The International Swaps and Derivatives Association (ISDA) recently issued the ISDA 2014 Resolution Stay Protocol (Protocol), which takes effect on 1 January 2015. The Protocol aims to prevent adhering parties from immediately terminating outstanding derivative contracts, and thereby gives regulators time to resolve in an orderly way transactions entered into by a bank that becomes insolvent.
The Protocol was developed in coordination with the Financial Stability Board (FSB) to strengthen systemic stability and reduce the risk associated with banks that are "too-big-to-fail".
18 major global banks (G-18) have adhered to the Protocol, which is also supported by the Board of Governors of the U.S. Federal Reserve System and the Federal Deposit Insurance Corporation. Concerns raised by the buy-side during the consultation process resulted in buy-side adherence being separated from bank adherence. The buy-side is not expected to adhere voluntarily in large numbers until further regulation is adopted in 2015.
Voluntary Adherence and Buy-Side Concerns
The Protocol follows a commitment made by the FSB at the G20 Summit in St. Petersburg in 2013, to develop policy proposals to enhance legal certainty in cross-border dispute resolution. The FSB agreed to pursue the rapid implementation of contractual solutions in relation to temporary restrictions or stays on early termination rights and cross-defaults in financial contracts. These contractual solutions are an interim measure pending adoption of comprehensive statutory regimes, which will take time to coordinate and implement globally.
In global derivatives markets, an unexpected insolvency event can result in the termination of derivative transactions with entities in multiple jurisdictions before regulators are able to coordinate an orderly response. Scott O’Malia, ISDA Chief Executive, commented:
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 derivative portfolios.
Buy-side firms – including hedge funds, private equity funds, pension funds and mutual funds – have been hesitant to adhere to the Protocol. Fiduciary duties owed to their investors need to be considered before voluntarily giving up advantageous contractual rights to early termination, which could otherwise be exercised without the delay imposed by the Protocol.
Regulators aim to bridge the gap between adhering and non-adhering parties by developing new regulations in 2015 that will promote adherence to the Protocol by all market participants. The FSB has suggested that prudential regulation could require banks, investment firms and other financial firms to adopt the Protocol in contracts with all their counterparties. Enacting that regulation at a national level will, of course, take time.
Delay in Termination Rights
The Protocol can delay the exercise of early termination rights up to 48 hours after the commencement of Chapter 11 proceedings or until midnight on the business day following the day on which termination rights are suspended in the UK. While this may not be enough time for regulators in multiple jurisdictions to coordinate a response, stressed market conditions could expose counterparties to large losses if they cannot close short positions before liquidity dries up or if they are forced to delay unwinding long positions in a falling market.
Counterparties that adhere to the Protocol will need to take account of whether or not their swap counterparty has also adhered to the Protocol, and will need to manage the risk of a potential delay in closing out transactions.
Adherence and Further Regulation
Counterparties that have not adhered to the Protocol may have an advantage in closing out transactions without delay (subject to regulators coordinating a response across multiple jurisdictions). A fund’s trading counterparty could also benefit from avoiding adherence to the Protocol, in the event of insolvency of another trading counterparty.
It is not anticipated that a large number of buy-side clients will adhere to the protocol voluntarily, until further regulation is adopted to require compliance by all market participants. However, if sell-side counterparties are restricted from trading with counterparties that have not adhered, such counterparties could pressure the buy-side to embrace the Protocol more generally than would otherwise occur.
The author would like to thank Emily Cairns for her research for this article.