Friday, May 20, 2016

Bloomberg: Fed Plan Targets Derivatives Contracts

Here we have an interesting new article on Bloomberg that covers a plan by the US Federal Reserve to deal with potential contagion from derivatives contracts. This is a topic we have covered here somewhat because a failure at a "too big to fail" financial institution could lead to risk for the entire global financial system. Below are some quotes from this Bloomberg article and then some added comments.


"Hedge funds, insurers and other companies that do business with Wall Street megabanks are poised to pay a price for regulators’ efforts to make sure any future collapse of a giant lender doesn’t tank the entire financial system.

The Federal Reserve proposed that so-called stays be included in contracts for derivatives and other financial instruments to prevent counterparties from immediately pulling collateral from a failed bank. The plan released Tuesday is meant to give authorities ample time to unwind a firm, hopefully heading off the frantic contagion that spread through markets in 2008 when Lehman Brothers Holdings Inc. toppled and its trading partners demanded instant payment on terminated contracts."

. . . . . 

"Fed Governor Daniel Tarullo said the rule is “another step forward in our efforts to make financial firms resolvable without either injecting public capital or endangering the overall stability of the financial system.”

. . . . . . 

"Before they can finalize the rule, which comes with a one-year implementation period, U.S. regulators must seek public comment on the proposal. The Fed will accept feedback until Aug. 5."

My added comments: Readers here know that we have covered the many warnings issued by the IMF and the BIS about risks that exist to the global financial system. This derivatives issue is a key one because of the interconnected nature of the global financial system. There are some who downplay the derivatives risk by saying that since financial institutions hedge derivative positions, the risk is much lower than it may appear when looking at the size of the full contract value of a derivative. The idea is that the institution will own a hedge position on the derivative that offsets (reduces) the risk.

However, this argument fails if a major institution goes under and cannot meet its obligations as a counterparty on its derivatives contracts. It's obvious this is a legitimate concern since the Federal Reserve itself wants to basically "freeze" derivative contract obligations for 48 hours if a big bank does go under as this Bloomberg article explains. The article quotes Fed Governor Daniel Tarullo as saying the plan is another step to "make financial firms resolvable without either injecting public capital (taxpayer dollars) or endangering the overall stability of the financial system." So its clear these derivative contracts can pose a systemic risk to the overall financial system despite the willingness of some to ignore that risk. Certainly, a big derivatives contract failure could trigger the kind of new major financial crisis that Jim Rickards and others are expecting at some point in the future.

On the other hand, I note that there does not appear to be any sense of urgency by the Fed to get this plan implemented. They will take public comments until August 5th of this year and then there is a one year time frame to implement the plan. So it could be the fall of 2017 or later before this plan is actually implemented. This suggests that the Fed does not see any kind of imminent crisis related to derivatives on the near term horizon and certainly not prior to the US elections in November. Since issues like this are not even addressed by the Presidential candidates, we have no idea how whoever is elected in November would feel about this proposed plan or how they would deal with a major systemic crisis if one did unfold.

No comments:

Post a Comment