THE DELTA REPORT
21 major global banks signed the ISDA 2015 Universal Resolution Stay Protocol at launch. Pursuant to the ISDA 2015 Universal Resolution Stay Protocol, these banks have agreed to suspend their termination rights in relation to their derivatives contracts facing a failing "systematically important financial institution".
As part of the ongoing push for global financial stability, on 12 November 2015, the International Swaps and Derivatives Association ("ISDA") published the ISDA 2015 Universal Resolution Stay Protocol ("2015 Stay Protocol"), a re-launch (and replacement) of the ISDA 2014 Resolution Stay Protocol ("2014 Stay Protocol"). The 2015 Stay Protocol extends the coverage of contracts to securities financing transactions ("SFTs") and expands the scope of the 2014 Stay Protocol to accommodate special resolution regimes ("SRR") developed in additional jurisdictions. It is otherwise substantially similar to the 2014 Stay Protocol in terms of the operative provisions. The aim of the 2015 Stay Protocol is to ensure that cross-border derivatives and SFTs are captured by the relevant statutory stays in the event a systemically important financial institution ("SIFI") enters insolvency proceedings and to give regulators sufficient time to facilitate an orderly resolution and limit any market contagion effects.
Development of the 2015 Stay Protocol
Since the collapse of Lehman Brothers, regulators have been concerned with market contagion effects should another major bank fail. It is clear from the 2008 financial crisis that regulators had limited tools with which to deal with failing financial institutions, particularly when large derivatives positions are on the books. Traditional insolvency proceedings and bailouts have proven to be costly (with the costs largely being passed on to taxpayers) and do not afford regulators much control in managing global financial stability. In response to public criticism, financial regulators have worked to develop a new regulatory framework to deal with the resolution of SIFIs and which is aimed at improving economic stability and mitigating systemic risk. As a result, various SRR such as the Orderly Liquidation Authority ("OLA") and the Bank Recovery and Resolution Directive ("BRRD") were progressively implemented in the US and European Union respectively.
The OLA and BRRD, among other things, temporarily stay the non-defaulting party's exercise of its early termination rights in an insolvency situation to give the relevant authority sufficient time to stabilise the failing SIFI. However, the OLA and BRRD are national statutory regimes and it is uncertain whether they could be enforced extraterritorially to apply to cross-border trades, particularly where the governing law of the contract at issue is different from that which authorised the resolution proceedings. Therefore until the relevant jurisdictions provide for recognition and enforcement of foreign SRR, financial regulators generally agree that a contractual approach to address such enforceability issues is necessary.
This was the impetus for the development of the 2014 Stay Protocol by ISDA and a working group composed of dealer and buy-side member firms in consultation with the regulatory authorities from Germany, France, Japan, Switzerland, the UK and the US ("Home Authorities"). A key aim of the 2014 Stay Protocol was to provide a contractual approach to cross-border recognition until comprehensive statutory regimes are developed and adopted.74 On the launch date, 18 of the world's largest dealers in OTC derivatives adhered to the 2014 Stay Protocol. As of 2 November 2015 when the 2014 Stay Protocol was closed, that number had increased to 189 dealers in OTC derivatives.75
In 2015, the Home Authorities requested ISDA to, among other things, expand the scope of the 2014 Stay Protocol to include: (1) certain master agreements that govern SFTs and (2) provisions pursuant to which annexes could be added to clarify that SRRs enacted in the member jurisdictions of the Financial Stability Board ("FSB") would be covered by the protocol.76 In response, ISDA developed the 2015 Stay Protocol which replaces the 2014 Stay Protocol in its entirety for those entities that had already adhered to it, provided that both parties to a Protocol Covered Agreement are Adhering Parties (both terms as defined below). If either of the parties that adhered to the 2014 Stay Protocol does not adhere to the 2015 Stay Protocol, the 2014 Stay Protocol will continue to have operative effect. On the launch date, 21 major global banks adhered to the 2015 Stay Protocol.
How does the 2015 Stay Protocol work?
The operative provisions of the 2015 Stay Protocol are substantially similar to those of the 2014 Stay Protocol with the exception of the expanded scope as mentioned above. Adherence is on a voluntary basis and parties adhere to the protocol in its entirety. Entities that have adhered to the 2015 Stay Protocol are listed on ISDA's website.
Protocol Covered Agreement
An entity that adheres to the 2015 Stay Protocol (each such entity an "Adhering Party") is deemed to have incorporated the 2015 Stay Protocol into the relevant Protocol Covered Agreement (defined below) as well as the transactions to which the agreement relates, unless the agreement already addresses the substance of the 2015 Stay Protocol or the parties expressly provide that the terms of the 2015 Stay Protocol will not apply. The 2015 Stay Protocol will not amend future Protocol Covered Agreements unless the parties agree bilaterally to make them subject to the terms of the 2015 Stay Protocol. Suggested wording for this purpose is included in Section 9 (Specific Questions on the Amendment Language) set out in the frequently asked questions relating to the 2015 Stay Protocol published by ISDA (the "2015 FAQs").
As it currently stands, the agreements covered under the 2015 Stay Protocol include ISDA Master Agreements (and its related Credit Support Documents) and certain master agreements published by the SFT Trade Associations (i.e. the Global Master Repurchase Agreement, the Global Master Securities Lending Agreement, the Master Equity and Fixed Interest Stock Lending Agreement, the Master Gilt Edged Stock Lending Agreement, the Master Repurchase Agreement, the Master Securities Loan Agreement and the Overseas Securities Lender's Agreement) entered into between Adhering Parties and related credit enhancements entered into between Adhering Parties or provided by one Adhering Party to another (each a "Protocol Covered Agreement").77
Although the 2015 Stay Protocol largely deals with uncleared transactions, if a cleared transaction is documented under a Protocol Covered Agreement, then those transactions will fall within the scope of the 2015 Stay Protocol. However if the 2015 Stay Protocol violates the rules of an applicable clearinghouse, it will not apply to the relevant Protocol Covered Agreement.
There are two ways in which the 2015 Stay Protocol amends a Protocol Covered Agreement and its related transactions – via the "Opt-in" mechanism pursuant to Section 1 and the application to ordinary US insolvency proceedings pursuant to Section 2.
Under Section 1, for each relevant Protocol Covered Agreement, Adhering Parties opt in to the SRR applicable to their counterparty and each of its related entities as well as the resolution regimes in the Home Authority jurisdictions ("Identified Regimes") even if it is not required to do so by law or regulation. This means the Adhering Party will only be permitted to exercise its termination rights under the Protocol Covered Agreement to the extent that the applicable SRR permits. Accordingly in this regard, Section 1 ensures the parity of treatment between Adhering Parties and those parties transacting under agreements governed by the laws of the jurisdiction of the applicable SRR.78 Note that the 2015 Stay Protocol extends to direct default rights as well as cross-default rights where such rights are stayed or overridden under the applicable SRR.
If the relevant resolution action is successful under the applicable SRR, then Adhering Parties are not permitted to terminate the relevant derivatives transactions to the same extent as a counterparty that is subject to such applicable SRR. If the relevant resolution action is not successful under the applicable SRR, then an Adhering Party can exercise its termination and cross-default rights to the same extent as a counterparty that is subject to such applicable SRR.
For example, if a UK bank which is subject to the BRRD enters into resolution, any derivative trades that its US subsidiary has with a US counterparty (assuming such trades are governed by New York law) may potentially be terminated by the US counterparty if a New York court does not recognise the application of the BRRD. However if the parties had adhered to the 2015 Stay Protocol, then the US counterparty would have opted in to the UK implementation of the BRRD and would be bound by its terms. In this case, the US counterparty would not be permitted to terminate those derivatives trades where it faces the US subsidiary of the UK bank.
In addition to the Identified Regimes, Adhering Parties will also opt in to the SRR of FSB jurisdictions and any jurisdiction in which a current or future global systemically important bank is headquartered ("G-SIB Jurisdiction") if these SRRs satisfy the relevant credit protection safeguards.79 The expansion to include G-SIB Jurisdictions is one of the key changes made to the 2015 Stay Protocol. Ultimately, the SRR that is applicable to a party is the one that is applicable to its direct counterparty or the SRR applicable to each of its related entities (which includes any Credit Support Providers or Specified Entities as such terms are defined in the relevant ISDA Master Agreements).
If an SRR is amended and negatively affects the enforceability of certain creditors' default rights, an Adhering Party may choose to opt out of future resolutions under that SRR.80
The Section 1 provisions came into effect between initial Adhering Parties on 1 January 2016.
It is anticipated that ISDA may, over time, publish additional "Country Annexes" to the 2015 Stay Protocol to include SRRs in the additional FSB jurisdictions and G-SIB jurisdictions. An Adhering Party to a Country Annex does not get to choose which Country Annex it wishes to adhere to, rather it adheres to all the Country Annexes that have been published as of the date of its adherence.81 Where Adhering Parties adhere to a Country Annex that was published after their initial adherence to the 2015 Stay Protocol ("Annex Implementation Date"), all Protocol Covered Agreements entered into prior to the Annex Implementation Date will be subject to the 2015 Stay Protocol.
US ordinary insolvency proceedings
Section 2 introduces similar stays and overrides under ordinary US insolvency regimes where none exist, such as the Bankruptcy Code and the Federal Deposit Insurance Act. In this section, each Adhering Party contractually agrees to override certain default rights under the relevant Protocol Covered Agreement if an affiliate of its bank counterparty becomes subject to ordinary US insolvency proceedings.
Default rights that arise because the affiliate that is subject to insolvency proceedings is a Specified Entity are treated differently to the default rights that arise because the affiliate is a Credit Support Provider (as defined in the relevant ISDA Master Agreement). Where a Credit Support Provider enters insolvency proceedings, Section 2 imposes conditions designed to preserve the value and effectiveness of the credit support as much as possible notwithstanding the insolvency of the Credit Support Provider.82 However, where a Specified Entity becomes subject to insolvency proceedings, the default rights of the non-defaulting counterparty are overridden in their entirety.83
Notably, when a direct counterparty enters into ordinary insolvency proceedings, non-defaulting Adhering Parties still retain their rights to terminate. This is also the case if the direct counterparty fails to satisfy a payment or delivery obligation.
Unlike with the Section 1 provisions which do not require the implementation of regulations, Section 2 provisions will only become effective between Adhering Parties who are counterparties when the related US regulations become effective and compliance is required. Further, the Section 2 provisions will only apply to a Protocol Covered Agreement if the relevant Adhering Party is subject to such US regulations.
Although it is generally accepted that the 2015 Stay Protocol could offer support to an orderly resolution of a SIFI by suspending the exercise of early termination rights upon the SIFI entering resolution proceedings, the protocol has yet to be tested in an environment similar to that of 2007-8 and therefore it remains to be seen whether the 2015 Stay Protocol could work as anticipated in practice.
Some of the main criticisms of the 2015 Stay Protocol reflect the lack of balance between the individual entity's interest and that of the financial regulator in pursuit of financial stability.
At present, not all market participants are Adhering Parties to the 2015 Stay Protocol. This creates an inequitable situation where one counterparty facing a distressed SIFI is an Adhering Party and therefore subject to the stays imposed by the relevant SRR and another counterparty facing the same SIFI is not an Adhering Party and is therefore in a position to exercise its termination rights. Such fragmented participation distorts the level playing field of market participants and is likely to lead to increased costs of participation. Until the protocol for buy-side participants is available and there is widespread adoption of such protocol, it is difficult to see how effective the stay protocol measure will be in the long run.
ISDA is currently developing the ISDA Resolution Stay Jurisdictional Modular Protocol ("Jurisdictional Modular Protocol"). It seeks to achieve the same policy goals as the 2015 Stay Protocol in relation to the orderly resolution of systemically important financial institutions. It is expected that the buy-side entities generally will not adhere to the 2015 Stay Protocol, but will adhere to the Jurisdictional Modular Protocol to be published by ISDA in the near future.
There is no expectation for sovereigns or clearing houses to adhere to the 2015 Stay Protocol, although they are technically permitted to do so in relation to transactions documented under Protocol Covered Agreements.
Investment or asset managers
Special considerations arise in relation to investment and asset managers. These are dealt with in greater detail in Section 7 (Special Considerations for Investment/Asset Managers) of the 2015 FAQs. Importantly, if the relevant investment/asset manager does not have authority from all clients or is not able to disclose the underlying client's identity (whether by name or by a unique identifier), the investment/asset manager will not be able to enter into the 2015 Stay Protocol for those clients and bilateral amendment agreements will need to be entered into with each relevant counterparty to incorporate the amendments made by the 2015 Stay Protocol.
74 ISDA, ‘ISDA 2014 Resolution Stay Protocol' www2.isda.org/functional-areas/protocol-management/faq/20 accessed 7 June 2016.
75 ISDA, ‘Adhering Parties' www2.isda.org/functional-areas/protocol-management/protocol-adherence/20 accessed 7 June 2016.
77 ISDA 2015 Universal Resolution Stay Protocol paragraph 4 definition of "Covered Agreement".
78 ISDA, ISDA 2015 Universal Resolution Stay Protocol FAQ www2.isda.org/functional-areas/protocol-management/faq/22 accessed 7 June 2016.
79 Attachment to the ISDA 2015 Universal Resolution Stay Protocol Clause 1(a)(iii).
80 Attachment to the ISDA 2015 Universal Resolution Stay Protocol Clause 4(b)(i).
81 ISDA 2015 Universal Resolution Stay Protocol Clause 1(f).
82 See Attachment to the ISDA 2015 Universal Resolution Stay Protocol Clause 2(b).
83 Attachment to the ISDA 2015 Universal Resolution Stay Protocol Clauses 2(a) and (e).
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