Buy-side warn on suspension of early termination rights for swaps

06 Nov, 2014

Industry associations including the Managed Funds Association (MFA) and the Alternative Investment Management Association (AIMA) have sent a letter to the Financial Stability Board (FSB) expressing concern about the potential suspension of counterparties’ early termination rights on swaps transactions during US bankruptcy proceedings.

This comes as the International Swaps and Derivatives Association (ISDA) drafted a voluntary protocol at the FSB’s request, which has since been accepted by 18 globally systemically important financial institutions (G-SIFIs)*, that would allow a failed banks’ derivatives contracts to remain open for two days giving regulators time to determine whether the positions can be transferred to another institution.

“The ISDA protocol is bad news for buy-side financial institutions, who simply have no choice but to sign up to it if they want to continue trading swaps with the G-SIFIs, who are of course the biggest swaps counterparties in the world. The buy-side will be unable to terminate these derivatives contracts for two days instead of immediately being able to terminate them should their swaps counterparty become insolvent. During this period, these contracts could move against or in favour of the counterparty, and the counterparty will be unable to determine its exposure,” said Cary Meer, partner at K&L Gates in Washington DC. 

Other signatories to the letter included the American Council of Life Insurers, the Association of Institutional Investors, the Commodity Markets Council and the Customer Commodity Coalition. “While supporting efforts to facilitate orderly liquidations and improve financial stability, the associations are troubled by the FSB’s proposal to finalise provisions in the ISDA protocol and have its members adopt prudential regulations that effectively amend our members’ protections under the US Bankruptcy Code,” read the letter.

The letter added the FSB consulted only a handful of market participants before it endorsed the ISDA protocol.   “The FSB did not make these changes through the rulemaking or legislative process, so most affected counterparties were not consulted as part of the process.  Only a small number of buy-side firms were members of the working group, so the buy-side has not been given a sufficient opportunity to express its views,” said Meer.

Regulators in the US and European Union are seeking to resolve these challenges too. Title II of the Dodd-Frank Act and the EU Bank Recovery and Resolution Directive both seek to address the challenges that might arise in the event of a bank failure. Both pieces of legislation impose procedures on how to handle a failing bank, and one of the proposals is to impose a stay on termination rights.

Others believe asset managers and institutional investors should not be surprised by these developments. “I do not understand why asset managers have waited until now to speak out as the imposition of a stay on early termination rights has been on the table for a long time. Admittedly, if I was a fund manager, I too might be upset. Fund managers have been dealing with so many other new rules and regulations, and this simply may have fallen off the radar. It all comes down to implementing the G 20 commitments to contain systemic risk in a crisis.  The focus in this regard has been on preventing too-big-to-fail financial institutions from becoming the source of this risk,” said one bank, speaking under strict anonymity.


*Banks that have signed up to the ISDA protocol

*Bank of America Merrill Lynch, Bank of Tokyo-Mitsubishi UFJ, Barclays, BNP Paribas, Citi, Credit Agricole, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Mizuho Financial Group, Morgan Stanley, Nomura Holdings, Royal Bank of Scotland, Societe Generale, Sumitomo Mitsui Financial Group, UBS

AIMAMFAK&L GatesderivativesG-SIFIsDodd-FrankISDAFSBearly termination rights