The Resolution Stay Protocol was introduced on 22 September by the International Swaps and Derivatives Association (ISDA), the global derivatives trade body, in order to force counterparties to observe a 48-hour waiting period when seeking to unwind cross-border derivative contracts with an ailing or near-insolvent bank. It was immediately signed by the 18 globally systemically important financial institutions (G-SIFIs) identified by the Financial Standards Board (FSB), which account for 90% of global derivative trades.
Regulators around the world have sought to introduce this ‘stay’ in derivatives unwinds as they try to incorporate lessons from the near-cataclysmic meltdowns of Lehman Brothers and the Icelandic and Irish banking systems, during the financial crisis. The aim behind the protocol, says ISDA, is to bring cross-border derivative trades into line with regulations which have, or are currently being, introduced on a national level to prevent the spread of systemic risk through disorderly trade unwinds.
But the protocol was met with a choked reaction by buy-side organisations when it slipped into force in October. Industry bodies – including the Alternative Investment Management Association (AIMA), the Managed Funds Association (MFA), the American Council of Life Insurers and the Association of Institutional Investors – expressed their disapproval in a letter to the FSB – the mastermind of the protocol – in early November.
Chief among their gripes was the forced concession of special termination rights on derivative trades in bank failures.
“There is no individual benefit to investors in agreeing to stay their contractual rights as envisaged in the ISDA Protocol,” says Richard Metcalfe, director, regulatory affairs at the Investment Management Association (IMA). “Hence investment managers will be reluctant to sign up for clients, as this could contravene their fiduciary duty to act in their client’s best interest. Signing-up might also breach regulatory requirements, such as UCITS.”
ISDA responds
Buy-siders also expressed severe concerns about the potential implications for regulatory and jurisdictional arbitrage and questioned the wisdom of suspending early termination rights, arguing such actions could actually incentivise behaviour that will exacerbate the contagion in the financial system during periods of stress, rather than quell it.
In order to understand the buy-side concerns properly, over something that is ostensibly looking to address the spread of systemic risk, it is worth looking at the background to the protocol draft. ISDA says that the protocol was created at the behest of global regulators – spearheaded by the FSB – in a working group that had both sell- and buy-side participants contributing to it. It is designed as a temporary measure which would enable banks to adhere to the stay on a contractual rather than legal basis.
“The most effective way to ensure cross-border recognition is through legislation but this will take time, so regulators asked ISDA to develop an interim contractual solution,” says David Geen, ISDA’s general counsel. “The protocol, which opts counterparties into certain foreign resolution regimes, only applies to trades between adhering parties.”
In a response to the buy-side concerns, ISDA put out a release in mid-November, emphasising that buy-side firms are not under any obligation to adhere to the protocol. It stated that only the initial group of 18 banks and certain of their affiliates have signed up to the protocol at the first stage and also said that buy-side groups were adequately represented in the working group discussions and moreover that their concerns over giving up termination rights were fully addressed and relayed to the regulators, which led to the first phase of voluntary adoption.
“The protocol is not a rule, and ISDA cannot mandate anyone to adhere to it,” says Geen. “Very early in the discussion, the buy-side made it clear they would not be able to sign the protocol voluntarily, which is why the first phase of adherence only included banks.”
Participants on the buy-side do not agree. Industry groups like AIMA and the MFA say they were not properly consulted on the rules. And, most believe, it is only a matter of time before they will be obliged to sign up to the protocol.
“I’m not sure ISDA’s comments give people any sense of comfort,” says Adam Jacobs, head of the markets regulation team, AIMA. “The FSB have been quite explicit that while initial adherents are the banks, the long-term goal is to encourage everyone to sign up to the protocol. It could say to banks that they can’t transact with non-adherents. And furthermore, based on the reaction from our members it is clear there was no huge awareness of what would be in the protocol.”
Arbitrage opportunities
If it seems like a battle of wills characterised by haphazard communication then it has not been helped by the uncertainty over the whole stay issue. Not only uncertainty over how the stays will be implemented, but also over what sort of impact it could have on counterparty positions.
“There are all sorts of uncertainties when a party goes into insolvency – it’s not the case they will want to close all trades,” says one buy-side participant who asked not to be identified. “They might want to net exposures. It could have a huge impact – the more derivatives trading a fund is doing the larger the impact. The 48-hour period can also be a long time if the market moves in the direction you don’t want it to.”
Participants say that even if buy-siders are not obliged to sign the protocol, there will be a disjunct between those able to close out derivatives books before the involvement of regulators, and those unable to do so, creating potential imbalances in counterparty trading positions.
“It could create some arbitrage if you are trading with someone not adhering to the rules – it could encourage firms to turn to banks not involved in this,” says Abigail Bell, partner at law firm Dechert. “Fund managers question how this would allow them to manage their portfolios – I would think many would find it difficult to sign up to this.”
Bell says that the 48 hours is a very short time to allow a regulator to transfer assets with all the due diligence and complicated legalese that would need to be undertaken and understood for this to work. At the same time the pause period could give rise to increased volatility in the underlying derivatives positions, as the lack of action ratchets up the perception of risk, creating more uncertainty. Fund managers argue that if they are forced to sign-up to this they would instantly look to close out positions before the stays kick in, due to a prevalent lack of confidence in regulators’ ability to fix a bank’s positions, and to deal with the volatility themselves.
However, the protocol is at present making connections between national resolution regimes which already contain this type of power. The orderly liquidation authority introduced by the Dodd-Frank Act allows US regulators to take control of stricken banks between US-regulated counterparties. In January next year, the European Union’s Bank Recovery and Resolution Directive (BRRD) will come into force giving European regulators much the same powers. But it remains unclear whether this will be implemented on a market-wide basis or from jurisdiction to jurisdiction.
“As a market participant, we do not think this should be a cause of concern as long as the rule is applied in a consistent way across multiple jurisdictions,” says Arnaud Fortier, Zurich’s head of financial engineering, in the strategy implementation team for investment management. “We welcome any initiative aiming to mitigate or reduce systemic risk. Given recent implementation of these changes though, we do stress the need to better understand the terms of this protocol and its impacts across different jurisdictions.”
AIMA’s Jacobs argues that in practise the protocol “is more aggressive than the EU BRRD.
“The protocol was not developed by legislative change,” he says. “It is one thing for legislators to put forward proposals which are delivered through debate. It is quite another to do this through a contract solution.”
Given all this prevailing uncertainty, what will happen in the future? It seems likely that most will wait until regulators decide whether to enshrine adherence to the protocol through legislation or attempt to do it on a national level. The IMA’s Metcalfe feels there may be need for a buy-side version of the protocol in order to cover any regulatory issues specific to buy-side entities.
The protocol is only a small part of the welter of documentation and operational issues the buy-side faces with regard to derivatives over the coming years. For some, this has clearly become a burdensome process.
“The buy-side has historically not had to worry about operational issues but, now, ensuring they are following best practices and compliant processes with global derivative rules is becoming a big burden,” says Matthew Streeter, capital markets strategist at FINCAD. “With regards to the protocol, the buy-side will be looking to see how prescriptive regulation will be in the near term – until then I wouldn’t see it as being unilaterally significant for all buy-side firms.”
Streeter says that if the aim is to reduce systemic risk that should be integrated into buy-side incentives to participate in the protocol. Incorporating the current change as part of achieving better risk oversight and control would ideally not constitute a significant cost increase or operational burden.
Yet, while the intention might be a worthy one, it is still a difficult subject for buy-siders. Might the FSB prevent banks from trading with buy-side firms who do not sign up to the protocol? Is it tenable that there is a two-tier system for those who adhere to the stay and those who do not? Should national legislation allow this, and will everyone go for it?
There are many questions which remain to be answered over this highly contentious issue. For now, the market sits and waits.