Streetwise Professor

November 2, 2008

The Bankruptcy Code and Runs on Derivatives Dealers–Bug or Feature?

Filed under: Commodities,Derivatives,Economics — The Professor @ 10:08 pm

he FT has an interesting article about how changes in the bankruptcy code in 2005 made it easier for firms in derivatives transactions to settle trades and demand additional collateral from their counterparties. According to the article, this made it easier for counterparties to demand additional collateral from Bear and Lehman when these companies began to experience trouble, and this accelerated their demise.

The article is wrong, though, on one thing. It says:

Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

The more important issue was that settlements and collateral obtained 90 days or less prior to a company’s declaration of bankruptcy could be deemed a “preference.” The bankruptcy trustee could sue the counterparty of the bankrupt firm to “to recover from creditors payments made shortly before the bankruptcy filing where the payment gave the creditor more than other, similarly situated, creditors would get through the bankruptcy process. ” Thus, if a firm settled an outstanding derivative contract with a firm that eventually went bankrupt within 90 days of the settlement, and received a $1 million payment from the eventual bankrupt pursuant to the settlement (e.g., the parties agreed to close a trade that was underwater from the perspective of the eventual bankrupt), the trustee could sue and claw back the entire $1 million. The firm that had obtained the money in the settlement is then put in the same boat with the rest of the bankrupt’s creditors. Treating settlements and collateral demands as a preference increases the default risk exposure of parties to derivative contracts.

There has long been a safe harbor provision in the bankruptcy code that protected settlements on forward contracts from preference claims. (I’ve worked as an expert in several cases involving forward contract settlements in bankruptcy.) The 2005 bankruptcy code broadened the safe harbor protections to cover explicitly instruments (e.g., swaps) and market participants; prior to this time, it was a matter of uncertainty whether certain kinds of swaps and other derivative contracts would fall under the safe harbor protections. Thus, the change to the bankruptcy code clarified ambiguities in the code, and reduced the legal risks of engaging in derivatives trades.

It is certainly the case that absent the risk of preference claims, derivatives counterparties are more likely to demand that financially shaky trading partners settle contracts that are assets to the financially sound company, and liabilities to the troubled one, or to demand additional collateral from the troubled company. This creates the potential for “runs” on shaky derivatives dealers. Counterparties want to be first in line to get more cash (either from settlements or collateral) from firms that might go under.

Although it seems that runs are a bad thing, the Diamond-Rajan articles on financial fragility show that runs can serve as a disciplining device for financial intermediaries who supply liquidity. Intermediaries supply liquidity. They take funds from lenders, and invest them in higher returning projects. The financial institution has an information advantage in engaging in this information intensive intermediation, however, that allows it to act opportunistically. Absent some form of market discipline, the information advantage allows the intermediary to hold-up the suppliers of funds. Diamond-Rajan show that runs are a disciplining force, and absent such discipline, the opportunism problem results in suboptimal creation of liquidity.

Many aspects of derivatives contracting in OTC markets, including credit triggers that require the immediate liquidation of contracts or the ability to call for additional collateral in the event of a credit downgrade by a party to a derivatives contract encourage run-like behavior. Although there is not an exact analogy between derivatives contracting, and the lending/financing intermediation that Diamond-Rajan model formally, derivatives dealers do supply liquidity to the derivatives market, and especially in more specialized contracts do have an information advantage in dealing with their counterparties. The Diamond-Rajan logic therefore suggests that it may be necessary to subject the dealer to the risk of runs to discipline opportunism. Thus, the fragility of derivatives dealers, so graphically illustrated by recent events, may be efficient, as unsettling (no pun intended) as that conclusion sounds.

Diamond and Rajan argue that measures intended to reduce the likelihood of runs on financial institutions can actually reduce the efficiency of financial markets by raising the cost of disciplining liquidity suppliers. This higher cost of enforcing contracts leads to a smaller supply of liquidity. Thus, in their models, eliminating runs is a bad thing, not a good one, as intuition might suggest.

If this logic extends to derivatives contracting, it has implications for the appropriate regulation of derivatives dealers. I conjecture that the logic can be so extended, but this deserves some formal modeling. Add that to the pile.

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