OTC Industry to Aid Bank Resolutions

Terry Flanagan

The rights of holders of OTC derivatives to terminate the contracts during the course of a bank resolution are likely to be trimmed back, according to regulatory and industry officials.

The Financial Stability Board, the oversight group of the world’s central banks, is working to mitigate the risks caused by early termination by lengthening the time required to suspend such contracts.

The Financial Stability Board has asked the International Swaps and Derivatives Association “to try to eliminate some of the challenges that are caused by the Isda Master Agreement during an attempted resolution,” said Stephen O’Connor, Isda chairman. “We are cooperating with them and we have representatives from the buy side and sell side working on the language, and also the way forward in an attempt to execute a protocol to implement that language. That’s something that’s very important to the global regulatory community and we are responding to get that done.”

At issue are the early termination rights of derivatives counterparties to banks, many of whose operating subsidiaries are counterparties to large volumes of OTC derivatives that provide for an event of default based on the insolvency of the parent holding company.

The U.S. currently operates its resolution regime for U.S. banks with a 24-hour suspension period. The Federal Reserve is working with the FDIC and global regulators, financial firms, and other financial market participants to develop a protocol to the Isda Master Agreement to address the impediments to resolvability caused by early termination rights, Federal Reserve governor Daniel Tarullo told the Senate Banking Committee on Tuesday.

The Financial Stability Board will be reporting progress on this effort in the fall, he added.

U.S. regulators are concerned that foreign subsidiaries and branches of banks may have contractual rights and substantial economic incentives to terminate those contracts as soon as the U.S. parent bank enters resolution. This could render a resolution unworkable by resulting in the disorderly unwind of an otherwise viable foreign subsidiary and the disruption of critical intra-affiliate activities that rely on the failing subsidiary.

“The challenge would be compounded in a bankruptcy resolution, because derivatives and other qualifying financial contracts are exempt from the automatic stay under bankruptcy law, regardless of whether the contracts are governed by U.S. or foreign law,” Tarullo said.

Featured image via jesadaphorn/Dollar Photo Club

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