Last checked at 
(This story originally appeared in IFR, a Thomson Reuterspublication)
By Philip Scipio
LONDON, Aug 11 (IFR) - The way the world's largest banks usederivatives is set for drastic change after the US FederalReserve and Federal Deposit Insurance Corp moved to stripfinancial counterparties of early termination rights on newderivatives contacts in the event of some future bank failures.
Such contract holders have until now enjoyed immunity fromthe automatic stay on liabilities once a firm enters bankruptcy,in effect allowing them to claim repayment immediately. Undernew rules, that protective language will be eliminated fromfinancial pacts at affected firms. The proposed changes willonly apply to contracts struck after reform is introduced, withoutstanding deals allowed to continue unchanged until theymature.
Under the proposals, counterparties will be required toagree to language changes in new contracts that would disablethem from claiming exemption. It would be a sea change for thefinancial industry, by some estimates affecting 90% of theUS$710trn derivatives market as those deals are rolled over.
Contracts at Bank of America, Bank of New York Mellon,Barclays, Citigroup, Credit Suisse, Deutsche Bank, GoldmanSachs, JP Morgan Chase, Morgan Stanley, State Street, and UBSwill all be affected.
"This may make derivative contracts less attractive toeverybody," said Franklin Edwards, professor of finance atColumbia. "But that may also be what regulators want."
Regulators have long complained that the automatic stay isone of the biggest obstacles to putting a large financialinstitution into bankruptcy. Amending the contracts at thosefirms "on an industry-wide and firm-specific basis" wouldeliminate that obstacle.
"This may make derivative contracts less attractive toeverybody."
To force banks to change the language in their contracts,the regulators are seizing on powers conferred on them throughthe Dodd-Frank Act to ensure that the biggest firms have viableresolution plans - or so-called living wills.
The Fed and the FDIC need to approve the living wills as"credible" and what they have said here, according to Universityof Pennsylvania law professor David Skeel, is that any livingwill that does not provide for a short-term stay is notcredible.
"I have to congratulate them on their cleverness - it's apretty persuasive statement," Skeel said.
Regulators have castigated banks for failing to presentworkable resolution plans for a second consecutive year. Thisyear, regulators offered guidance on how to make the plansacceptable and they seized on an opportunity to end theso-called safe harbour from the automatic stay.
LEHMAN NIGHTMARE
When Lehman Brothers collapsed in 2008, counterparties linedup to void pacts and seize cash and collateral the day of thebankruptcy filing. It's the nightmare scenario that hauntsregulators.
While regulators have long complained that the earlytermination rights were an obstacle to winding down largefinancial firms, the effort to eliminate those rights nevergarnered much support. Lawyers and regulators have argued thatthe best way to limit safe harbour protections financialcounterparties claimed was through revising the bankruptcy code.
The power of derivative lobbyists and the high level ofdysfunction in the US Congress, however, made that pathunlikely. Even efforts by the International Swaps andDerivatives Association to revise its master contract to limitearly termination rights have been bogged down.
It was not uncommon in the US for reform to be introducedthrough changes in contract language instead of new laws orregulations, said Jay Westbrook, a law professor at Universityof Texas. "[Doing so] has the benefit in our current state ofgridlock in Congress of not requiring legislation and, given theslow-moving Dodd-Frank process, it doesn't need regulation," hesaid.
Sources familiar with the process said the regulatorsexpected that pushing these 11 firms to include these clauseswould have a big impact of how the industry worked.
The Fed and the FDIC have jointly sent letters to the 11firms detailing the specific shortcomings at each firm. Thedeficiencies would need to be addressed next in the 2015 livingwill submissions, the regulators said.
Specifically, the regulators expressed disappointment withthe level of planning in the living wills. The firms were stillnot accounting for the complexity of their corporate structuresand were still making unrealistic assumptions about how otherinstitutions, customers, counterparties and even regulatorswould behave in the event of their collapse, the regulatorssaid.
In the plans to be filed by July 2015, the regulators areasking that the firms make plans to organise legal structuresthat are more rationally resolvable, develop holding companystructures that support single point of entry for a manageableresolution and change the language in their financial contracts. (Reporting by Philip Scipio, Editing by Gareth Gore, MatthewDavies)
