The Association for Financial Markets in Europe (AFME) has published a new protocol governing OTC equity transactions that it is intended to put an end to uncertainty over the liabilities of sell-side trading counterparties in the event of an insolvency.
The protocol, which has been constructed for principal-to-principal trades and as such will not cover agency trades between buy-side and sell-side firms, allows a signatory to strike a cash balance for open trades with a signatory that defaults, following the model used in other OTC markets.
John Serocold, managing director of AFME, said that the association has extended an open invitation to the Investment Management Association (IMA), the UK trade body for investment managers, to develop a protocol that would operate for agency trades between buy- and sell-side firms.
A paper issued by the UK Treasury in December 2009 about resolution arrangements for investment banks threatened government intervention if the industry was unable to develop a protocol.
“The advantage with the protocol is that you know all of those trades are dead and that you can go back into the market and replace them. That was the snag [when Lehman Brothers collapsed],” he explained. “These trades were stuck in settlement systems and you had to cancel them all bilaterally.” While Lehman's administrator deliberated, the bank's counterparties were unable to ascertain their book positions.
On 16 September 2010, another UK Treasury consultation paper proposed a special administration regime for investment firms, to minimise disruption to the market in the event of a failure. The paper acknowledged the need for reform on grounds that the normal distribution of assets between creditors according to statutory ranking – as operates under the current regime – is not easily reconciled for investment banks.
“The purpose of this OTC protocol is to provide a way to limit and manage the risks arising on insolvency of open bilateral cash equity trades between adhering banks and investment firms,” said Serocold. “They will benefit from the ability to manage their risks and, if appropriate, put their customers in the position they would have been in, had the trade settled as expected.”
Guy Sears, director, wholesale at the IMA, confirmed that adjustments to the existing protocol would be required for buy-side purposes.
“As a matter of practice, we should have a single regime that says that all trades are settled at a hammer price so that in case of default, the equity contract is closed out in cash terms. Then it wouldn't matter when we sent trades off if they ended up in a prop book, on a crossing network or on an exchange.”
AFME's OTC protocol does not extend to trades covered by exchange rules or trades covered by other contractual arrangements.