Softened EU swap stay still threatens margin hike

Moratorium cut to two days, but pre-resolution stay could make EU a non-netting jurisdiction

Step up? Is going from five days to two days a move in the right direction?

Two steps forward, one step back is the idiom being used by swap market participants to describe the latest European Union proposals on moratorium powers under the updated Bank Recovery and Resolution Directive (BRRD). 

The controversy revolves around regulators’ powers to stay swap counterparties from closing out their trades with a bank that enters resolution. If this happens before the resolution authority has a chance to move the portfolio to a bridge bank or sell it to another market player, the failed bank’s estate will be left with a completely unmatched book of derivatives that is much harder to wind down.

The latest amendments proposed by the Council of the EU and members of the European Parliament (MEPs) should be enough to limit stays on the close-out rights of swaps counterparties to two days. This would bring the EU in line with the International Swaps and Derivatives Association’s 48-hour contractual swap stay protocol.

At the same time, the EU has retained the option of a pre-resolution moratorium, which does not exist in other jurisdictions. Worse still, an exemption for derivatives from the pre-resolution stay, which was in the European Commission’s (EC) original draft in November 2016, has been struck out of a proposed compromise text drafted by the Bulgarian Council presidency at the end of January and seen by Risk.net.

The Bulgarian draft at least makes clear the existing two-day in-resolution suspension power, under article 69 of the BRRD, cannot be triggered if the new pre-resolution moratorium has already been used. This is intended to prevent compounding pre- and in-resolution stays adding up to more than two days, although there are still some legal ambiguities to clear up (see box: Four-day stay?).

But market participants say the inclusion of swaps under the pre-resolution rules could still inhibit the ability of foreign counterparties to net their derivatives exposures to EU firms, potentially forcing non-EU banks to hold prohibitively high capital and margin requirements that reflect gross counterparty exposures. 

“Going from five days to two days for the pre-resolution moratorium is a step in the right direction, but the length of the moratorium is only one of the relevant issues, so we do not consider the problem solved,” says Ann Battle, assistant general counsel at Isda.

Substantially similar?

The EC’s original exemption, which has now been removed from the Council’s proposal, was for netted or collateralised derivatives contracts – the vast majority of the market. The exact text read: “Where financial contracts are subject to a netting arrangement or a financial collateral arrangement, termination rights are preserved, and payment or delivery obligations being or becoming due and payable pursuant to the contractual terms of such contracts are not suspended.”

In the US, banks are allowed to net their derivatives positions for the purpose of calculating margin and counterparty credit risk capital only if the moratorium regime of their counterparty is deemed “substantially similar” to that of the US by the Federal Reserve.

“Netting under capital and margin regulations in jurisdictions like the US requires stays to be similar to the stays in their jurisdiction. Resolution regimes in those jurisdictions do not apply a moratorium to derivatives during the pre-resolution phase, which makes a ‘substantially similar’ determination very difficult,” says Battle at Isda.

Before the Council non-paper proposed limiting the moratorium to a maximum of two days, firms were worried the Single Resolution Board (SRB) might be able to enforce a moratorium for up to 12 days – far longer than the US regime’s one-day stay and highly unlikely to meet with Fed approval.

Resolution regimes in those jurisdictions do not apply a moratorium to derivatives during the pre-resolution phase, which makes a ‘substantially similar’ determination very difficult

Ann Battle, International Swaps and Derivatives Association

Although the internationally agreed two-day in-resolution moratorium has received the Fed’s blessing, a pre-resolution moratorium is an unfamiliar concept to many jurisdictions around the world, including the US, which may disagree with the view of the EU authorities that it improves financial stability.

“Although the SRB and others have argued the pre-resolution stay is necessary to have a stabilising effect, we think it could actually cause a liquidity drain that might drive a firm into resolution. So if this is a tool that arguably hinders the entity more than [it] stabilises it, non-EU regulators of counterparties facing that entity will continue to be wary of its application,” says Battle.

The Federal Reserve is unlikely to say whether a two-day pre-resolution stay would be deemed substantially similar to the US one-day in-resolution stay before BRRD II is implemented, by which time it would be too late to amend the rules. Therefore, lobbyists are pushing for either outright deletion of the pre-resolution stay — to be called Article 33a under BRRD — or at least the reinstatement of the clear carve-out for derivatives contained in the original EC draft.

Some lawyers, however, have become less concerned with US netting rules in light of the latest Council draft. One regulation expert at a US bank says he is confident, having consulted lawyers on the issue, that the two-day pre-resolution stay will be deemed substantially similar to the US regime.

Knox McIlwain

“We’ve asked the lawyers and they say the Fed will probably consider this substantially similar to the US, so hopefully we will not have to put collateral against trades with European banks on a gross basis, but that is, of course, still to be confirmed. Previously, we knew that up to a 12-day stay was far too long for us to get beneficial treatment under US regulation, so we are at least moving in the right direction,” he says.

Knox McIlwain, counsel at law firm Cleary Gottlieb, says he can imagine the Fed determining the EU stay regime – as amended by the Council – is substantially similar to the US for netting purposes. But even if the regulator does not ask banks to calculate exposures on a gross basis, he warns the Fed could still increase counterparty credit risk weights for contracts with European banks.

The Fed declined to comment.

The regulation expert adds that his US bank and others are pushing for a carve-out for custody business, given the potential knock-on effects for individuals would be as damaging as freezing deposits. 

“Because custody banks are really a holding fund for hedge funds, pension funds [and] insurers, we worry about the disruptive effects if these funds are included in a stay. These aren’t the banks’ funds; they’re held separately, and if they are frozen it could cause a lot of havoc if, for example, pensions don’t get paid out,” the regulation expert adds.

Playing politics

The likely reason behind the decision to remove a moratorium exemption for derivatives in the Council non-paper is that politicians do not want to be seen to favour dealers and other market players above depositors, say lobbyists. The Council presidency paper says the advantage of its latest proposal is “avoiding more favourable treatment for derivatives than for covered deposits”.

“I think they have acknowledged the potential difficulties this is going to create for derivatives markets, but politically they also don’t want to be seen to be giving special treatment to large financial institutions,” says the regulation expert at the US bank.

In the Council’s proposal, depositors would be given a daily withdrawal allowance to cover living costs and business administrative expenses, but would not be shielded completely from a moratorium. A national option to exclude covered deposits (those of less than €100,000, which are eligible for deposit insurance) from the scope of a moratorium was deleted in the presidency non-paper. Instead, the Council committed to ensuring resolution authorities have sufficient power to prevent liquidity outflow.

Industry clamours that a pre-resolution stay could precipitate a liquidity crisis even earlier have not gone unnoticed by MEPs. In parliamentary amendments to the BRRD published on January 29, many supported an outright deletion of the pre-resolution moratorium for this reason.

The introduction of a preventive moratorium may prove counterproductive as it can undermine confidence, lead to a bank run and eventually accelerate the fall of the bank

Group of seven socialist MEPs

Overall, the opinions of MEPs are mixed, but there are more amendments in support of deleting the pre-resolution moratorium or limiting it to two days than the five-day pre-resolution moratorium put forward by the EC. Market participants say they were pleasantly surprised to see the socialist grouping in the European parliament support outright deletion.

“The introduction of a preventive moratorium may prove counterproductive as it can undermine confidence, lead to a bank run and eventually accelerate the fall of the bank,” wrote a group of seven socialist MEPs, among them economic and monetary affairs committee (Econ) chair Roberto Gualtieri.

Syed Kamall, a UK MEP and member of the European Conservatives and Reformists Group, deleted the pre-resolution moratorium altogether in a proposed amendment to the parliamentary draft. He explained: “The pre-resolution moratoria is very problematic as it would in essence be a resolution trigger, causing bank runs and contagion. In addition, it is likely capital requirements would be raised.” 

Photo: AG Gymnasium Melle

Markus Ferber

On the other side of the debate, German MEP Markus Ferber, vice-chair of Econ and a member of the European People’s Party, proposed extending the pre-resolution stay from five days to seven days.

“The idea behind the moratorium tool within the resolution framework is to give a resolution authority a certain timeframe during which it can freeze payment and delivery obligations. That allows the resolution authority to determine the best way forward without having to fear the respective bank is falling apart under its watch,” Ferber says, speaking to Risk.net.

“The key consideration for the moratorium tool to work is that the resolution authority can buy enough time to do its job even in complicated cases without having to rush. Therefore, I do not support the idea to limit the moratorium period to only two days. Five days should be the minimum and I feel having a little extra breathing space in complicated cases would definitely be advantageous.”

The balance of opinion would therefore put the Council non-paper, suggesting a maximum two-day moratorium, as the most likely compromise between MEPs, who want extra powers deleted from the updated BRRD, and the EC and regulators who are hoping for a pre-resolution moratorium of five days. A trialogue between the Council, EC and Parliament to finalise moratorium powers is expected in March.

Given the array of other issues and priorities, lobbyists say it is unclear how derivatives will end up being treated. Banks say the outright deletion of Article 33a, thereby doing away with the concept of pre-resolution moratoria entirely, would offer the most certainty. They add, however, that a carve-out of derivatives would be enough to reduce the threat of heightened capital and margin requirements being imposed on non-EU banks facing EU counterparties.

Ultimately, the question is whether MEPs and member states within the Council can accept a carve-out for netted or collateralised derivatives positions while offering only limited access to funds for depositors. Alternatively, if a carve-out is allowed for both depositors and derivatives contract holders, it would cast doubt on whether the pre-resolution tool is of any use to regulators.

“Overall, it’s a choice between what’s politically appealing and what makes sense for financial markets to function properly. It’s not clear yet which side they will come down on,” says the US bank regulation expert.

Four-day stay?

Although the Council non-paper makes clear the existing Article 69 resolution stay cannot be triggered if the pre-resolution moratorium has already been used, Knox McIlwain, counsel at law firm Cleary Gottlieb, says a stay could still theoretically run for four business days. This is because two other articles set out stay powers in more detail.

“According to the paper’s outline, we could end up with a four-day stay. It’s only Article 69 that gets shut off if Article 33a is used, but this doesn’t preclude articles 70 and 71 being used in order to delay termination,” he says.

Article 70 outlines the regulator’s power to restrict the enforcement of security interests, while Article 71 sets out the power to temporarily suspend termination rights. Both articles give regulators the power to suspend payments until midnight on the next business day following publication of a suspension decision.

“Considering the scenario of ‘what if the bad thing happens?’ rather than ‘what if the good thing happens?’ in a banking crisis – which is what banks have to do – the 33a stay is imposed, resolution happens for whatever reason the bad thing happens and you, as a contract holder, have a default right exercisable under BRRD, but the resolution authority can suspend that termination right for an additional two days and foreclose any collateral,” says McIlwain.

He does not believe this is the intention of the Council, but says that without clarification this is the scenario banks and regulators in other jurisdictions will have to plan for under current proposals.