New Derivatives Contracts from ISDA

IAccording to The Financial Times, International Swaps and Derivatives Association (ISDA) has spent nearly a year on new derivatives contracts to “give failed institutions a temporary stay on investors’ claims on their swaps…Regulators worry that if a counterparty exercised its right to their swaps, positions in the bank that had been hedged using derivatives could become unhedged and plunge the institution into default and markets into further chaos – a problem illustrated by the failure of Lehman Brothers.”

David Gyori, is Executive Director of Xallis Consulting, a boutique research and consulting company. He explains the situation below:

The Master Agreement of ISDA is the framework of the global swaps and derivatives market. This is basically a template for financial companies to use when conducting swaps and derivatives transactions. So this template is designed in a way which serves the interests of the financial community.

Since Lehman, regulators across the globe are showing increased efforts to protect the interests of taxpayers in case a major financial institution fails. Regulators found that one of the obstacles to protect taxpayers when clearing up the wreckage of a major bank failure is the clause in the ISDA Master Agreement that gives counterparties the right not to honor existing swaps and derivatives contracts with a failed bank.

So there is a Regulators versus ISDA, a Taxpayers versus Financial Community conflict of interests behind this issue. The fundamental question is this: There is bank A and bank B. If bank A fails can bank B look at it’s relation to bank A on a net exposure basis or not. Regulators say not, since this would ruin the hedged positions of bank A and make them unhedged thereby causing losses for bank A and through this probably to governments and taxpayers. As opposed to this, the financial community (ISDA) argues that early termination of swaps and derivatives is a right that counterparties are likely to insert into contracts since they want to look at their assets and liabilities towards a failed partner in an integrated way.

Who will win in this argument? We don’t know yet, but ISDA has a major advantage over regulators: ISDA is a global entity while regulators serve one country. This global, international edge gives a valuable advantage to ISDA when the argument is about an industry that is truly global (the swaps and derivatives industry). Regulators of economies with a major financial industry try to cooperate on this issue, but it is a challenge to coordinate e.g. US, UK, German and Swiss regulators along with the regulatory bodies of many other countries.

This arises the question: How, when and under what circumstances will the international community become able to set up global regulatory bodies? Is this necessary or it is just an overreaction after 2008?

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