The adaptation of the ISDA stay protocol to securities financing trades won’t be welcome news for buy-side participants. Adding a delay before executing a liquidation adds incremental risk, even if it is just for 48 hours. We have been thinking about how this might impact the repo/sec lending CCPs and the push toward buy-side direct participation.
Investors are putting up a stink about the restriction of termination rights. From “Too Big to Default: Policy and Legal Perspectives on Current Bank Regulator Initiatives to Restrict End-Users’ Default Rights against Big Banks” published by the Managed Funds Association, September 2015:
“…Default Rights protect an end-user, its investors, and other stakeholders by allowing the end-user to terminate and settle financial contracts with a failing bank entity, and thereby, minimize its exposure to such entity and better manage market risk. Because MFA members have affirmative fiduciary duties to act in their investors’ best interests, they are not able to waive Default Rights voluntarily without robust legal justification…”
The buy-side has been told time and time again that the protocol is voluntary. From an article “Buy-siders up in arms over new ISDA derivatives protocol” in The Trade (January 8, 2015):
“…The protocol is not a rule, and ISDA cannot mandate anyone to adhere to it,” says [ISDA’s general counsel, David] Green. “Very early in the discussion, the buy-side made it clear they would not be able to sign the protocol voluntarily, which is why the first phase of adherence only included banks…”
But is this going to be a case of Hobson’s Choice — take it or leave it? It looks like regulators may not allow market participants many alternatives but to accept the new rules. On a bilateral repo, the terms of the protocol would be in the (amendments to the) master agreement that governs the trade — so both sides are by definition agreeing if they have signed off to the amendment.
An aside: Will some beneficial owners, who often look at sec lending income as acceptable only as long as the risk is de minimis be pushed over the edge and exit the market?
What would happen if a trade took place in a repo or sec lending CCP that accepts investor participation (like the OCC, Eurex, or sometime soon FICC)? CCPs may not have to abide by the stay protocol. From the Managed Funds Association paper:
“…The applicable rules and laws that each G- 20 jurisdiction adopts will dictate the scope of entities and transactions that the Regulators’ Stay Initiatives will cover in that jurisdiction. With respect to affected entities, both the Bank of England Proposal and the Germany Recovery and Resolution Act exclude central governments/banks and central counterparties (i.e., clearinghouses) from the obligation to recognize their regimes’ stays on Default Rights…”
So if securities financing trades done in CCPs are not subject to the stay, but bilateral trades are, that suggests that central clearing of SFTs may accelerate. Won’t the bifurcation of the market make risk management that much harder? Say a dealer borrows a security from a RIC on a CCP then lends it to a hedge fund in a bilateral trade. The first trade may not be subject to a stay if the dealer goes bankrupt….but the bilateral trade could be a different story. If CCPs end up subject to the stay, then everyone better sign up. CCPs can’t be in a position where there are fundamental differences between a pair of trades they have cleared — especially in how a default is managed.
We conclude by quoting a paper “A Dialogue on the Costs and Benefits of Automatic Stays for Derivatives and Repurchase Agreements” (January, 2012), written by Darrell Duffie and David Skeel, two academics well known for their research on CCPs & SFTs. They divide the market by type of instrument — liquid versus illiquid — and advocate different stay treatment for each:
“…we both believe that repos (and related QFCs such as securities lending agreements) that are backed by liquid securities should be exempted from automatic stays, or receive an effectively similar treatment. Repos backed by illiquid assets, on the other hand, should not be given this safe harbor…”