New Swaps Protocol Aimed at Avoiding ‘Too Big to Fail’

The new procedure will in theory keep an insolvent bank's counterparties from stepping in and seizing collateral during a crisis.
Matthew HellerOctober 13, 2014

Eighteen of the world’s largest banks have agreed to a new derivative protocol aimed at promoting the orderly resolution of a troubled bank and avoiding the “too big to fail” scenario.

Under the new “resolution stay” protocol announced by the International Swaps and Derivatives Association, the banks will delay closure of swaps contracts when an institution becomes insolvent, giving regulators more time to arrange orderly resolutions.

Swaps contracts with an insolvent bank will remain legally “alive” for two days so that regulators can consider whether to transfer these open positions to another institution. The current system provides banks with early termination rights.

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“This is a major industry initiative to address the too-big-to-fail issue and reduce systemic risk,” ISDA Chief Executive Scott O’Malia said in a news release, adding that the agreement will “facilitate cross-border resolution efforts and reduce the risk of a disorderly unwind of derivatives portfolios.”

Avoiding “too big to fail” bailouts has been a major concern of regulators since the global financial meltdown.

The new protocol “is an important step toward mitigating the financial stability risks associated with the early termination of bilateral, OTC derivatives contracts triggered by the failure of a global banking firm with significant cross-border derivatives activities,” the Board of Governors of the U.S. Federal Reserve System and the Federal Deposit Insurance Corporation said in a statement.

But asset managers are voicing opposition to the plan, warning that it may undermine their fiduciary duty to investors.

“It is unclear why asset managers as fiduciaries would be willing to sign up to the revised ISDA protocol, which is not mandatory and appears to offer them nothing in return,” Thomas Donegan, a partner in the financial institutions advisory and regulatory group at the law firm Shearman & Sterling, tells the Financial Times.

According to Bloomberg, ISDA changed the resolution stay protocol under pressure from U.S. regulators. The agreement covers banks including JPMorgan Chase, Goldman Sachs Group, HSBC Holdings and Credit Suisse Group and is set to take effect Jan. 1.

“Voluntary adoption of the ISDA protocol further demonstrates the industry’s commitment to ensuring that even the largest global banks can be resolved in an orderly way without cost to taxpayers,” Clearing House Association President Paul Saltzman said in a statement.