A November 6th article in the FT “Regulators urge rewrite for derivatives contracts” by Sam Fleming caught our eye. The article is behind the pay wall, but we urge you to read it. We wonder if it is a solution that is pointed in the wrong direction.
The article said that several influential regulators – including Mark Carney of the Band of England, Martin Gruenberg, chair of the FDIC, Elke König, president of Germany’s BaFin, and Patrick Raaflaub, chief executive of the Swiss Financial Market Supervisory Authority – sent a letter to ISDA asking that
“…the standard documentation provided by the International Swaps and Derivatives Association should be changed to provide for a short-term delay in closing out a contract in the case of the insolvency or resolution of a large bank…”
“…This would help prevent the “disorderly termination” of over-the-counter derivatives contracts and give regulators time to enact plans for the orderly resolution of the bank…”
We have a couple thoughts about this. We were under the impression that the Lehman derivatives portfolio was closed out in an orderly manner and without losses. With the migration to central clearing, tighter risk management (read: mandatory initial margins) and more transparency in the market, we wonder if these kinds of delays, designed to avoid fire sales, are appropriate?
And, of course, we always look at this sort of stuff through our (occasionally myopic) repo and sec lending glasses. The funding crisis, which really started well before Lehman with the sub-prime & ABS mess and the spill over to tri-party, certainly got a lot worse when Lehman went bust. As repo businesses closed out trades with Lehman, it created cash positions that needed to be liquidated, perhaps at fire sale prices. (We should note that if a repo desk lent a bond to a counterparty who defaulted, they had to go out and buy it back…so repo unwinds aren’t always sales that force market prices lower.) We have written a lot recently about the Federal Reserve’s focus on fire sales and expect some big changes imposed on the tri-party funding markets (including, perhaps, the same sort of delays in liquidating trades that is being asked of ISDA). Is this starting to sound like a coordinated effort to slow down liquidations? Fearful of the unintended consequences in other markets, some at the Fed have expressed reluctance to change bankruptcy laws (as they relate to repo) in order to allow for a stay in bankruptcy. But it sounds like the same could not be said of liquidations and derivatives markets by other regulators.
So what are the practical issues that come if liquidation is slowed down? Haircuts (and initial margin) are designed to absorb liquidation risk should counterparty default. This layer of protection has to be thick enough to allow for the market going again the non-defaulting party while they are liquidating the trade. Fear that the haircut won’t be enough (or already has wasted away and could get still worse) encourages quick sales. Time is not your friend in liquidations. So if the time frame is lengthened, the risk guys will tell you the worst-case scenario is only going to get worse and potential exposure higher.
The other side of the argument is that if you can afford to wait until more rational markets return, prices and liquidity will be better. But in repo, where you have to crystalize the loss (or specify an unwind price in lieu of liquidation) in order to make a claim on the defaulted counterparty, waiting is a good way to find yourself wearing the liquidation loss should markets continue to go against you. That is a tough bet to lose. Lawsuit to follow.
So how will the market adjust to a world of longer liquidation periods? Higher haircuts and bigger initial margins. Better get ready.