action by a prudential regulator, which may not be related to solvency, (e.g. it could be about governance) from triggering ‘events of default’ clauses in ISDA like agreements. Such triggering clauses include any action that might smell like a pre-cursor to insolvency.

    More recently, the Financial Stability Board ( published a report ‘Key Attributes of Effective Resolution Regimes’ that requires (and I mean require because the FSB is an international standard setting body and countries are subject to periodic assessment against this sort of thing) that jurisdictions should have the capacity to stay close-out netting for up to 48 hours. ISDA has sensibly taken the view that it would be better to have some consistency about how this is applied globally and thus they are thinking about a standard contractual solution. ISDA, and the market, has an intense interest in this as a likely legislative solution for this is to remove legal certainty for netting within the stay period. Legal certainty that contracts operate according to their terms underpins liquidity in any market. More so now that prudential regulators will treat net exposures as gross for capital purposes if they don’t tick all the regulatory boxes.

    Guarding against an incentive to run are two things. First, a counterparty needs a legitimate ‘Event of default’. Being concerned about a counterparties solvency, of itself, is not a trigger. Second, if you get it wrong, and take action before some regulatory umpire or braver soul has effectively declared default, you are asking to be sued for damages. What you will sensibly do is immediately call for a collateral top up. Failure to meet such a call is a seperate trigger for close out netting in terms of ISDA like agreements AND the FSB Attributes.

    Comment by noir — July 30, 2014 @ 11:00 pm

  2. Do not agree entirely, as the risk of a run, due to the current nature of the business can never be fully eliminated.
    What you have in reality is a trade-off between frequent but small “runs” and less frequent runs with large consequences.(Mark Spitznagel’s forrest fire analogy). Look at the effect deposit insurane has had on liquidity buffers/ equity in the banking system – they went down.
    The reason is that market discipline (The third pillar of Basel II, which nobody talks about) is weakened and replaced by regulatory oversight. Now, I believe experience shows this is a bad substitute for two reasons:
    * the regulator cannot possible know the relevant information (Hayek’s pretense of knowledge)
    * the regulators end up being captured by the industry they are supposed to regulate

    The proposed change will make banks more cautious (higher liquidty buffer, pricing) which increases market discipline and hence stability of the system (marginally) – of course the transitory effects could potentially be enourmous and need to be adressed.

    Comment by Viennacapitalist — July 31, 2014 @ 4:02 am

  3. O/T I can’t believe you blogged nothing about the death of the last original Ramone,d.aWw

    Comment by Green as Grass — July 31, 2014 @ 6:32 am

  4. The real underlying issue is imperfect knowledge. Prudential regulators have an imperfect view of banks’ exposures up until some indeterminant time after they take control of a troubled bank. Within the FSB framework they will have to scramble within 48 hours (and preferable 24). While the intent may be to restore a bank to full financial viability (which is probably in the best interests of creditors), the regulator’s dilemma is that taking control, or any analogous action, provides a signal to the market to run. The market is prone to running because it lacks perfect knowledge of the troubled bank and regulatory intent.

    Close out netting clauses in master netting agreements contractually embed the starting gun for a run. One reason that these clauses specifically cover regulators’ actions is that the market lacks the capacity to monitor and assess regulators’ mandates and intent. It would be a non-trivial cost to rectify that across multiple jurisdictions.

    It is relatively easy to guard against a run by unsecured creditors (a moratorium on payments) and, in principle, secured creditors timely close out of positions is loss neutral to both borrower and lender. However, those positions are probably hedging exposures held by the troubled bank. Loss of those hedges massively complicates resolution. That is what stays attempt to guard against and, so long as collateral top ups/margin calls are maintained, replacement cost risk to creditors is mitigated. Stays also guard against some trivial regulatory action, not related to solvency, inadvertently starting an uninformed panic run.

    Viennacapitalist’s point around market response is spot on. But that is another reason it is preferable that ISDA work with industry to come up with a solution that adresses regulatory concerns in the least disruptive way. The alternative is that the market comes up with a solution that thwarts the regulatory response (and I have no doubt that they can), but that will lead to another round of regulation and, probably, more draconian capital requirements.

    Comment by noir — July 31, 2014 @ 5:56 pm

  5. If the intent of the regulations impelling this response from ISDA is to reduce systemic risks where a run on one entity triggers runs on another, then what might be needed is a stay power that only comes into effect when a macro indicator of systemic crisis, not manipulable by the entity or its creditors, is triggered. Perhaps an interest spread threshold or a volume-decrease threshold in some thick market could be used as the indicator–that kind of detail goes way beyond my level of knowledge of the markets. But the principle that circuit-breaking by rule or by bankruptcy trustee action should be limited to some non-manipulable macro indicator of a general liquidity crisis seems like a good one to me. Such a limitation would reduce much of the run-inducing properties that TSP is concerned about.

    Comment by srp — July 31, 2014 @ 8:03 pm

  6. […] U.S. and European derivative counterparties benefit from a variety of “safe harbors” if their counterparties enter into bankruptcy.[14] They can offset winning against losing trades and if the amount is positive pay only a net amount. Normally the bankruptcy trustee can cherry pick by not performing on losing contracts and insisting on performance on winning ones (Pirrong, 2014). […]

    Pingback by OTC Derivative Counterparty Risk | The OTC Basement — December 20, 2014 @ 10:22 pm

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