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Markets Regulation
Investors warn on derivatives crisis plan
From the Financial Times of Wed, 08 Oct 2014 18:10:46 GMT
People place their first live trade as they take part in new Trader training programme on a trading floor in central London on September 19 2011©AFP

Institutional investors and pension funds have warned they may resist a plan by the world’s biggest banks to rewrite their derivatives contracts as part of reforms aimed at preventing a failing institution from destabilising global markets.

More than 90 per cent of the contracts in the $710tn off-exchange market are expected to be affected by new protocols agreed by the banks, which are set to be formally unveiled in coming days.

Eighteen of the biggest banks have agreed to give up their right to immediately close out their swaps contracts with a failing institution in order to to allow authorities more time to work out a resolution plan.

The breakthrough has been hailed by the Financial Stability Board, a co-ordinating regulator for the G20 economies, as an important step towards resolving the issue of “too big to fail” financial institutions.

Regulators have been concerned by the fallout if a counterparty exercised its right to close out swaps in those crucial hours after a central bank intervention.

So the banks, working through the International Swaps and Derivatives Association, have agreed these swap contracts should legally “stay alive” while authorities assess their options for a stricken bank and potentially transfer open positions to another institution.

But institutional investors, who are on the other side of many derivative contracts, have warned they cannot voluntarily give up the right to cut off business with a failing bank because of a fiduciary duty to protect their investors’ interests just to help a single institution.

“These particular measures seem to aim to protect failing banks and failing banks are not the same as ‘the financial system’,” said Guus Warringa, chief counsel at APG Asset Management, a Dutch pension fund with pension assets worth €334bn.

“If pensioners have to give up rights they currently enjoy in order to support a failing bank, you will appreciate that APG can and will not support such measures as doing so seems rather unreasonable,” he added.

However, four bank negotiators said they believed the combined force of regulators and banks would make it impossible for institutional investors to resist the change.

Officials around the world are drawing up rules that would force banks’ counterparties to give up their ability to terminate derivatives contracts in the event of a default. They are aiming to pass them next year, according to people familiar with the process. “That is a key piece that needs to be done by regulation and each country using different regulation,” said one bank lawyer.

Several institutional investors in the US and Europe said privately on Wednesday that they would have to discuss the next move with their customers. They need to determine if their clients are prepared to accept the risk that failing to close out derivative positions could cost them money.

Others worried that the legislation could create an unlevel playing field between US asset managers and their subsidiaries, and their overseas competitors.

“We are presently considering how best to ensure that asset managers’ clients – whose interests are what matter here – can work with the approach,” said Richard Metcalfe, director of regulatory affairs at the UK-based Investment Management Association.

Abigail Bell, a partner in financial services group at lawyers Dechert, said it was difficult to see how asset managers could sign up to the proposed Isda protocols unless there was no available alternative.

“If the protocols were implemented then asset managers would look for additional protections in pre-bankruptcy termination agreements, perhaps using credit rating downgrades as triggers to terminate prior to bankruptcy,” she said.

At an Isda conference in London two weeks ago Stephen O’Connor, chairman of Isda, estimated that more than 90 per cent of the world’s contracts would be affected, either by the new protocol or by provisions in new regulation. The Dodd-Frank act stipulates banks must prepare so-called “living wills” that lay out an orderly process for their bankruptcy.

Additional reporting by Chris Flood in London and Tom Braithwaite

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