ISDA stymied over derivatives contracts rewrite

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A global regulatory initiative to rewrite the way derivatives contracts work in a default may be slowed amid concerns that parts of the industry will not sign up to the changes.

The International Swaps and Derivatives Association, a trade association, has been working for nearly a year on contracts that will give failed institutions a temporary stay on investors’ claims on their swaps. The legal rights are triggered by a default on payments.

ISDA, which represents many of the world’s biggest users and broker-dealers, is planning to update its master agreements, the legal framework on which trillions of dollars of derivatives deals are based.

However, some participants in its working group have raised concerns that investors could be disadvantaged by signing up to the default suspension, according to two people who have seen drafts of the proposed master agreements.

Resolving defaults by large banks and other critical financial institutions without setting off further instability across markets is one of the most contentious parts of the post-financial crisis agenda for global regulators.

Over-the-counter derivatives are particularly complex as they are frequently conducted across borders and do not have a single domicile where they are ultimately registered. Regulators worry that if a counterparty exercised its right to their swaps, positions in the bank that had been hedged using derivatives could become unhedged and plunge the institution into default and markets into further chaos – a problem illustrated by the failure of Lehman Brothers.

ISDA’s work aims to resolve the problem of uneven global regulation. Some jurisdictions, such as the US, have stipulated a temporary stay on the default clauses to allow regulators to work out their options for the failed institution, such as a bail-in or default. Other countries have no rules in place and it is likely to take many years for them to catch up.

Last November the US, UK, Swiss and German regulators collectively urged ISDA to provide a short-term suspension of so-called “early termination rights” by getting its members to voluntarily sign a legally binding contract.

However, people familiar with the situation said some ISDA members were worried about widespread industry adoption, as some investors also had fiduciary rights to shareholders. In the event of a default, those who did not sign up to the contract for their derivatives trades would have the right to unwind their contracts immediately, putting them at an advantage to others.

To break the impasse, others have suggested that regulators introduce a set of incentives for market participants, such as preferential capital margin treatment.

ISDA declined to comment beyond a statement it made in November. “Developing such a provision that could be used by counterparties will continue to be a primary focus of our efforts in this important area of regulatory reform,” it said.

Regulators are hoping to have the framework in place before a meeting of the Financial Stability Board in Brisbane, Australia, in November.

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