A new clause for the ISDA master contracts aims to prevent messy, Lehman-like default scenarios in the future.
A long-debated measure to curb systemic risk and avoid messy defaults like the one that befell Lehman Brothers in September 2008 went into effect last week, when 18 major banks agreed to sign the International Swaps and Derivatives Association’s (ISDA) Resolution Stay Protocol.
The ISDA Stay Protocol allows regulators to force firms with active derivatives contracts to delay – stay – the exercise of their early termination rights in the event that a counterparty enters bankruptcy resolution proceedings.
The new protocol fills a gap in existing derivatives contracts and regulatory frameworks.
Due to the international nature of derivatives markets, any one regulator would have been unable to unilaterally impose a similar stay, because it would only affect firms within their jurisdiction. If enough overseas firms holding derivative contracts with an endangered bank decided to exercise their early termination rights, there was no way for a domestic regulator to stop them – making the entire exercise pointless.
Under the new ISDA protocol, firms will have to wait between 24 and 48 hours to exercise their early termination rights, giving regulators time to get a troubled firm’s house in order.
The ISDA agreement is technically voluntary, but regulators in France, Germany, Japan, the U.K. and the U.S. “have made it clear that the largest swap dealers must sign up to the protocol,” according to the Risk.net news service.
“This is a major industry initiative to address the too-big-to-fail issue and reduce systemic risk, while also incorporating important creditor safeguards,” says ISDA Chief Executive Scott O’Malia, in a statement. “The ISDA Resolution Stay Protocol has been developed in close coordination with regulators to facilitate cross-border resolution efforts and reduce the risk of a disorderly unwind of derivatives portfolios.”
According to an ISDA statement, global regulators will be working throughout 2015 to adopt new rules that will extend the provisions to banks beyond the so-called G-18, a group of the largest and most systemically important banks.
By adhering to the ISDA protocol, the G-18 banks will extend the coverage of stays to more than 90 percent of their outstanding derivatives notional, according to the statement.
The protocol takes effect on January 1, 2015 and will apply to both new and existing trades between participating derivatives markets participants.
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