Automatic stays in the case of a default sends shivers down the spine of securities financing traders. If the non-defaulting party can’t liquidate immediately, it calls into question how much risk a trade absorbs.
The result will be higher haircuts for liquid paper. For illiquid securities – many of us remember how difficult it was to trade even investment grade corporate paper post-Lehman’s collapse – the answer may be to avoid the assets altogether.
But don’t we already live in this world? The Orderly Liquidation Act (OLA) allows the FDIC to suspend liquidation for a day while they figure out what to do with the trades. This was fine as long as both counterparties were under the same legal jurisdiction. In October 2014, ISDA created a protocol to extend the stay to cross-border derivatives trades. But does this apply to repos and sec lending trades too? There have been efforts to extend the cross-border stay to repo.
From an October, 14, 2014 article published by the law firm Weill, Gotshal “Major Banks Take Action to Facilitate Cross-Border Resolution Efforts by Agreeing to Sign ISDA Resolution Stay Protocol”:
“…Under the Bankruptcy Code, “qualified financial contracts” (QFCs), including repurchase agreements, interest rate and currency swaps, credit default swaps, and other derivatives, are exempt from the automatic stay. Therefore, QFC counterparties are afforded special treatment and are free to take certain actions that otherwise would be prohibited by the automatic stay when their contract counterparties commence bankruptcy cases, including closing out their derivatives contracts. The rationale for this special treatment has been that allowing counterparties to exit immediately from their contracts upon the failure of an important market participant would stem the tide of the potential chain reaction of insolvencies that could occur. Some scholars, however, have disagreed with this rationale reasoning that the Bankruptcy Code’s special treatment of derivatives may actually increase systemic risk by causing a run on the failing firm and a massive destruction of value.
To address the potential systemic collapse of the financial system, and without amending the safe harbor provisions of the Bankruptcy Code, Congress enacted different procedures for the treatment of QFCs in Title II of the Dodd-Frank Act. Title II, the Orderly Liquidation provision of the Dodd-Frank Act, provides a process to quickly and efficiently liquidate a large, complex financial company that is close to failing. Title II provides an alternative to bankruptcy in which the Federal Deposit Insurance Corporation (FDIC) is appointed as a receiver to carry out the liquidation and wind-up of the company…”
One day to decide if a complex SFT book has trades that should be kept or liquidated isn’t much time. So should this stay be made longer? And at what cost?
Why create the stay in the first place? One reads about it being a tool to deal with TBTF banks, buying some time to figure out what regulators are dealing with. By way of comparison, the unwind of Continental Illinois – then the 7th largest bank in the US before their 1984 failure — wasn’t complete until 1991. Interesting enough, the term “Too Big to Fail” supposedly stems from Congressional hearings on Continental Illinois. A day for the FDIC to figure things out isn’t going to help much. A couple months – well, maybe.
There is another side to stays – preventing (or slowing down) fire sales. Will securities finance traders (and probably derivatives traders too) simply hedge their positions if they are unable to liquidate the underlying transaction due to a stay? Sure. Will putting on those hedges push markets around and create the externalities that the Fed has been trying to contain? Yes. Depending on how the hedges are constructed, the basis risk could make for an even more complicated book of trades. So if a stay isn’t long enough to make well thought out decisions about trades and hedging will pressure the market, we wonder if stays really help or just make matters worse.