Six years ago, the $700 trillion derivatives market helped turn Lehman Brothers’ collapse into a full-blown global financial crisis.
But this weekend, regulators and large banks expect to agree on a change to derivatives that is intended to contain the damage caused by the crash of a large bank, several people briefed on the negotiations said.
Many in the industry are promoting the change as evidence that banks and regulators are substantially reducing the threat that large banks pose to the financial system and the wider economy. While consumer advocates say that they support the change, they also contend that it does not do enough to dislodge the privileged, and potentially precarious, position that they say derivatives still occupy in the financial system.
Derivatives are financial contracts that allow banks and other financial companies to bet on interest-rate movements, the prices of stocks and bonds and the creditworthiness of companies or countries. Large Wall Street banks make significant profits from derivatives.
Still, the ability of failures in this market to cause serious financial pain became apparent when Lehman, a big derivatives trader, collapsed. Under derivatives contracts, Lehman’s trading partners had the right to immediately terminate their derivatives trades when the company declared bankruptcy. All of a sudden, Lehman’s derivatives trades had to be unwound quickly and chaotically, causing huge new losses for the company and disruption in the wider market.
Clearly, what was needed was a “circuit breaker” for derivatives when companies fail. Regulators specifically wanted a brief delay before derivatives contracts could be unilaterally terminated after a bank collapsed.
Such a delay would, in theory, give the regulatory authorities the time to sell the failing company to a buyer who could keep the derivatives business running. Alternatively, a delay would give regulators time to rapidly restructure the business to put it on firmer financial footing, a power that authorities were given under the 2010 Dodd-Frank Act.
Last year, the Financial Stability Board, an international group of regulators headed by Mark J. Carney, the governor of the Bank of England, called on the industry to add language to derivatives contracts that would allow for such a delay. United States regulators added pressure this year, asserting that the delay was needed as part of their so-called living will overhaul, which tries to make it simpler to wind down problem banks. The International Swaps and Derivatives Association, a trade group that provides a template for derivatives contracts, has agreed to the delay, known as a stay in the legal world. It could, for example, last for one business day.
The Financial Stability Board and the association could formally announce the plan to change the contracts this weekend, after a meeting between the banks and regulators in Washington, people briefed on the negotiations said. The Financial Times earlier reported on the timing of the announcement on the changes to derivatives contracts.
Banks and their legal representatives say the change could go a long way toward ending the too-big-to-fail problem, or the threat that some banks are so big that the government would be forced to bail them out to shield the wider economy. Without the change, they say, the government would have a much harder time winding down a big bank in an orderly fashion.
“Dealing with the derivatives and the stay was critical,” said H. Rodgin Cohen, a senior chairman at the law firm Sullivan & Cromwell.
Some critics of the banking industry say more must be done.
“There is no question that this potentially very important change could, if done right, dramatically improve the ability to stop a crisis spreading,” said Dennis M. Kelleher, president of Better Markets, a group that has pressed for a more stringent overhaul of banks, “But the other pieces are critical, too.”
Even after the change, derivatives will enjoy superior rights. The new provision would still allow a derivative to be terminated early if the entity directly on the other side of a derivatives trade went into a bankruptcy proceeding like Chapter 11.
“It is indefensible that derivatives get preferential treatment over all other creditors,” Mr. Kelleher said. “That becomes a key accelerant in spreading a financial crisis.”
The banks may have secured an important concession in the negotiations. Some regulators wanted to reserve the right to stop meeting contractual obligations, like margin payments, on a derivatives trade during a stay. But the banks have not given that up, according to a person briefed on the talks.
Still, the new contract terms may now limit so-called cross-default rights in a typical bankruptcy. If a bank fails now, its trading partners may be able to terminate trades with any of the bank’s other subsidiaries. But it appears that the new contract will restrict that right only to trades with the entity that is in default, a person briefed on the negotiations said.
The change could affect a vast majority of derivatives contracts, even existing ones. And it could plug big loopholes when American banks do much of their derivatives trading overseas, particularly in London.
The regulators have focused the pressure for the contract change on the nearly 20 big banks that dominate derivatives trading. But the regulators do not have the power to lean on large investment firms that trade heavily in derivatives. So the regulators may require that all the banks’ derivatives trades be struck under the new contracts, even those trades done with investment firms.
“In many jurisdictions, banks, investment firms and other financial firms subject to prudential regulation could be required by prudential rules to adopt the necessary contractual language on stays in resolution with all their counterparties,” the Financial Stability Board said last month in a document.