Derivatives Update: ISDA Resolution Stay Protocol
As of 1 January 2015, the ISDA Resolution Stay Protocol has been in effect in relation to OTC derivatives as between the G-18 banks, and it is expected that during the course of 2015 regulations will be developed in a number of jurisdictions to "encourage" participation in the Protocol by non-SIFIs. In this alerter, we summarise the background to, and effect of, the Protocol and highlight some of the issues around adherence.
Since the failure of Lehman Brothers in 2008, a key concern for regulators across the globe has been addressing the so-called "too big to fail" issue. This is being addressed in many jurisdictions by adopting a resolution strategy (known as a "special resolution regime", or "SRR") applicable to entities which are considered too big to fail (known as "systemically important financial institutions", or "SIFIs"). Click here for a summary of the SRR applicable in the UK.
SRRs are put in place to enable regulators to step in and either "rescue" the SIFI or ensure that it is wound down in an orderly fashion. Clearly the success of any resolution would be significantly undermined if counterparties were free to terminate positions early or exercise cross-default rights in relation to other entities in the SIFI's group. Not surprisingly then, most SRRs include a temporary stay on those termination and cross-default rights. Indeed the Financial Stability Board has confirmed that it considers a temporary stay on termination rights to be a core element necessary for an effective resolution regime.
To the extent that, for example, both parties to an English law ISDA Master Agreement were organised in the UK, it is clear that the UK SRR would be applicable and that the stays on exercising the early termination rights in the ISDA Master Agreement would be enforceable. Difficulties arise, however, where there is a cross-jurisdictional element to the contractual relationship. If, for example, a UK SIFI were party to a New York law ISDA Master Agreement with a Swiss counterparty, it would not necessarily be clear that the UK SRR (and particularly the stay on termination rights) would be enforceable against the counterparty if the UK SIFI were to enter resolution.
The 2014 ISDA Resolution Stay Protocol
In order to ensure cross-border recognition of temporary stays in SRRs, and in view of the G-20 commitment in 2013 to make progress towards resolving the "too big to fail" issue, ISDA published in October 2014 the ISDA Resolution Stay Protocol.
The Protocol is in two sections. The first (Part 1(a)) deals with SRRs, and the second (Part 1(b)) relates specifically to the living will provisions of the US Bankruptcy Code. For the purposes of this alerter, we consider only Part 1(a).
The Protocol effectively provides for a contractual "opt-in" to covered SRRs by adhering parties. The purpose is not to create a new stay on early termination rights, but simply to remove any doubt as to the cross-border enforcement of the provisions of the SRRs. The Protocol will not apply to every SRR implemented across the globe: other than certain existing regimes which are expressly covered, the Protocol applies only to SRRs in FSB jurisdictions which meet the conditions set out in the Protocol. One such condition is that the stay imposed by the SRR must not be longer than 2 business days.
When the Protocol came into effect on 1 January 2015, the adhering parties were limited to 18 major global banks and their affiliates (plus a couple of additional adherents, which came as something of a surprise to ISDA). The regulators (and ISDA) are cognisant that it is not realistic to expect non-SIFIs to adhere voluntarily. To address this, during 2015 regulators intend to develop regulations in the FSB jurisdictions to support adherence. The regulations are not expected to mandate adherence to the Protocol; rather they will require some form of temporary stay on termination rights, and ISDA expects many market participants to use the Protocol as a convenient tool for compliance. Further, regulators are not expected to impose the stays directly on non-SIFIs (not least because not every non-SIFI firm is regulated): the regulations are more likely to be framed so as to limit the SIFIs to trading only with counterparties who have accepted a stay.
In the context of the Protocol, there are various issues to consider for non-SIFIs. For example:
- Regulators (including in the UK) have said that they expect the regulations supporting adherence by non-SIFIs to apply prospectively only. This opens up the possibility that parties could choose to "split" their ISDA relationships with SIFIs – effectively closing off the existing ISDA Master Agreement to new trades and creating a new ISDA Master Agreement for future trades, with only the latter affected by the Protocol. However, this would of course split the netting set and therefore parties need to consider (perhaps on a case-by-case basis) whether preservation of the netting set is more important than accepting temporary stays in relation to existing trades.
- The Protocol, as currently drafted, takes an "all or nothing" approach. Once a party has adhered, it will be bound by the stays in all SRRs which fulfil the criteria in the Protocol. Conversely, the regulations which effectively require the buy-side to accept stays will be introduced on a jurisdiction-by-jurisdiction basis. Therefore in practice, adherence to the Protocol as a means of complying with regulations in one jurisdiction is likely to precede any regulations in other jurisdictions.
- Consideration should be given to whether full title transfer of collateral (i.e. under the English law Credit Support Annex) is appropriate in a post-Protocol arrangement. If trading with an entity which is not a SIFI, but which is in the same group as a SIFI, it might be worth considering whether collateral should be segregated if the SIFI enters resolution and cross-default rights are subject to a temporary stay.
- Investment managers are in a particularly difficult position, as voluntarily relinquishing market-standard rights against counterparties on behalf of clients could arguably expose the managers to actions for negligence or breach of duty.
The Protocol currently only covers ISDA Master Agreements entered into between adhering parties. However, there is an expectation that the regulators will ask for equivalent stay provisions to be incorporated into master agreements governing repo and stock lending transactions (primarily, in the UK market, the GMRA and GMSLA respectively). This requirement may be implemented through an expansion of the scope of the Protocol or through the development of separate solutions in respect of the repo and stock lending markets. Industry bodies in those markets are currently considering the issue and further information is expected in the coming weeks.
It is of course arguable that, with or without the Protocol, a 48 hour stay is an insufficient period to implement a strategy that will calm the markets in the event of a major player being subjected to resolution. However, SRRs and the Protocol are undoubtedly important weapons in the battle against "too big to fail".
 Financial Stability Board, "Key Attributes of Effective Resolution Regimes for Financial Institutions", October 2011
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