CALLING TIME ON "SWAP' TIL YOU DROP" DERIVATIVES PARTY / THE WALL STREET JOURNAL

Heard on the Street

Calling Time on ‘Swap ’Til You Drop’ Derivatives Party

By John Carney 

Oct. 8, 2014 2:17 p.m. ET


An impending change to the basic contract governing derivatives demonstrates how much power regulators have to reshape the financial system under Dodd-Frank—and their greater willingness to use it.

Many of the world’s largest banks reportedly have agreed to a change in contracts that will impose a temporary stay on collateral rights under derivatives contracts should regulators step in to resolve a failing financial institution. The International Swaps and Derivatives Association is expected to announce that the change will be part of the basic documents governing swaps, known as “master agreements,” in the next few days.

This comes after the Federal Reserve and the Federal Deposit Insurance Corp. used their review of big banks’ so-called living wills to rebuke them for not moving quickly enough to adopt these changes.

The hope is that this will make the failure of a large financial company less chaotic by preventing swaps counterparties from exercising rights to immediately seize collateral, as happened when Lehman Brothers failed. Preserving the assets of a failing firm could also make it easier to find a buyer, something that proved impossible for Lehman.

Under U.S. bankruptcy provisions, creditors are barred from terminating contracts or grabbing collateral by automatic stays that attach upon filing. But derivative contracts have been carved out of automatic stays by laws creating various safe harbors and exemptions.

Individual banks faced a collective-action problem when it came to reforming derivatives. Attempting to change their own contracts risked pushing customers to competitors who stuck with the status quo. Something like the Fed’s and the FDIC’s hand was required to push the banks to act together.

Yet the fact this change came about because of Fed and FDIC pressure, but without any formal rule-making process much less new bankruptcy legislation, is a reason for pause. After all, regulators are hardly immune from error. If the checks on the power of financial regulators are insufficient, costly regulatory mistakes are more likely.

And since regulatory failure played a significant role in the financial crisis, this isn't a risk investors can’t afford to overlook, even when it comes to sensible changes.