Streetwise Professor

August 17, 2014

This Never Happens, Right?: Regulators Push a Flawed Solution

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 6:06 pm

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.

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  1. In a largely-unnoticed passage in Flash Boys, Michael Lewis makes the point that the (soi-disant) abuses of the market inherent in Wall Street practices both current and historical are rooted in the desire to find loopholes, out-think, and generally game the regulation regime in force at the time. When such (soi-disant) unfairness is noted, and new regulation is promulgated, the process repeats. The game may change, but the impetus, and usually the players, remain the same.

    Comment by mutant_dog — August 18, 2014 @ 10:57 am

  2. The market innovates around regulation where the benefit outweighs the cost. However, putting that to one side, how exactly does one run from a contractual collateralised exposure? Does one abandon posted collateral at the same time as breaching a contract that will land you in court? Stays only apply to one contractual trigger – action by regulators. Other triggers remain intact, but perception of weakness is not a trigger. Actions prior to default are constrained by these considerations.

    Absent a stay, countertparties will close out against an institution subject to resolution or other actions by regulators. That is hardwired into existing ISDA contracts. The reason is uncertainty about regulatory outcomes. But closing out will be fatal to the affected institution. There is a public policy case to avoid systemic disruption arising from a disorderly failure. Stays do not necessarily expose counterparties to additional replacement cost risk so long as collateral top ups continue to be met until positions are transferred or the institution subject to regulatory action is restored to full financial soundness. I also note that a subset of potential regulatory action that has absolutely nothing to do with solvency can trigger ISDA termination clauses without a stay.

    Comment by noir — August 18, 2014 @ 6:10 pm

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