A big step in tackling too big to fail

Early next month, a group of 18 global banks will formally sign a new ISDA Protocol that will ensure the cross-border derivatives they trade with each other are captured by national resolution regimes. By knitting together these various statutory regimes, the ISDA Protocol is an important step in meeting a regulatory and industry objective to address the too-big-to-fail problem.

As I explained in a comment piece published by the Financial Times recently, a number of statutory resolution regimes either already exist or will shortly be introduced that suspend certain rights that allow derivatives counterparties to terminate outstanding transactions with a bank under resolution. The idea is that this ‘stay’ will give national authorities time to deal with the troubled bank in an orderly way and avoid the market instability that might occur should counterparties all close out their derivatives trades with it at once.

Those national special resolution regimes include Title II of the Dodd-Frank Act and the European Union Bank Recovery and Resolution Directive. Between them, they will ensure a large share of the derivatives market is covered by stays should a bank counterparty enter into resolution. The risk, however, is that cross-border trades might not be captured by any single regime. If a US bank enters into resolution, for example, there is doubt over whether the stay under Title II of Dodd-Frank would apply to any English law or other non-US law contracts it might have agreed with its counterparties.

Recognising this might hamper regulatory efforts to resolve the failing institution in an orderly way, 18 global banks last month agreed to adhere to ISDA’s Resolution Stay Protocol. The Protocol, which essentially changes the terms of derivatives agreements to opt adhering parties into certain foreign resolution regimes, will be signed by those firms early next month and will come into effect on January 1, 2015. The Protocol also includes a stay that could be used when a US financial holding company becomes subject to proceedings under the US Bankruptcy Code – although this will only become effective once relevant rules are issued by US regulators.

By adhering to the Protocol, the 18 banks will extend the coverage of stays to more than 90% of their notional derivatives outstanding, and this will increase as more institutions sign the Protocol.

Additional banks are expected to adhere during 2015, but not all firms will be able to sign up to this initiative voluntarily. Buy-side institutions, for instance, have fiduciary responsibilities to their clients that mean they cannot voluntarily give up contractual rights. Regulators have acknowledged these concerns, and declared they will implement new regulations on a country-by-country basis in 2015 to encourage broader adoption. In a report published in September, the Financial Stability Board outlined some potential regulatory options, covering both direct and indirect measures.

The first step, however, is get the 18 global banks on board. That in itself represents a big piece in the too-big-to-fail puzzle, and will help put financial markets on a sounder footing.

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