As part of Dodd-Frank, Fed continues to throw basic idea of defaults, collateral and buy-ins into question in securities finance

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

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2 Comments. Leave new

  • O Huettner
    May 4, 2016 9:25 am

    A few observations on this proposal:
    1. The press release specifically refers to “apply to bilateral uncleared QFCs.” Given that a majority of derivative transactions and a large portion of the repo market currently settle via central counterparties are we not creating basis risk between cleared and uncleared transactions? If this serves to drive a greater proportion of QFCs on to exchanges are we in fact accomplishing anything?
    2. There are numerous events of default short of a bankruptcy filing; a missed margin call for example. Given the insertion of a 48 hour stay into the default process are we not actually encouraging counterparties to act sooner and perhaps declare a default based upon an event as benign as an inadvertent missed margin call?
    3. A 48 hour stay will ultimately result in a demand for greater margin postings. This will impact the economics of these transactions.
    4. If fire sales are such a concern why have these same regulators allowed counterparties to post anything other than cash and short dated AAA sovereign securities?
    5. Does anyone seriously believe that in 48 hours the Fed can find a buyer for a SIFI? Keep in mind the cost JP Morgan paid for helping out the Fed when it purchased Bear Sterns. Despite solving a major systemic problem JPM was forced down the road to pay substantial settlements for Bear Sterns prior ‘sins’. The same could be said of Bank of America and Merrill Lynch and Countrywide. It is highly unlikely that any institution will accept that level of liability. A more likely scenario would be a solution closer to Barclay’s purchase of some of Lehman’s assets without rescuing the ongoing entity. If that is the case, this process accomplishes nothing.
    6. Finally, it is naïve to think that market participants will not see signs of an impending bankruptcy of a SIFI. This will encourage early action to avoid future losses and in the end may not solve anything as counterparties trade their books in anticipation of the impending large scale liquidation therefore precipitating the market action the Fed is hoping to avoid.

    Reply
  • Josh Galper
    May 4, 2016 1:13 pm

    Matt Levine at Bloomberg Views put out an insightful piece on this proposal today, “Regulators Want to Slow Runs on Derivatives.” He noted that perhaps an intention of regulators was to make derivatives and securities finance transactions appear less safe, hence making investors think twice before engaging in them. Here’s a link to his article: http://www.bloombergview.com/articles/2016-05-04/regulators-want-to-slow-runs-on-derivatives

    Reply

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