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More Wet Towels on Order as ISDA Relaunches Resolution Stay Protocol

On 12 November 2015, ISDA relaunched the ISDA 2014 Resolution Stay Protocol (now called the “ISDA 2015 Universal Resolution Stay Protocol”).  Twenty-one major banks have signed the 2015 protocol at launch.

Both the 2014 protocol and the 2015 protocol seek to address the question of “too big to fail”.  Specifically, they look to tackle the uncertainty surrounding the enforceability of statutory stays on early termination rights in cross-border situations by enabling adhering parties to amend the terms of master agreements and related credit support arrangements so as to ‘opt in’ to certain foreign resolution regimes that enforce statutory stays on cross-default and early termination rights in the event that a bank counterparty enters into resolution.  The terms of the 2015 protocol are substantially similar to those of the 2014 protocol.  However, the scope of the 2015 protocol has been expanded, at the request of regulatory authorities from Germany, Japan, Switzerland, the United Kingdom and the United States of America, to address:

  • Securities Financing Transactions Documentation – the 2015 protocol incorporates a new SFT Annex (developed jointly by ISDA, the International Capital Market Association (ICMA), the International Securities Lending Association (ISLA) and the Securities Industry and Financial Markets Association (SIFMA)), extending in-scope documentation to include the most popular Securities Financing Transaction Master Agreements[1];
  • Other Agreements – in the future, ISDA may publish an “Other Agreements Annex” through which other agreements could also be brought within scope of the 2015 protocol; and
  • The definition of “Protocol-eligible Jurisdiction” – which has been expanded to include all G-SIB Jurisdictions, in addition to FSB jurisdictions.

The 2015 protocol invokes the concept of an ‘Equivalent’ agreement (i.e. a notional agreement having the same terms as the actual master agreement or credit support arrangement signed between two adhering counterparties, but which is governed by the laws of the jurisdiction of relevant “Special Resolution Regime”) in order to control the exercise of early termination and transfer rights.  Broadly, in circumstances where an adhering party (“A”), A’s Credit Support Provider, or one of A’s “Specified Entities” enters into resolution, then the early close-out and transfer rights of any counterparty to any covered agreement will be determined by reference to the law governing the party which entered into resolution.

All sounds simple – yes?  No.

In fairness, the task facing ISDA is an unenviable one.  In truth, national regulators should apply themselves to finding a way to cooperate and recognise each other’s authority, in which case none of this would be necessary.  Even putting that to one side – it is one thing for regulators to demand that master agreements be amended to make provision for contractual stays.  However, it is quite another to actually implement this change in accordance with a deadline, across tens of thousands of counterparties, in relation to complex agreements, whilst taking account of key dependencies between multiple entities, such as counterparties, Credit Support Providers and Specified Entities.

Nonetheless, it is time to question whether our use of protocols, together with their increasing complexity, is simply creating new risks at a rate beyond our current ability to process, understand or mitigate.  Put simply, do we really know what we are signing up to?  It seems unlikely.

It is certainly the case that the 2015 protocol is a very impressive example of legal drafting.  It is also true that protocols are (in theory at least and dependant on rates of adoption) a cost-effective and efficient way to amend large numbers of contracts.  However, by virtue of their ‘one size fits all’ approach, protocols inevitably take the form of a sledgehammer to crack a nut.  The 2015 protocol is almost 50 pages long and involves the insertion of a contractual amendment running to almost 30 pages.  The drafting does not help matters either, with sentences running to 12, 14 or even 16 lines of text commonplace.  None of this aids understanding.

A quick glance at the 2015 protocol is enough to gain an appreciation of the degree of complexity involved.  Section 1 deals with the entry into resolution of an adhering party.  Section 2 creates default rights (where none currently exist) in relation to US insolvency proceedings in respect of an affiliate.  Section 3 deals with the exercise of default rights in circumstances where a party has entered into resolution but one or more of its affiliates is subject to US insolvency proceedings and/or resolution.  Still with us?  Well, further complexity is layered on top in the form of ‘opt-outs’ to the ‘opt-ins’.  Broadly, prior to entry into resolution, there are provisions allowing one party to opt out in the event that its counterparty is not required by its regulator to amend documentation to include contractual stays.  There is also the ability to opt out if subsequent amendments to the stay provisions of an “Identified Regime”, or the provisions of a newly-enacted or amended resolution regime in a “Protocol-eligible Regime”, materially and adversely affects the ability of an adhering party to exercise default rights.  Next, there are further provisions allowing a party to opt-out if it or its affiliates are not required to amend documentation or if they have no transactions in place under an agreement with a counterparty.  Unfortunately, in some circumstances, these opt-outs can become automatically null and void – meaning that parties are ‘opted back in’ – a situation that will need to be monitored.  Last, but certainly not least, the Securities Financing Transaction Annex of the 2015 protocol effectively amends the prior provisions of the 2015 protocol itself so that they apply to SFTs.

You would be forgiven for breathing a sigh of relief when learning that ISDA does not expect other market participants to adhere to the 2015 protocol.  Unfortunately, there is no escape, as ISDA is instead expecting adherence to the “ISDA Resolution Stay Jurisdictional Modular Protocol” – a work in progress to be published at some point in 2016 and which will largely take the same form as the 2015 protocol.

The point is that all of this complexity creates risk, all of which needs to be assimilated and monitored.  Granted, in any given set of circumstances, many of the provisions of the 2015 protocol may not apply to a particular counterparty.  However, it is incredibly difficult to know this for sure before the event.  Even then, the simple fact that something is irrelevant does not mean that it entails no risk.  Quite the opposite – it just makes it all the more difficult to identify where risk exists.

One is left with the feeling that we are trading regulatory compliance for significant amounts of legal and operational risk.  Undoubtedly, bilateral amendment exercises are painful, slow and expensive.  But what price to have a certainty of contract?  Unfortunately, protocols are becoming too long and too complex and the potential consequences are too important to be dealt with in this way.

[1] The Global Master Repurchase Agreement, The Global Master Securities Lending Agreement, the Master Equity and Fixed Interest Stock Lending Agreement, The Master Gilt Edged Stock Lending Agreement, The Master Repurchase Agreement, The Master Securities Loan Agreement and The Overseas Securities Lender’s Agreement

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