The Fed has thrown into question a core tenet of securities finance transactions. In a proposal released today, in case of bankruptcy or a resolution process, counterparties to a trade would no longer declare a default and use their collateral to buy-in positions. The same issue applies to OTC derivatives. The issue had already been raised as part of Dodd-Frank’s Orderly Resolution Authority, but now it comes with more details.
Here’s the press release:
The Federal Reserve Board on Tuesday proposed a rule to support U.S. financial stability by enhancing the resolvability of very large and complex financial firms.
The proposal would require U.S. global systemically important banking institutions (GSIBs) and the U.S. operations of foreign GSIBs to amend contracts for common financial transactions to prevent the immediate cancellation of the contracts if the firm enters bankruptcy or a resolution process. This change should reduce the risk of a run on the solvent subsidiaries of a failed GSIB caused by a large number of firms terminating their financial contracts at the same time.
These contracts, called qualified financial contracts (QFC), are used for derivatives, securities lending, and short-term funding transactions such as repurchase agreements. The proposal would apply to bilateral, uncleared QFCs. Because GSIBs conduct a large volume of transactions through these contracts, the mass termination of QFCs may lead to the disorderly unwind of the GSIB, spark asset fire sales, and transmit financial risk across the U.S. financial system.
The proposal ensures consistency with restrictions on financial contracts under Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act that support the orderly resolution of financial firms. By requiring GSIBs to make clear in their QFCs that the U.S. special resolution regimes apply, the proposal would help ensure that all QFC counterparties–domestic and foreign–would be treated in the same way in an orderly resolution. The proposal would also require GSIBs to ensure that their QFCs restrict the ability of counterparties to terminate the contract, liquidate collateral, or exercise other default rights based on the resolution of an affiliate of the GSIB. This restriction on default rights will help ensure that the affiliates of a GSIB that are able to meet their obligations are not forced to enter resolution by the failure of another affiliate of the GSIB.
Under the proposal, GSIBs may also comply by using QFCs that are modified by the International Swaps and Derivatives Association (ISDA) 2015 Resolution Stay Protocol. The ISDA Protocol was developed by market participants that are members of ISDA, in coordination with the Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and foreign regulators.
“The proposal would complement earlier steps by the Federal Reserve Board and the FDIC to address the risk QFCs pose to financial stability through their review of the firms’ resolution plans,” said Gov. Daniel K. Tarullo. “It also complements industry efforts, pursued in coordination with the Federal Reserve and other regulators, to amend these contracts through adherence to the ISDA Protocol.”
The comment period on the proposal will be open until August 5, 2016.
The press release is here: http://www.federalreserve.gov/newsevents/press/bcreg/20160503b.htm