New regulations approved by the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corp. will fundamentally change the playing field for end users or buy-side counterparties that engage in certain types of financial agreements with the world's largest financial institutions. The new rules have been adopted as part of the regulators' ongoing efforts to address the "too-big-to-fail" problem. They will require any U.S. top-tier bank holding company that is a global systemically important banking organization (GSIB), the subsidiaries of such a GSIB (including state member and nonmember banks and state savings associations and most of their subsidiaries), and the U.S. operations of any foreign GSIB (collectively with GSIBs and their subsidiaries, "covered entities") to include specific provisions in certain types of noncleared contracts (qualified financial contracts or QFCs). QFCs include, among other contracts:

  • Swaps and other derivatives,
  • Repurchase and reverse repurchase agreements, and
  • Securities lending and borrowing agreements.

Broadly speaking, the provisions required by the new regulations are designed to enhance the orderly resolution of a failed GSIB by imposing limitations on the ability of a GSIB's QFC counterparties to immediately terminate such contracts or exercise other default rights in the event that the GSIB or one of its affiliates becomes subject to a resolution proceeding. The Office of the Comptroller of the Currency is expected to issue substantially identical rules for national banks in the future.

The regulations will impact a broad range of end-user or buy-side counterparties that do business with GSIB entities, including institutional investors, sovereign wealth funds, investment funds, sovereign entities, central banks and others. The significance of the new rules to counterparties that enter into QFCs with GSIBs and other covered entities is illustrated by comments that the board and the FDIC received when they were originally proposed. The board acknowledged concerns by commenters that the rules will restrict contractual rights of counterparties which, among other things, have traditionally been exempted from the automatic stay provision of the U.S. Bankruptcy Code, shift the costs of resolving major financial institutions to nondefaulting counterparties, and increase market and credit risk for end-user or buy-side counterparties.1 The board and the FDIC carefully weighed these considerations before adopting the new regulations, but each party to a qualified financial contract will wish to assess how the new rules will affect its transactions with covered entities. We have prepared the following brief summary and a description of matters that parties to QFCs should consider as the new regulations go into effect.

Summary of the New Regulations

In very brief terms, under the new regulations of the board and the FDIC, and the anticipated regulations from the OCC, any GSIB, most subsidiaries of GSIBs, and U.S. operations of any foreign GSIB will be subject to restrictions on their QFCs.2 QFCs typically include provisions that allow parties to immediately exercise default rights if the counterparty, an affiliate of the counterparty, or a credit support provider of the counterparty becomes subject to some form of resolution proceeding. These default rights may include the right to suspend performance of the nondefaulting party's obligations, to terminate or accelerate the contract, to seize and liquidate collateral, or to set off amounts owed between the parties. The exercise of such rights by a nondefaulting party to a QFC is generally not subject to the otherwise applicable automatic stay under the U.S. Bankruptcy Code due to special "safe harbor" provisions in the U.S. Bankruptcy Code. Moreover, QFCs usually contain restrictions on the transfer of the agreement or related credit support.

The immediate exercise of such default rights is not consistent with the envisioned operation of the FDIC's orderly liquidation authority, established by Title II of the Dodd-Frank Act, for troubled financial firms whose failure could disrupt the financial system, or with the FDIC's authority under the resolution framework established by the Federal Deposit Insurance Act (FDIA) to administer the receivership of an insured depository institution. Under both the Dodd-Frank Act and the FDIA, when an institution is subject to such a resolution, its QFC counterparties are temporarily stayed from exercising termination, netting and collateral liquidation rights, while the contracts are transferred to a new bridge entity or other entity that is not in a resolution proceeding.

The new regulations will require that the QFCs of covered entities include terms to ensure that the U.S. special resolution regimes established under the Dodd-Frank Act and the FDIA will be respected, particularly by courts in foreign jurisdictions.3 The QFCs of such firms will now be required to explicitly provide that any default rights or restrictions on the transfer of the QFC will be limited to the same extent as they would be pursuant to the special U.S. resolution regimes. This would reduce the risk that a counterparty or court in a foreign jurisdiction might challenge a stay and transfer under such special resolution authority. However, a covered QFC that is governed by U.S. law and involving only U.S. parties (other than the covered entity) would not be required to include such terms, because it is sufficiently clear that the above-described U.S. special resolution standards would apply.

The new rules also impose limitations on the exercise of cross-default rights by QFC counterparties. More specifically, a covered entity would be prohibited from entering into QFCs that allow the exercise of any default rights that are triggered, directly or indirectly, by the entry into resolution (under any insolvency regime in the U.S. or abroad) of an affiliate of the covered entity that is the direct party to the QFC.

Finally, the board will allow covered entities to comply with the new rules by adhering to the 2015 Universal Resolution Stay Protocol (universal protocol), published by the International Swaps and Derivatives Association (ISDA). While the provisions of the protocol do not exactly mirror the new rules, the board is of the view that they are, nevertheless, consistent with such rules' requirements. In addition, to facilitate compliance with the new rules, the board has indicated that adherence to ISDA's Resolution Stay Jurisdictional Modular Protocol, with a yet to be published U.S. jurisdictional module, will meet the requirements of the new rules, provided that its terms are "substantively identical" to the universal protocol.

Phase-In Process

The new regulations become effective in November 2017, but there will be a phase-in process for compliance. Covered entities will be required to conform their QFCs with other covered entities by Jan. 1, 2019. For contracts with other financial counterparties that are not covered entities or small financial institutions, the deadline will be July 1, 2019. For contracts with small financial institutions and all other entities, the compliance deadline will be Jan. 1, 2020. Pre-existing QFCs must generally be conformed to the new standards if a covered entity or its affiliate enters into a new QFC with the same counterparty or a consolidated affiliate of the counterparty on or after the first compliance date.

Effects on the Marketplace

End-user or buy-side counterparties to QFCs with GSIB entities, including investment funds, smaller financial firms, sovereign wealth funds, central banks and other institutions, will be impacted by the new regulations. Any entity that engages in swaps, repos, reverse repos, securities lending or other QFC transactions should consider the following action items.

  • End users and buy-side counterparties should identify each outstanding QFC to which it is a party with a GSIB, a subsidiary of a GSIB, or a foreign GSIB.
  • For each such QFC, a determination should be made regarding the applicability of the new regulations in light of the governing law provision and the jurisdiction in which the counterparties are located.
  • Counterparties should evaluate whether they wish to adhere to the provisions of the ISDA 2015 Resolution Stay Protocol, utilize other existing jurisdictional modules or negotiate specific provisions bilaterally with their covered entity counterparties.
  • Market participants should assess the extent to which their contractual default rights would be restricted pursuant to the application of U.S. special resolution authority and develop contingency plans in the event their covered entity counterparties undergo financial distress.
  1. The FDIC noted that many of the comments it received had attached comments that had been sent to the board.

  2. The board identified eight current U.S. GSIBs: Bank of America Corp., The Bank of New York Mellon Corp., Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley Inc., State Street Corp., and Wells Fargo & Co. The board identified the following 22 foreign banking organizations as foreign GSIBs: Agricultural Bank of China, Bank of China, Barclays, BNP Paribas, China Construction Bank, Credit Suisse, Deutsche Bank, Groupe BPCE, Groupe Credit Agricole, Industrial and Commercial Bank of China Ltd., HSBC, ING Bank, Mitsubishi UFJ FG, Mizuho FG, Nordea, Royal Bank of Scotland, Santander, Societe Generale, Standard Chartered, Sumitomo Mitsui FG, UBS, and Unicredit Group.

  3. This resembles the EU requirements that require acknowledgment of bail-in provisions in certain financial contracts subject to non-EU law.

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