(This story originally appeared in IFR, a Thomson Reuters publication)
By Philip Scipio
LONDON, Aug 11 (IFR) - The way the world's largest banks use derivatives is set for drastic change after the US Federal Reserve and Federal Deposit Insurance Corp moved to strip financial counterparties of early termination rights on new derivatives contacts in the event of some future bank failures.
Such contract holders have until now enjoyed immunity from the automatic stay on liabilities once a firm enters bankruptcy, in effect allowing them to claim repayment immediately. Under new rules, that protective language will be eliminated from financial pacts at affected firms. The proposed changes will only apply to contracts struck after reform is introduced, with outstanding deals allowed to continue unchanged until they mature.
Under the proposals, counterparties will be required to agree to language changes in new contracts that would disable them from claiming exemption. It would be a sea change for the financial industry, by some estimates affecting 90% of the US$710trn derivatives market as those deals are rolled over.
Contracts at Bank of America, Bank of New York Mellon, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Morgan Stanley, State Street, and UBS will all be affected.
"This may make derivative contracts less attractive to everybody," said Franklin Edwards, professor of finance at Columbia. "But that may also be what regulators want."
Regulators have long complained that the automatic stay is one of the biggest obstacles to putting a large financial institution into bankruptcy. Amending the contracts at those firms "on an industry-wide and firm-specific basis" would eliminate that obstacle.
"This may make derivative contracts less attractive to everybody."
To force banks to change the language in their contracts, the regulators are seizing on powers conferred on them through the Dodd-Frank Act to ensure that the biggest firms have viable resolution plans - or so-called living wills.
The Fed and the FDIC need to approve the living wills as "credible" and what they have said here, according to University of Pennsylvania law professor David Skeel, is that any living will that does not provide for a short-term stay is not credible.
"I have to congratulate them on their cleverness - it's a pretty persuasive statement," Skeel said.
Regulators have castigated banks for failing to present workable resolution plans for a second consecutive year. This year, regulators offered guidance on how to make the plans acceptable and they seized on an opportunity to end the so-called safe harbour from the automatic stay.
When Lehman Brothers collapsed in 2008, counterparties lined up to void pacts and seize cash and collateral the day of the bankruptcy filing. It's the nightmare scenario that haunts regulators.
While regulators have long complained that the early termination rights were an obstacle to winding down large financial firms, the effort to eliminate those rights never garnered much support. Lawyers and regulators have argued that the best way to limit safe harbour protections financial counterparties claimed was through revising the bankruptcy code.
The power of derivative lobbyists and the high level of dysfunction in the US Congress, however, made that path unlikely. Even efforts by the International Swaps and Derivatives Association to revise its master contract to limit early termination rights have been bogged down.
It was not uncommon in the US for reform to be introduced through changes in contract language instead of new laws or regulations, said Jay Westbrook, a law professor at University of Texas. "[Doing so] has the benefit in our current state of gridlock in Congress of not requiring legislation and, given the slow-moving Dodd-Frank process, it doesn't need regulation," he said.
Sources familiar with the process said the regulators expected that pushing these 11 firms to include these clauses would have a big impact of how the industry worked.
The Fed and the FDIC have jointly sent letters to the 11 firms detailing the specific shortcomings at each firm. The deficiencies would need to be addressed next in the 2015 living will submissions, the regulators said.
Specifically, the regulators expressed disappointment with the level of planning in the living wills. The firms were still not accounting for the complexity of their corporate structures and were still making unrealistic assumptions about how other institutions, customers, counterparties and even regulators would behave in the event of their collapse, the regulators said.
In the plans to be filed by July 2015, the regulators are asking that the firms make plans to organise legal structures that are more rationally resolvable, develop holding company structures that support single point of entry for a manageable resolution and change the language in their financial contracts. (Reporting by Philip Scipio, Editing by Gareth Gore, Matthew Davies)