Pact raises caution flag on swaps

Asset owners that use swaps could ultimately face losses and added risk as a result of an agreement among 18 major global banks.

The Oct. 11 agreement to a protocol introduced by the International Swaps and Derivatives Association allows the banks to delay the wind-down of swaps when one of the parties is in financial stress. It will apply to new and existing cross-border agreements among the 18 banks, which together have more than 90% of outstanding notional derivatives worldwide

The goal is to help reduce systemic risk in the overall market by giving regulators time to facilitate an orderly resolution of a troubled bank before its counterparties seek to terminate swaps contracts and collect associated payments, according to details on the ISDA's website.

Sources said the ISDA protocol, effective Jan. 1, is the blueprint for ultimate final cross-border regulations applied to all swaps participants. In the U.S., delays in domestic swap wind-downs already are in force through the Dodd-Frank Wall Street Reform and Consumer Protection Act. This agreement would extend to the largest banks in Europe and Asia as well, once their regulators adopt the protocols

The intent of reducing systemic risk was lauded by sources interviewed for this story. But some also said asset owners that use swaps will be hurt by any delay, also called a stay, in liquidating the derivatives. (Most existing contracts allow asset owners to withdraw their money from counterparties immediately upon request.)

“It's the stay, not the protocol, that introduces business risk to us,” said David Long, senior vice president and chief investment officer, asset-liability modeling and derivatives and fixed income, at the C$51.6 billion (US$45.9 billion) Healthcare of Ontario Pension Plan, Toronto. As of Dec. 31, HOOPP had total derivatives with a notional value of C$200.03 billion, of which C$135.5 billion were in swaps, according to the pension plan's 2013 annual report.

Mr. Long is concerned about how the protocol would affect contractual agreements already in place for swaps. “If we take away the contractual protections in these contracts, risks go up and we have to look at how to mitigate those risks, including being much more selective with counterparties,” he said.

There are two problems with the stay, Mr. Long said: the potential for losses as a result of the delay in wind-downs, involving the change in value of swaps during the time the stay is in place, and the uncertainty of how contracts will be resolved after the stays expire.

“If the counterparty declares bankruptcy, then the expense for us is done,” he said. “But what if the counterparty emerges after the stay and is solvent? Is the contract still in force?”

Investors in general could see the protocol as an overall imposition, said Kevin McPartland, principal and head of market structure research at Greenwich Associates, Stamford, Conn.

“I imagine that investors feel like they'll have less choice, that investment banks are the ones setting the standards,” Mr. McPartland said. “It could make investors feel as if they could be caught in limbo if things get bad. The feeling is that under a fiduciary standard, it's imperative when things get bad to get away as quickly as possible. The swaps delay goes against that.”

While there's concern about the impact on asset owners, the ultimate goal of the protocol is similar to other regulations that emerged from laws like Dodd-Frank — to lessen the chances of another Lehman Brothers-type catastrophe. “I think you need to step back, see how the protocol is designed,” Mr. McPartland said.

“It's ultimately intended to reduce systemic risk. It's meant to prevent a run on the banks, which is understandable. But it takes away some control from the investor, which is difficult for them.”

Scott Malpass, vice president and chief investment officer at the University of Notre Dame, South Bend, Ind., said he understands the concerns of those opposed to the protocol.

“Many people, academics and regulators, felt that imposing just a one- or two-day stay for derivatives would allow regulators some time to address these issues, maybe get a new dealer to step in to take the trades,” Mr. Malpass said in an e-mail response to questions. “But large buy-side players didn't feel they should give up their rights. I understand their view, since they may need to immediately get their collateral out to finance a replacement trade immediately to keep a position hedged.

“For us, it's not a big deal given the nature of our trades, which are not overly complicated. We could wait a couple days for our mark-to-market collateral ... We are not opposed to a one- or two-day stay, particularly if the stay provisions help to stabilize the system in another Lehman-type event — although I'd say that result is up for debate.”

Mr. Malpass oversees the university's $9.8 billion endowment; he said the endowment does not disclose the value of its exposure to swaps.

In its announcement, the ISDA said regulators in several countries have committed to develop new regulations in 2015 to broadly adopt the stay provisions.

“Regulatory agencies are trying to be more homogenous and cooperative in reducing overall systemic risk,” said Anthony J. Perrotta Jr., principal and head of fixed-income research, TABB Group Inc., New York. The protocol “is a systemic way to avert a run on the banks.”

Teresa Bechtold, an attorney and partner, Rutherford & Bechtold LLC, Minneapolis, whose clients are money managers and asset owners, said her clients are concerned “that the U.S. regulations and laws don't match European markets, certainly. If regulations and laws elsewhere in our global swap markets coalesce around certain timing and the U.S. regulations and laws don't follow suit, trading becomes more difficult.”

For asset owners, there's not much choice other than abiding by the protocols. “The 18 banks control 90% of outstanding swaps in the market,” Mr. Perrotta said. “I guess you could go to other banks, but then there are concerns about (those banks') creditworthiness. ... There's not a lot they can do about it.”

Added Molly Moore, counsel at the law firm of Ropes & Gray LLP, Washington, who specializes in derivatives for hedge fund, endowment and foundation clients: “There aren't a lot of options with derivatives (for asset owners),” she said. “Not much they can do but follow the rules. ... It's going to be a condition for anyone using swaps. Our message to clients has been that right now we need to keep an eye on it, because this will be a big issue in 2015.”

Banks that agreed to the ISDA protocol are Bank of America Corp., Bank of Tokyo-Mitsubishi UFJ, Barclays PLC, BNP Paribas, Citigroup Inc., Credit Agricole, Credit Suisse Group, Deutsche Bank AG, Goldman Sachs & Co., HSBC PLC, J.P. Morgan Chase & Co., Mizuho Financial Group, Morgan Stanley, Nomura Holdings, Royal Bank of Scotland PLC, Societe Generale, Sumitomo Mitsui Financial Group and UBS AG.

HOOPP's Mr. Long said he's willing to give regulators the benefit of the doubt as to how the protocols will eventually turn into regulations.

“We'll wait and see what the protocol ultimately means in terms of the regulatory framework that evolves from it.” Mr. Long said. “It doesn't directly affect us right now, but we'll see what evolves. The idea of us having stays on contracted provisions is not the most welcome idea.”