Unintended Consequences of Staying Early Termination Rights
The topic of “too big to fail” has been an intense area of focus for policymakers and market participants, and for good reason: Everyone has a vested interest in avoiding a repeat of the 2008 financial crisis and its corresponding aftershocks. One way these efforts have taken shape is through “special resolution regimes” (SRRs)1, which provide regulators with a framework and tools to step in and resolve a failing bank or financial utility. One such tool is the ability to override or “stay” for a defined amount of time a party’s contractual right to exercise certain remedies against its counterparty, such as early termination and closeout of outstanding transactions between them, if there are direct defaults and cross-defaults that are triggered as a result of an entity going into resolution. This gives the regulators more time to resolve the troubled party without having to simultaneously address the closeout of potentially tens of thousands of derivatives contracts, which would further complicate the ability to bring a troubled entity out of resolution. However, there is some debate over whether a stay imposed under a particular SRR in one jurisdiction would be enforceable in another jurisdiction. As a result, several regulatory authorities from different jurisdictions around the globe2 are seeking to eliminate this uncertainty contractually until statutory regimes are adopted.
This new contractual “stay” agreement or “protocol” has already been agreed upon among the 18 so-called global systemically important banks (G-SIBs). The G-SIBs have voluntarily agreed, effective 1 January 2015, to be subject to or “opt-in” to the resolution regime in the jurisdiction applicable to their counterparty as well as its affiliates if the counterparty or affiliate becomes subject to the proceedings under a SRR. In addition, the protocol will also require a party to give up certain cross-default and direct-default rights for up to 48 hours, which may be triggered when an affiliate becomes subject to proceedings under “ordinary” U.S. insolvency regimes. Under such U.S. insolvency regimes, there is no statutory stay on the exercise of cross-default rights or related default rights with respect to derivatives transactions. As a result of the new contractual stay agreement, G-SIBs will forfeit their ability to terminate derivatives contracts with each other should one of them or one of their affiliates face trouble. The stay and override of such termination rights is intended to provide regulators with more time and certainty while working out a way to “save” a troubled bank by preventing a run and reducing the risk that the remaining exposures become unbalanced.
This “stay” may sound esoteric – and it is – but the intention of regulators is to expand this contractual stay requirement beyond the G-SIBs to non-bank participants, which includes clients of asset managers. Global regulatory authorities propose to accomplish this through new rules that would prevent G-SIBs from transacting with any non-bank participant who has not contractually agreed to 1) recognize and be subject to or “opt-in” to the SRR applicable to its counterparty as well as its affiliates and 2) stay certain cross-default and direct-default rights when an affiliate becomes subject to proceedings under ordinary U.S. insolvency regimes. This proposal could have potentially adverse ramifications for non-bank market participants, which includes PIMCO clients.
Currently, under most derivatives contracts with counterparties, many market participants have the ability to terminate such transactions with a counterparty under various circumstances (e.g., trouble for the counterparty, its affiliate or guarantor). These early termination provisions are intended to protect a party against further risk to a counterparty in circumstances that reflect a material decline in the counterparty’s creditworthiness. For instance, when Lehman Brothers Holding Co. filed for Chapter 11 bankruptcy in the U.S. and Lehman Brothers International Europe filed for bankruptcy in the UK courts, PIMCO’s clients had the contractual right and ability to terminate all of their derivatives transactions under PIMCO’s ISDA (International Swaps and Derivatives Association) Master Agreements with Lehman. This right was crucial to our clients’ abilities to avoid further credit risk and potential unsecured exposure to Lehman that may have arisen due to the increased value of existing derivatives transactions where Lehman may not have been able to satisfy its performance obligations.
Global regulatory authorities have worried that the ability to terminate a trading relationship under defined circumstances with a globally significant financial institution could hasten that institution’s demise (or worse yet, could cause its demise), which may create broader financial instability and lead to systemic risk. As such, over the last year, global regulatory authorities have called for an “industry-led voluntary” solution for derivatives transactions under ISDA documentation, in which all market participants that trade derivatives with one another voluntarily agree to be subject to the SRR in the jurisdiction of its counterparty, as well as forgo their ability to terminate derivatives transactions early with a counterparty by agreeing to stay that ability for up to 48 hours. In addition, the protocol requires that if a guarantor of a counterparty were to enter into U.S. insolvency proceedings, such guarantee would be transferred to a third-party successor or a newly formed “bridge” entity. This can introduce uncertainty with respect to who the ultimate guarantor or counterparty may be to a transaction in the event an entity goes into resolution and/or is subject to an ordinary U.S. insolvency regime. This uncertainty can completely change the credit analysis of a counterparty and also greatly reduce the value of a guarantee.
To date, all 18 of the G-SIBs have agreed to this protocol for transactions covered under ISDA Master Agreements. The expectation is that by the end of 2015, the regulators will push non-bank participants, including our clients, to adopt a similar protocol for transactions covered under ISDA Master Agreements. Additionally, PIMCO expects that the global regulatory authorities will look to expand these contractual “stays” and “opt-ins” to SRRs to other forms of master agreement documentation (Master Securities Forward Transaction Agreement, Global Master Repurchase Agreement, etc.) in 2015 and 2016.
With clients our priority, we are wary of unintended knock-on effects
While PIMCO is supportive of efforts to reduce systemic risk and prevent taxpayers from being on the hook to bail out troubled banks and systemically important financial institutions, PIMCO’s first priority is our fiduciary duty to our clients – i.e., our legal duty to always act in the best interest of our clients. We manage assets in several types of investment structures, though it is often individual investors that we ultimately serve, such as by managing assets for a retirement plan or via our mutual funds. It is not clear to PIMCO that it would be, in all cases, in our clients’ best interests to voluntarily forgo their existing and carefully negotiated rights to mitigate further potential financial harm in the event of a counterparty default. For this reason, PIMCO and other asset managers have strongly resisted global prudential regulators’ efforts to require market participants to voluntarily agree to be subject to another jurisdiction’s SRR and to voluntarily stay the ability to terminate trading positions (and relationships) early with a counterparty. While there are circumstances where a client may not be impacted by having waived such rights, a priori, it is not possible to determine if that will be the case in all circumstances, and as such, giving up such protections regardless of the circumstances would not be in our clients’ best interests. PIMCO has explained to the global regulatory authorities from the beginning that any solution that would apply to asset managers on behalf of their clients would have to be regulated or legislated – and, in light of their fiduciary duties, asset managers would opt in to a SRR and contractually agree to a stay of termination rights only if there were sufficient “incentives” imposed by regulators. While the regulatory authorities have heard the industry’s concerns on this issue, their current approach gives the impression that they think it is more important to protect the “system” even though it may be at the expense of the end investor. Global regulatory authorities now plan to move forward with a regulated solution (i.e., a stick) – not a voluntary one (i.e., a carrot) – that would apply to all non-bank market participants who trade derivatives.
PIMCO is concerned that the global regulatory authorities’ current plans to impose a contractual stay on non-bank participants may itself have serious, unintended and potentially systemic consequences. Most notably, PIMCO worries that forcing the asset managers and their clients to keep existing positions open with troubled trading partners would necessarily lead the asset managers to seek other up-front protections on behalf of their clients. We expect that these additional protections will have the unintended consequence of exacerbating a capital drain for large counterparties and lead to greater costs and reduced liquidity for end users. For instance, asset managers may insist on increased protections such as rating downgrade triggers that would require the posting of more initial margin or additional collateral for existing trades by banks to client investors. If the large banks don’t agree to these added protections, asset managers may be incentivized to trade less, require less creditworthy banks to provide more aggressive prices to offset potential credit risk, or move existing positions away from a certain counterparty. These prudent, protective steps by investors could harm market liquidity, create bifurcated markets and/or hasten the financial troubles of a counterparty. Additionally, the lack of ability to terminate a counterparty relationship may lead to the pro-cyclical purchasing of protection on the bank (through the credit default swap market), lack of lending to that bank, selling (or shorting) of physical bonds, or selling (or shorting) of the bank’s stock in order to hedge default risk of the counterparty. All of these consequences would be unintended, unfavorably pro-cyclical and highly probable should global regulators move forward with the current “stick” approach.
Important factors for regulators to consider
Asset managers admittedly are not the only voice in this debate, and despite our concerns for our clients, global regulatory authorities may very well move forward. Should the global regulatory authorities proceed, we strongly recommend that they consider the following factors:
- We believe the stay should apply only prospectively to trades, not retroactively. Removing protections retroactively on trades may change the effective economics of trades without just compensation, akin to a “taking” of property without due process, and distort and further fragment the market.
- We believe that the regulatory authorities should pursue a maximum 24-hour stay, not a maximum 48-hour stay as currently envisioned under the protocol. A 24-hour stay greatly reduces the length of time our clients would be subject to a high degree of counterparty and market risk compared to the risks they would be subject to under a 48-hour stay.
- When the stay is in place, we expect that counterparties will continue to post collateral to our clients for mark-to-market moves, but if our clients are required to post collateral to counterparties, such client’s collateral should be held by a “bankruptcy remote” entity, i.e., an unaffiliated third party (for both initial and variation margin), as a prudent and reasonable measure to avoid even further credit risk to a troubled counterparty.
PIMCO’s commitment and first priority is always our fiduciary duty to our clients and to act in their best interests. PIMCO is supportive of global regulatory authorities’ efforts to reduce overall systemic risk and provide stability to the global financial markets. However, the carefully negotiated termination rights contained in contractual agreements are tools which parties typically use to mitigate risk when transacting with certain counterparties. If such risk mitigation tools are taken away through the global regulatory authorities’ efforts to impose rules on G-SIBs which prevent them from transacting with any market participant who has not contractually agreed to opt-in to a particular SRR and forgo their termination rights, these market participants, which include asset managers such as PIMCO on behalf of its clients, will look for “other” ways to hedge or mitigate its risk to the counterparty. In addition, market participants may also be more proactive and decide to move more quickly when assessing the present creditworthiness of a counterparty and its ability to perform its obligations under certain transactions. Market participants may choose to cease trading or move trades away from a counterparty sooner rather than wait and risk being subject to a stay of termination rights. While the intentions may be good, this “voluntary” contractual solution proposed by the global regulatory authorities’ may in fact result in unintended consequences and knock-on effects that will in the end not reduce systemic risk but in fact create more risk and as a result a more unstable global financial system.
1 E.g., Orderly Liquidation Authority under Title II of the Dodd-Frank Act and the European Union Bank Recovery and Resolution Directive.
2 France, Germany, Japan, Switzerland, the United Kingdom and the United States of America.
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