Contrary to what Stephen Lubben at Credit Slips and other academics have argued, provisions that accord legal certainty to derivatives and foreign exchange -- in the bankruptcy code and elsewhere under U.S. law -- do not increase systemic risk. In fact, they are fundamental risk mitigants.
When the bankruptcy code was revised in 1978, it became evident that its core approach did not work well for financial market transactions. In Chapter 11, "executory contracts" (which require performance at a future date) are automatically stayed, can be accepted or rejected, and allow the claw-back of transfers made in the 90 days before bankruptcy.
Unlike most executory contracts, however, the values of financial markets transactions are constantly changing.
In addition, financial markets participants enter into a substantial number of transactions with each other or with a clearing house, with the expectation that they will only be obligated to pay the net amount owing on the aggregate set of contracts.
Market participants expect that all performance will occur for all contracts without cherry picking by a bankruptcy trustee (who is likely to accept all of the gains and reject all of the losses). In addition, when market participants transfer collateral, securities or other property, they expect it to be final.
In short, financial markets depend on the legal certainty of intended results. The predictability of expected obligations and prompt resolution of failure are important conditions that foster liquidity. Providing an exception to the automatic stay for financial contracts is fundamental to resolution of the uncertainty created by a defaulting party.
Immediate close-out means that no one is playing the market as to defaulted transactions. To ensure that orderly and timely performance takes place, transfers made in connection with such contracts need to be final. Netting and set off of contracts and collateral further diminishes the uncertainty and potential harm caused by a default upon a market and its participants.
Put another way, heres' what might happen if the current set of bankruptcy code exceptions were rescinded:
Exposure would balloon, as market participants would no longer be able to net transactions.
Market sensitivity would increase dramatically as the enforceability of hedging transactions would become uncertain.
Unintended speculation could occur – even for a bank with a fully matched book -- if a bankruptcy trustee engaged in cherry picking, accepted all of a defaulting party's gains, while leaving banks bearing all of the losses on transactions.
Risk managment would be severely impaired, as parties could not be certain as to whether all of the positions in a portfolio, including hedges, would be performed.
Weakened participants would lose access to capital markets as their counterparties would become increasingly less willing to enter into transactions given the risk of cherry-picking and clawback in the event of a bankruptcy.
Market gridlock would occur upon default of a participant, as no one would be certain as to the finality of transfers.
Diminished liquidity would result, as banks would become increasingly reluctant to enter into transactions with elevated risks and burdens.
All of the above would dramatically increase systemic risk
Existing bankruptcy code exceptions avert such problematic consequences. Beginning with exchange-traded securities and commodities, Congress has reviewed these provisions on multiple occasions and found them to be valuable risk mitigation tools for an increasingly wider variety of financial markets. Other legislation has embraced the systemic risk benefits of such provisions, such as laws broadened the scope of enforceable netting (FIRREA) and affirming such netting and set-off for insolvent banks (FDICIA).
I repeat, these provisions have been essential tools in prompt resolution of defaults, avoiding market gridlock and mitigating damages. Congress should continue to address systemic risk with this background. Bankruptcy code provisions relating to derivatives facilitate resolution of troubled financial institutions and may help avert the failure of weakened market participants.
Jeff Lillien is an attorney with extensive experience in foreign exchange and derivatives.