Change in Derivatives Contracts Goes Only So Far

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Scott O’Malia, chief of the International Swaps and Derivatives Association.Credit Gary Cameron/Reuters

It’s not every day that Wall Street comes out and celebrates a change that erodes its rights in a lucrative market.

On the surface, the applause for the change, which was agreed upon this past weekend, didn’t make sense. Why would the banks back something that could lessen their longstanding privileges in one of their most profitable businesses — derivatives trading? Could it be that the industry was embracing the notion that sacrifices must be made for a safer financial system? Or was Wall Street cleverly securing some important gains for itself as it cheered on the overhaul?

Derivatives are the financial contracts that banks sell to their clients and trade among themselves. They are used to make bets on the direction of interest rates, the price movements of stocks and commodities. They can even be used to wager on the creditworthiness of companies and countries. Wall Street earns some of its biggest profit margins on derivatives, and the market has ballooned in size in recent decades.

The 2008 financial crisis, particularly the collapse of Lehman Brothers, revealed the dangers lurking in the derivatives market. Since then, governments around the world have responded by requiring important adjustments in how the market works.

But a big weakness in derivatives contracts remained. This flaw helped cripple the system when Lehman collapsed. Financial firms that were doing derivatives trades with Lehman had the right under their contracts to immediately terminate those trades once the firm went into bankruptcy. This prompted a chaotic unwinding of Lehman’s large derivatives book, creating huge new losses for the firm and helping to spread panic to other large banks.

To try to fix this, regulators have pushed for a short delay, or stay, to be imposed on derivatives-termination rights. Their theory is that the delay will give the authorities some time to find a solution for the failing bank that avoids a typical bankruptcy — and a mass unwinding of the bank’s derivatives book. One such solution could be selling the firm to another bank that would then honor the derivatives. Or the authorities themselves might seize the bank and put it on a more stable footing, by creating brand new equity capital out of other parts of the bank’s balance sheet.

The Dodd-Frank Act of 2010 introduced such a stay, which applied to many derivatives. But there were big gaps, particularly on contracts struck overseas. This past weekend, the stay was extended so that it effectively covered derivatives trades that American banks did in their large London subsidiaries.

Many on Wall Street hailed this as a big step toward ending the too-big-to-fail problem, the notion that some banks are so large that the government would have to bail them out to keep their collapse from harming the wider economy. In theory, after the stay becomes part of derivatives contracts next year, regulators will be able to wind down a large failing firm without Lehman-like chaos. In principle, regulators also won’t have to use any taxpayer funds to stabilize a failing bank, because they will have the power to transform a failing firm’s debt obligations into enough equity capital to make it viable again.

“This is a major industry initiative to address the too-big-to-fail issue and reduce systemic risk,” Scott O’Malia, chief executive of the International Swaps and Derivatives Association, said in a statement. The association provides the foundation, or master agreement, for derivatives contracts. It will now add language to those contracts that allow for a stay of termination rights. Final, full-fledged versions of the provisions were not released this weekend, but are expected to come out next month. Bank regulators pushed for the changes.

So why might the banks have supported something that limits their rights?

Common sense is one reason. Messy Lehman-style bankruptcies can hurt all banks and harm the wider economy. It is in the interest of Wall Street, and even Main Street, to be able to wind down a failing firm in an orderly fashion. This overhaul may well prevent disorderly crashes of large Wall Street firms.

But the banks may also have benefited.

There is a notable gap in the contract overhaul that suggests the banks were keen to protect the status of their derivatives business. In one important situation, the contract change does not, in fact, delay early termination rights on derivatives. Take a situation in which a derivatives trading entity that is part of a bank enters United States bankruptcy proceedings. Trading partners, or counterparties, of that entity would still be able to terminate their trades early.

The weekend overhaul merely prevents that bankruptcy from setting off so-called cross-default rights across the whole firm. Under the old contract language now in effect, a bankruptcy of one arm of a bank may allow counterparties to immediately terminate trades with other parts of the failing bank. The weekend overhaul would stay that right.

But if early termination can be so destabilizing, why didn’t regulators go all the way and press for a contract change that would provide for a stay even for the actual derivatives entity that files for bankruptcy?

One theory is that the industry would have fought hard against it.

Derivatives have long had a special standing under the law that, in effect, gives them seniority, even over standard types of secured debt. If, for instance, a creditor has made a loan to a company that is secured with assets of the firm, the creditor still has to endure the expense and inconvenience of bankruptcy proceedings to collect. But derivatives, arguably a form of secured debt, are different. Take, for example, a bank that owes a pension fund $20 million on a derivatives trade that doesn’t close for another year. The bank has most probably already passed the fund $20 million in collateral (cash or Treasury bonds) to cover what it owes. If the bank goes bankrupt, the fund gets to keep that $20 million of collateral, and it does not become part of the bankruptcy proceedings.

Bankers say that derivatives have to be given this special treatment. If not, trading partners would lose certainty about what they might be able to collect from derivatives. But skeptics counter that this uncertainty hangs over other financial instruments and has not dented their popularity.

And in some ways, the weekend overhaul enshrines a practice on Wall Street that some people say leads to taxpayer subsidies on derivatives.

Banks do most of their derivatives trading out of their insured bank subsidiaries that take Mom-and-Pop deposits. The taxpayer-backed deposit insurance most likely makes those subsidiaries more financially stable, and thus more attractive to the banks’ derivatives trading partners.

Once the derivatives overhaul is in place, regulators can take debt issued by the parent company of a failing bank and turn it into equity capital to shore up those derivatives-trading subsidiaries — potentially making them even more secure in counterparties’ eyes. And, at the same time, the stay on cross-default termination rights keeps the derivatives books at the subsidiaries intact.

The effect of layering on new protections is that trading partners of banks will feel even more confident about making bets with large banks. And the derivatives market will become an even bigger business than it is now.

Mark J. Roe, a professor at Harvard Law School, said that the contract overhaul was in some ways a good thing because it would most probably lead to a more orderly winding-down of large banks. But he also argued that the advantages that derivatives continue to enjoy could, over time, reduce the strength of the market. Trading partners, knowing their bets would be paid off, might devote less attention to assessing the true creditworthiness of the big derivatives banks, he said.

“On that dimension, it doesn’t make us better off, and that’s an important dimension,” Mr. Roe said. “The bottom line is that this chips away at too-big-to-fail, but too big to fail is still big.”