ISDA launches resolution stay jurisdictional modular protocol

The International Swaps and Derivatives Association, Inc. (ISDA) has announced the launch of a new protocol that will enable all market participants to comply with new regulations aimed at ensuring the cross-border enforceability of stays on contractual termination rights. These stays are intended to give regulators time to facilitate an orderly resolution of a troubled bank, including transferring derivatives positions to another institution.

The ISDA Resolution Stay Jurisdictional Modular Protocol (JMP) was developed by a working group of buy-side and sell-side firms and other trade associations in close cooperation with the Financial Stability Board (FSB) and national regulators. It is a standalone protocol with its own operative provisions, separate from the ISDA 2014 and 2015 Universal Resolution Stay Protocols, and is specifically intended for use by sell-side market participants in their trading relationships with their buy-side counterparties.

Together with the JMP, ISDA is also launching the UK (PRA Rule) Jurisdictional Module, enabling firms to comply with Prudential Regulation Authority requirements that prohibit certain UK-regulated banks from trading with a counterparty under an agreement not governed by UK or other EU law, unless that counterparty has agreed to be bound by stays on termination rights under UK law. Additional Jurisdictional Modules will be launched in due course to meet other national regulations.

What does the Protocol do?

The JMP is a major component of a regulatory and industry initiative to address the too-big-to-fail issue by improving the effectiveness of cross-border resolution actions against a big bank - endeavouring to mitigate the requirement for taxpayer money to prop up a failing institution.

Under an ISDA Master Agreement, the insolvency of a derivatives counterparty, or the start of resolution actions against it, can trigger certain close-out rights - including termination of the swap, foreclosure on collateral and claim for payments. Regulators had expressed concern that the simultaneous close-out of derivatives transactions during the resolution of a large, cross-border bank could hamper resolution efforts and destabilise markets.

This issue is being addressed in certain countries through the development of statutory resolution regimes - for example, Title II of the Dodd-Frank Act and the EU Bank Recovery and Resolution Directive - which impose a stay on termination rights in the event a bank is subject to resolution action in its jurisdiction. If the resolution is successful, then counterparties would face a creditworthy institution and no longer have the right to terminate their transactions.

The problem is that these statutory regimes do not typically contain provisions that recognise the resolution regimes of other jurisdictions, and the concern is that cross-border trades could end up falling between the cracks.

That could potentially be a big problem for regulators trying to resolve a large bank with global activities across multiple overseas subsidiaries. There is a question as to whether stays on termination rights under a particular resolution regime would be enforceable against all swap counterparties of the banking group, which would likely be located in different jurisdictions and transacting under the laws of a variety of jurisdictions.

Regulators wanted the industry to consider the development of a protocol - a means of amending ISDA Master Agreements to incorporate contractual recognition of stays under various statutory resolution regimes.

When does the Protocol take effect?

18 major banks adopted the original Resolution Stay Protocol on 01 January 2015, and the revised Universal Resolution Stay Protocol was signed by 21 financial groups at launch in November 2015.

Buy-side firms were not originally included. These institutions were unwilling, and potentially unable, to voluntarily adopt those protocols for a variety of reasons, including their fiduciary responsibilities to their underlying clients in some cases. By voluntarily giving up advantageous contractual termination rights, they potentially left themselves open to legal action, an issue recognised by the FSB.

The latest Protocol, the JMP, is intended to help the broader market meet the new regulations. It will have separate Jurisdictional Modules, each designed to closely reflect the requirements in a particular jurisdiction. Each Jurisdictional Module will contain the operative provisions necessary for adhering parties to comply with applicable requirements.

For the PRA Rule, if both parties to an agreement are Regulated Entities under the PRA Rule, or if one party is a Regulated Entity and the beneficiary of such agreement is a Regulated Entity; or if one party to such agreement is a Regulated Entity and the other party, or beneficiary, is either a “credit institution,” “investment firm,” or an “undertaking” which would be an “investment firm” if it had its “head office” in an “EEA State,” the compliance date for the PRA Rule is 01 June 2016. Otherwise, the compliance date for the PRA Rule is 01 January 2017.

How does this affect me?

The JMP has been designed to be used by all market participants, and to provide flexibility to allow adhering parties to choose which jurisdictional "modules" to opt in to.

Under a framework established by the FSB, various national regulators are introducing requirements for certain banks in their jurisdiction to obtain consent from their counterparties for statutory stays on early termination rights to apply to financial contracts between those parties, regardless of the governing law of the contract.

There are various additional considerations for asset managers including how to adhere on behalf of one, some, or all clients represented, and how to add clients to umbrella master agreements after adhering to a Jurisdictional Module.