Derivatives contracts are exempt from normal bankruptcy law

by on September 15, 2008 at 4:58 am in Law | Permalink

More or less (there are complex details).  Here is one account:

…in a series of amendments through the 1980s US bankruptcy law was
altered to provide extraordinary protection to over the counter (OTC)
derivatives. This favorable treatment under the law is undoubtedly one
of the reasons that markets in these derivatives did not follow the
historical pattern and move onto centralized exchanges. [TC: heterogeneity of contracts is an issue as well]

By providing over the counter derivatives extraordinary protection
under the law, the bankruptcy amendments dramatically reduced the need
for market participants to monitor the financial health of their
counterparties. One of the principal reasons that financial market
participants choose to establish cooperatively run exchanges (recall
that the NYSE is to this day a private organization) is to protect
themselves from counterparty risk. The exchange is the counterparty to
every trade, so the only concern is whether the exchange itself is
well-capitalized and well-run.

Here is more detail.  Here is again more detail, with this as the bottom line:

…counterparties to derivatives contracts are free to terminate the contracts and then seize collateral to the extent that they are owed money…

In other words, there is no bankruptcy stay.  That’s not obviously a good arrangement and it can lead to hair trigger failures (sound familiar?) by implicitly subsidizing these transactions.  I first heard of this reading the excellent Felix Salmon.  Here is yet further detail.  Here is how some of it came from the 2005 Bankruptcy AmendmentsCongress thought, at the time, that this would limit systemic risk. 

1 SJ September 15, 2008 at 6:34 am

It’s just a netting provision.

I sell you 1000 contracts at $1 each. Later in the month, I buy them back at $1.01 each. The gross effect is that you owe me $1000, and I owe you $1010. The net effect is that I owe you $10.

If you went bankrupt, under the normal regime, your liquidator would require me to pay you the full $1010, and would require me to wait in line with all the rest of the creditors for the return of my $1000.

The ISDA contract, however, requires that all trades be netted, so that I just pay you the $10. If the situation was reversed, so that you owed me a net $10, I’d have to wait in line with all the rest of the creditors for the $10.

I can’t see anything unfair in this.

2 ken September 15, 2008 at 8:51 am

Sounds like this provides a second best argument for the SEC to ban short sales on the stocks of financial firms. And since now it is the taxpayers largely on the hook for what Atrios calls the big shitpile, why isn’t a short sale ban good policy? The answer can’t be the standard “how naive can you be to think the short sale ban can affect prices ?” If the short sale ban has no effect, then it does no harm.

3 Bernard Yomtov September 15, 2008 at 9:45 am

Sj,

Are you sure that’s the limit of it, that it applies only to cash settlement and the amounts involved in them? I was under the impression that financial firms have broader ability to seize assests they hold for their creditors when the creditors go bankrupt.

4 Norman Pfyster September 15, 2008 at 10:54 am

It’s analogous to the offset provisions of the Bankruptcy Code, which, although it does not avoid the automatic stay, effectively grants the creditor first priority.

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