ISDA Stay protocol

The world’s biggest banks have agreed to rewrite  the rule book on derivatives contracts to make it easier to resolve a future failing institution like Lehman Brothers. ISDA announced that eighteen major global banks or G-18 have agreed to sign the ISDA stay protocol. The Resolution Stay Protocol is a major component of a regulatory and industry initiative to  address the too-big-to-fail issue by improving the effectiveness of cross-border resolution actions against a big bank – therefore ensuring taxpayer money is never again needed to prop up a failing institution. 

“This is a major industry initiative to address the too-big-to-fail issue and reduce systemic risk, while also incorporating important creditor safeguards. The ISDA Resolution Stay Protocol has been developed in close coordination with regulators to facilitate cross-border resolution efforts and reduce the risk of a disorderly unwind of derivatives portfolios,” said Scott O’Malia, ISDA Chief Executive.

Credit support annex of ISDA contracts governs the ~$700 trillion OTC derivatives market. In these type of ISDA contracts banks or firms have the right of termination of trade and seize the collateral when the counterparty fails. Banks or firms exercise this option to minimise the counterparty risk. According to report  from GAO office,Eighty percent of Lehman's derivative counterparties closed their deals with the bank with in five weeks of bankruptcy filing.  

Regulators had expressed concern that the simultaneous close-out of derivatives 
transactions during the resolution of a large, cross-border bank could hamper resolution efforts and destabilise markets.This is being addressed in certain countries through the development of statutory resolution regimes – for instance, Title II of the Dodd-Frank Act and the EU Ban Recovery and Resolution Directive – which impose a stay on termination rights in the event a bank is subject to resolution action in its jurisdiction. But regulators have realised that this can't be effective for cross border trades. 

The orderly liquidation authority (OLA) contained in the Dodd-Frank Act in the US, and the EU's Bank Recovery and Resolution Directive (BRRD) are two examples of so-called special resolution regimes, which allow authorities to take control of a stricken institution, restructure and recapitalise it, in the space of a day or two. These regimes include mandatory stays, but would only apply to a trade if both counterparties were subject to the law. In cross-border trades, that is unlikely to be the case. Hence becomes important that banks themselves give up  their rights to close the deals in case of counterparty fails. 

Some of the issues are still not clear as whether other market participants like asset management firms will follow the suite.Buy side firms can't voluntarily give up their rights because of fiduciary responsibilities to their clients. This further adds complications, major global banks will adhere to the stay protocol from Jan 2015 while other market participant will not adhere to it. Some market participants such as buy side firms will continue have the rights of terminating deals while banks no more can do it. This can create unbalanced scenario for the dealers or major banks.

Another more awkward issue is capital issue. Opinions are split on whether this will impacts the margin period of risk (MOPR) or not.The MPOR represents the length of time regulators believe it would take a bank to exit a portfolio of trades with a defaulting counterparty - the longer the MPOR, the longer the surviving dealer's exposure can grow.

How fruitful this protocol will be in future can be known in future. However working group members believe the document they ultimately produce will make the global financial system more resilient.