What are the Fed’s rules on stays in defaults really trying to accomplish?

Last week we highlighted the Fed’s proposals on stays for qualified financial contracts (QFC), and how this throws into question a fundamental idea in securities finance. There are some deeper concerns here including the fact that institutions of all sizes represent individual investors directly or indirectly, and that maybe regulators want institutions to be uneasy about the risk they are taking in these contracts.

Regarding the needs of individual investors, a fundamental question of Dodd-Frank is who are we really trying to protect, from whom, and to the benefit of whom?

Let’s set some context to frame the concerns with just a simple look at retirement investors:

These are private individuals and taxpayers. They are not saving their money in jars buried in the back yard, nor are they depositing $5 a week in passbook savings accounts. They are relying on their mutual fund companies, brokers, investment managers and pension funds to invest in capital markets such that they can one day retire in some degree of security. Their investment institutions in turn have a fiduciary responsibility to protect and grow their customers’ assets. They do whatever is necessary within their investment objectives to meet the expectations of their customers, including engaging in QFCs.

The vast majority of these investment firms are not systemically important, but they need to do business with institutions with that status in one way or another. As a result, customers of non-significant, non-bank financial institutions could get stuck in a QFC with a defaulted, bankrupt counterparty with no way to protect their assets. If an investment firm can’t take responsible action (to which they are otherwise legally entitled with any other counterparty under any other circumstances), that means their customers are less protected than customers of systemically important banks. The conclusion to customers is either: a) make sure my financial institution is systemically important; or b) make sure my firm doesn’t do business with one. Otherwise, I have no clear idea whether or not I am equitably protected or when I’m protected or not protected…

We also note a smart comment made by Bloomberg’s Matt Levine following the release of the Fed’s proposal. In “Regulators Want to Slow Runs on Derivatives,” published May 4, he noted that “The new rules are a way of saying… your repo claims and derivatives assets are not safe. We hope they’ll be safe — and the new rules are meant to allow for efficient bank resolution that will protect the value of those claims — but there is no backstop, no certainty, no magic. If your bank counterparty fails, you’ll probably get your money back, but not by way of a seamless instantaneous closeout.”

So maybe the argument is that instead of arguing for customer protection, the real conversation is to explicitly discourage these kinds of investments in the first place. That all seems reasonable, but isn’t this the US$600 trillion swaps market that we are talking about first and foremost?

The Fed’s current proposal on defaults, collateral and stays suggests a lack of focus on equitable rules for investors, not to mention a potential preference towards SIFIs for retirement investors. Conditional legal entitlements over which no one other than the regulator has any real control are not the right answer.

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