The launch of ISDA’s Resolution Stay Protocol*, which opened for adherence last week, has inspired a variety of comments in the press. Among them are articles reporting on concerns expressed by some buy-side firms – an important element of our membership – about the process of drafting the Protocol. Others have touched upon whether a contractual approach is the best way to deal with cross-border resolution issues. Both are valid points to raise, but we are particularly concerned that some misperceptions have crept into the coverage.
Buy-side representatives (including trade groups that represent scores of firms) were involved in this initiative from its outset, and participated in a Protocol working group that ISDA established. As such, they were sent all drafts of the Protocol and were encouraged to voice their opinions throughout the process. ISDA also organised and participated in several meetings between buy-side representatives and regulators.
Very early on, the buy side raised concerns about any change to derivatives contracts that would result in the loss of a right to close-out trades with counterparties that enter into resolution. They argued they have a fiduciary duty to their clients that prevents them from voluntarily signing away advantageous contractual rights. And they’re right.
ISDA repeatedly made these points to regulators, including through a letter co-signed with the asset management group of the Securities Industry and Financial Markets Association. These concerns were acknowledged and accepted by regulators, as highlighted in a recent report by the Financial Stability Board (FSB).
This brings us to an important point: as a result of these concerns being aired, buy-side adherence to the Protocol was separated from bank adherence. That’s why only 18 large and global financial institutions signed the Protocol during its first phase.
The FSB report has proposed that national regulators should introduce rules in their jurisdictions in 2015 that would encourage – directly or indirectly – a broader array of firms to adopt contractual stays. It is anticipated that the development and imposition of these rules will follow the normal rule-making process of each individual jurisdiction. It is also expected that ISDA may publish amendments to the Protocol to reflect these rule-makings, so that if and when buy-side firms do adhere, they will adhere strictly to the language of the regulations in a particular jurisdiction.
In addition, it is important to point out that this Protocol has a ‘sunset clause’, and requires regulation to ensure the continuity that market participants and regulators would expect from such an important remedy. If the rest of the market is not subject to a particular special resolution regime within a specified time, the 18 banks can give notice that they are no longer bound by that regime. A contractual approach is a useful short-term solution – a point that a number of market participants can accept so long as there is a level playing field.
Clearly, the most effective way to ensure that any stay on early termination and cross-default rights applies on a cross-border basis is through legislation – a point ISDA has made repeatedly. The FSB report also agrees that a framework for statutory cross-border recognition would be preferable, but argues this a longer-term goal.
Until a legislative solution is implemented, the Protocol establishes an effective mechanism for those firms that choose to use it to quickly and efficiently alter their outstanding contracts. The Protocol is not a rule, nor does it require firms to sign – ISDA cannot and does not mandate adherence to its protocols.
Whether other firms sign is a matter for them to decide – or for regulators to propose, issue and implement rules requiring or incentivising their adherence.
Going forward, ISDA will remain the neutral broker and clearing house of ideas regarding the implementation of the Protocol, as well as responding to the expected regulatory and legislative proposals. Ensuring we have a well-defined and workable recovery process that is consistent with the regulatory objectives and protects the rights of creditors is in the best interests of all market participants and the stability of the global financial system.
*Editor’s Note: The Protocol was developed at the request of global regulators to ensure cross-border derivatives transactions are captured by existing and forthcoming statutory resolution regimes. By signing the Protocol, adhering firms are agreeing to change derivatives contracts with other adhering parties to abide by the early termination stays introduced by these statutory regimes. By doing so, they remove uncertainty over whether a stay imposed by one country’s resolution authority (which would cover all derivatives trades subject to local law contracts, without need for the Protocol) would be enforceable in a cross-border situation. The Protocol also provides for an override of cross-default rights when an affiliate of a counterparty becomes subject to certain US bankruptcy proceedings.