Tensions are building in an enormous market that nearly brought Wall Street to its knees in 2008.
Financial regulators are pushing for an arcane but crucial modification to the contracts that stand behind the $700 trillion global market for derivatives. The change is part of the regulators’ efforts to avoid the sort of systemic chaos that occurred after Lehman Brothers crashed.
Large banks and investment firms, however, are concerned that the adjustment — which would affect how trades are treated when a bank fails — could weaken their legal rights and may even make the market for derivatives riskier. The financial firms have been expressing their fears in talks with the Federal Reserve and the Federal Deposit Insurance Corporation, the bank regulators behind the push.
While Wall Street is largely resigned to the regulators’ ultimately getting their way, it is nevertheless pressing for measures seen as protections in return.
“It will be an incredibly significant change,” said John F. Simonson, a partner at PricewaterhouseCoopers who covers financial regulation. “The derivatives books of the largest dealers today are considerably larger than Lehman’s.”
The International Swaps and Derivatives Association, representing banks and investors, is negotiating with global regulators to try to reach an agreement by the time the Group of 20 nations meets in Australia in November. By that time, international financial regulators hope to have worked out how the change would apply to large banks that have subsidiaries in different countries.
The tussles underscore the centrality of derivatives to regulators’ efforts to put the financial system on a firmer footing. Derivatives are financial instruments that allow banks and other investors to bet on interest rates, securities prices and the creditworthiness of countries and companies. Their complexity and reach allowed dangerous risks to build up in the system before the financial crisis, and they intensified the chaos in the markets in the days and weeks after Lehman failed in September 2008. Certain regulations introduced since the crisis appear to have strengthened the derivatives market.
But the authorities are concerned that derivatives still have the power to make the failure of a large bank difficult for regulators to control. Derivatives pose this threat because they allow the trading partners of a failed bank to immediately terminate their trades, often placing them ahead of other creditors. As Lehman’s demise showed, a stampede of terminations complicates efforts to determine the true financial condition of a failed bank and run the bank’s derivatives book in an orderly fashion while the bank is being resolved.
With the post-Lehman turmoil in mind, Congress inserted into the Dodd-Frank Act of 2010 a provision that could suspend for one day the right of trading partners of a failed bank to terminate their trades. The idea of such a “stay” was to give regulators time to transfer the failed institution to a new owner, or to have the F.D.I.C. run it in an orderly fashion.
Still, crucial exceptions persist that have unsettled regulators. The Dodd-Frank stay on termination would apply only to derivatives contracts struck under United States law, leaving vast amounts of trades exempt.
“The problem is that Dodd Frank only applies to U.S. contracts,” Darrell Duffie, a professor of finance at Stanford, said. “And the U.S. firms have at least half of their contracts in London.”
What is more, under Dodd-Frank the stay also kicks in only when the F.D.I.C. takes over the failed bank, to resolve or sell it. A stay would not be possible if a bank went into a typical bankruptcy proceeding, like Chapter 11, according to derivatives specialists.
To end the exceptions, global regulators came up with an approach that struck some on Wall Street as an unconventional power grab. The regulators have leaned on the International Swaps and Derivatives Association to change, or add to, derivatives contracts so that they provide for a stay even in instances not envisioned under current laws. In the talks with the trade group, the American regulators have even suggested that any changes or additions would affect existing trades, not just new ones.
And the Fed and the F.D.I.C. have an advantage that gives them added power to get the adjustments they want. Under United States regulations, banks have to prepare plans called living wills that lay out how they could go into bankruptcy in an orderly way.
Just last week, the Fed and the F.D.I.C. sharply criticized the banks’ living wills. In laying out some of the improvements that regulators wanted to see, Martin J. Gruenberg, the F.D.I.C.’s chairman, said that the banks had to make “amendments to their derivatives contracts to prevent disorderly terminations during resolution.”
The industry is resisting.
The investment firms, for instance, fear losing rights in derivatives contracts that have given them protection when banks failed. As a result, they are pressing for certain concessions if they agree to a potential stay on termination rights, according to three people briefed on the negotiations. One request is that an investment firm would be able to temporarily suspend paying any money it owes on a derivatives trade to a failed bank. The payments would resume once it can be determined that any new entity formed out of the failed bank can meet its financial obligations.
The big derivatives trading banks, however, are concerned about losing some of their termination rights while the investment firms get to keep theirs. This, they say, could create a divide in the system that could add stress during turbulent times.
H. Rodgin Cohen, a senior chairman at the Wall Street law firm Sullivan & Cromwell, said that he supported the regulatory push to put a possible stay on termination rights. Still, he argued that the rule should ideally apply to investment firms as well as banks. As a result, Mr. Cohen suggests that the Financial Stability Oversight Council, a new regulatory body that has a broader purview, should recommend a rule on termination rights that also applies to investors.
“The banking industry is saying that, if we waive termination rights and the buy-side doesn’t, you have this total disparity,” he said. “The asymmetry is a very risky proposition.”