Repo and securities lending face swap-style stays

BoE's Gracie confirms termination rights will be removed as regulators seek to shore up resolution regime; meeting is set for March 2

Stays will suspend termination rights

Rules to stop firms fleeing a defaulting counterparty are to be introduced in the repo and securities lending markets, the Bank of England (BoE) has confirmed, in the first expansion of the controversial 'stays' regime beyond over-the-counter derivatives markets.

In an article for Risk, Andrew Gracie, the BoE's executive director of resolution, writes that global systemically important banks (G-Sibs) and other market participants will be compelled to give up termination rights in these markets on broadly the same terms as those laid out by the contentious contractual add-on for OTC trades that was voluntarily signed by 18 swaps dealers in November 2014. The fear is that a wave of counterparty terminations could derail attempts to resolve a stricken bank.

The adoption of the so-called resolution protocol by the dealers means more than 90% of their "bilateral OTC derivatives trading activity" is now covered by either existing statutory stays – which apply as long as both parties are subject to the same regulation – or by the contract, which allows firms to opt into a statutory regime, Gracie says. But this is just a first step. Stays in OTC contracts will be extended to other market participants via regulation this year, and Gracie says the regime will also cover repo and securities lending.

"Over the coming year, regulators will require G-Sibs and other banks subject to significant cross-border close-out risk to move to trade with their counterparties, including buy-side firms, on terms that recognise the stay provisions in the resolution regime of the G-Sib's home country. This should address the remaining 10% of G-Sibs' bilateral OTC derivatives exposure. The additional aim is to include provisions in the repurchase and securities-lending agreements that have the same effect as the Isda protocol, and these measures are expected to come into force in the major trading jurisdictions in early 2016," Gracie writes.

"In order to achieve this and ensure consistency across jurisdictions," he continues, "regulators are actively working together to align the key principles of any regulatory measures. Furthermore, the Financial Stability Board (FSB) will monitor progress towards adherence to the protocol across the G-Sib population and will look out for any adverse market developments that seek to find a way around statutory or contractual stays."

I would not be surprised to see a widespread objection from the buy side

March 2 meeting

Risk has learned a meeting is to be held on March 2 in London between European, UK and US regulators, market participants, and the industry trade associations responsible for drafting standardised documentation for securities lending and repo transactions.

In the same manner that most OTC derivatives transactions are governed by International Swaps and Derivatives Association contracts, repo transactions are governed by the global master repurchase agreement (GMRA) – developed and maintained by the International Capital Markets Association (Icma) – while securities lending is governed by the global master securities lending agreement (GMSLA), developed by the International Securities Lending Association (Isla).

Icma and Isla have been informed by regulators that the standard GMRA and GMSLA documents need to be amended to provide for stays during resolution, as was the case for Isda's master agreement for OTC derivatives.

The consultation on amending the GMRA and GMSLA is at a very early stage and although there is currently no timeline for implementing it, one may be agreed at the March 2 meeting. It is also widely expected by those close to the discussions that mid-2016 is the target date for such a protocol to come into effect in repo and securities lending markets.

"Regulators were pretty clear after the Isda protocol came out that they wanted to extend this treatment to other master agreements such as the GMRA and GMSLA, but it's probably not been on many people's radar. Certainly repo transactions, which inherently include overnight transactions, will create their own specific challenges which will require careful consideration," says Eric Litvack, head of regulatory strategy at Societe Generale in Paris.

Lawyers specialising in recovery and resolution had been expecting repo and securities lending to be among the next product classes to be subject to mandatory stays. In July 2011, a report by the FSB entitled Effective resolution of systemically important financial institutions cited both markets in the context of possibly removing exemptions from early termination stays.

"Repos and securities lending are subject to potential stays under both the US and UK insolvency and rehabilitation regimes, so I was expecting the regulators to simulate the approach of the Isda protocol in this area. Whether it is sensible is a different matter. Such instruments are typically easier to value than a portfolio of OTC derivative instruments so one might have anticipated a different approach. However, the regulators are increasingly of the view that the courts need to be sidelined, while the contractual close-out mechanisms in the master agreements that the market has historically relied upon are becoming less and less relevant," says Anthony Fawcett, counsel at law firm Purrington Moody Weil in New York.

The imposition of termination stays could provoke protests from buy-side participants in repo and securities lending markets, especially those that do not trade OTC swaps and may therefore not be aware of the broadly similar moratorium that is to be introduced in most major derivatives markets in the coming year.

"The average buy-side firm is not aware of these discussions. Indeed, this will be particularly surprising to those firms that do not engage in derivatives trading and which, thus far, have not been directly impacted by Dodd-Frank regulations. I would not be surprised to see a widespread objection from the buy side – even broader than the response to the Isda resolution stay protocol – particularly because repos and securities lending agreements are materially different from swaps," says Lauri Goodwyn, counsel in the corporate finance group at law firm Seward & Kissel in New York.

Institutional investors and other buy-side firms reacted with confusion and anger in mid-2014 when it first became clear they would be forced by local regulation to comply with the terms of the Isda termination stays protocol by national regulation.

Some asset managers claimed at the time that all such a moratorium will do is move up a run on a collapsing swap dealer by a day or two as buy-side clients and fellow dealers seek to close out positions with an ailing bank before resolution proceedings begin and the stay takes effect. Members of the working group behind the Isda protocol called that a "false argument".

Some buy-side firms are already critical of the idea that they will have to give up termination rights in repo markets, predicting it will make firms less willing to loan out riskier bonds.

"I don't know operationally how termination stays in repo would work but it is certainly an unattractive prospect. We lend out bonds in the repo market, especially riskier bonds such as corporates or emerging market paper. If you lend a bond to a bank and that institution collapses, risk assets would presumably sell off. What I have done at that point is loaned a bond to that counterparty and I have the cash value of the bond in my possession. If the bank then collapses, I will be over-collateralised at the point of the termination of the trade because the price of the bond has probably dropped markedly," says Michael O'Brien, global head of trading at Eaton Vance in Boston.

"To the extent a two-day moratorium on repo terminations is introduced, I now own that bond for two days as the prices collapses. That makes it a lot less attractive for me to lend risky bonds, especially since I don't believe a failed bank would be rescued in all instances," O'Brien adds.

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