Low volume swaps users could exit derivatives due to suspension of early termination rights
Low volume swaps users including fund managers and institutional investors could exit derivatives if the Financial Stability Board (FSB) suspends 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.
"Some low volume derivatives' users may stop trading swaps if they view the suspension of early termination rights as a challenge. However, I expect a big derivatives user with 10 or 12 counterparty relationships will continue trading swaps,” said Lauri Goodwyn, counsel at Seward & Kissel in New York.
The ISDA protocol will theoretically prevent buy-side firms engaged in swaps transactions with those 18 G-SIFIs to sit out their exposure for two days, during which time those contracts could become valueless. “At present, our fund clients are not bound by the protocol. If a G-SIFI were to be placed into a special resolution or bankruptcy prior to any national regulations being enacted by the FSB regulators, then non-adherents to the protocol would have intact termination rights,” said Goodwyn.
Non-G-SIFIs which have not signed up to the ISDA protocol could also benefit by seeing fund managers port derivatives business towards them. However, there are risks. “More financial institutions may adhere to the protocol, although some firms that are not adherents could benefit in the near-term,” she said.
However, the suspension of early termination rights could allow the market to restore order, and avoid panic. Nonetheless, many in the buy-side feel they have been shut out of the discussions, a point made in a letter to the FSB penned by a consortium of interest groups including the Alternative Investment Management Association (AIMA), the Managed Funds Association (MFA), the American Council of Life Insurers, the Association of Institutional Investors, the Commodity Markets Council and the Customer Commodity Coalition.
Despite the implications, some fund managers appear to have given the proposals little thought. “Clients are overloaded with regulations, and many simply have not devoted the resources to deal with this issue,” said Goodwyn.
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.
*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