The Bankruptcy Code is a legal act which describes the rights and obligations of the sides, namely business counterparties in the case of one of the parties’ bankruptcy. One of the main requirements of this law is the implementation of the “automatic stay” procedure, which protects the debtor’s assets to ensure his firm’s going-concern surplus. In this case, the creditor loses the opportunity to terminate the collateral, which the debtor filed at the conclusion of the contract. The Code provides a unique position only in the cases of financial derivatives. For such situations, the Code provides the opportunity to exempt from an “automatic stay” procedure and “permits counterparties to terminate derivatives contracts with a debtor in bankruptcy and seize underlying collateral” (Edwards & Morrison, 2004, p.2). Whereas such provisions, Congress was guided by the desire to avoid systemic risks that could have arisen in the market as a result of non-compliance of the derivatives transactions by the parties.
Franklin Edwards and Edward Morrison criticized special treatment in respect of financial derivatives in the article “Derivatives and the Bankruptcy Code: Why the Special Treatment?” In this paper, the authors consider a systemic risk as a weak argument in favour of a specific approach to financial derivatives. One of the arguments in support of this position is that the freezing obligations on financial derivatives do not always lead to systemic risks in the market. On the other hand, there are examples of situations in which the execution of the Code requirements stimulates the development of crisis tendencies in the industry. The common example of this case is the story of the Long-Term Capital Management (LTCM) fund. Due to the scope of the company, the Federal Reserve Bank made a decision to block the execution of the requirements of counterparties’ derivatives. Otherwise, there was a threat of a “chain reaction of insolvencies” (Edwards & Morrison, 2004, p.5), which would affect the entire economy. At the same time, the example of Enron Company showed that the company can fulfil the Code requirements in case of its outstanding liabilities covered by income from the out-of-the-money contracts.
Another argument against systemic risk as a reason for special treatment to financial derivatives is that the Code does not take into account the scale of the debtor’s company and focuses only on the derivatives (Edwards & Morrison, 2004, p.8). Since the Code does not consider the scale of the company and the number of its counterparties which could be affected by the firm bankruptcy it is difficult to define the level of real systemic risk that the company can cause to the industry.
In their study, Edwards and Morrison also criticize the Bankruptcy Code with regard to special treatment afforded financial derivatives. They consider the financial derivatives to be not the only factor of systemic risk for the economy which requires special treatment. According to them, “if systemic risk arises from transactions other than derivatives contracts, as it undoubtedly does, the Code’s singular focus on derivatives contracts is puzzling” (Edwards & Morrison, 2004, p.8).
Another argument against special attitude to derivatives is that termination of the derivatives contracts by counterparties can lead to decrease of the debtor’s value and complicate the fulfilment of his obligations to other partners. Here the authors use the concept of a “pecuniary externality”, which the debtor reaches when he performs the Code requirements. Edwards and Morrison state that the termination of the derivatives contract “indirectly reduces firm value by raising the price it must pay to hedge risk” (Edwards & Morrison, 2004, p.27).
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Special attitude to the derivatives also stimulates the search for detours by the creditors. One of such methods is the registration of credit operations as a financial derivative. In this case, banks can circumvent the restrictions imposed by the Code, which casts doubt on the effectiveness of the legislative approach used in the document.
Taking into account all the limitations of the Code, the authors define “the economic theory underlying the automatic stay to be a better reason for treating derivatives differently” (Edwards & Morrison, 2004, p.16). Since the economic essence of the automatic stay is to prevent the premature depletion of the bankrupt company and to ensure the equivalent fulfilment of requirements to all borrowers, the process must provide the opportunity to preserve the value of the debtor. A loaner cannot obtain the debtor’s firm-specific assets but has an opportunity to receive its fungible assets that do not create additional value for the bankrupt. From this point of view, the derivatives operations cannot be cancelled in case this operation reduces the value of the company. As a conclusion, the economic theory of the automatic stay provides a better definition of the conditions that allow specific behaviour in respect of financial derivatives.
The presented ideas find support from other researchers of this problem. Frank Partnoy and David Skeel also find systemic risk to be a weak argument for the derivatives special treatment (Partnoy & Skeel, 2006, p.43). They also find it difficult for non-financial companies to implement the requirements of the Code and cancel the derivatives contracts, “making it much more expensive for the debtor to enter a new hedging contract” (Partnoy & Skeel, 2006, p.44). Partnoy and Skeel state that special treatment for the financial derivatives requires serious reconsideration. Otherwise, the existing procedure can lead to more significant costs for the debtors, since firms use the derivatives as an insurance tool more actively.
Analysis of Key Issues of Financial Derivatives
The Four Horsemen of the Derivatives Regulation
In this study, Frank Partnoy intends to describe the principles of the derivatives market regulation. It is difficult to develop a universal tool of market regulation, due to its scale and variety of financial instruments. Partnoy highlights four general paths of the derivatives regulation, which are common in the world. According to the author, differences between these methods include the principles of legal rules generation.
The legal rules of the International Swaps and Derivatives Association (ISDA) are one of the most common methods of the derivatives private regulation. “ISDA is a global trade association representing the leading market participants in the OTC derivatives industry” (Partnoy, 2002, p.5). This organization provides ex-ante legal private rules of the derivatives market adjustment, which are regarded as a law by its members. A company develops standard documentation for the derivatives.
The National Association of Securities Dealers (NASD) is another institution of the derivatives regulation. This organization provides ex-post legal rules whose task is to judge disputes privately. This tool of regulation allows counterparties to avoid litigation and to resolve the conflict on the basis of the dispute. The negative aspect of private legal rules is the presence of suspicion among the participants that the rules are guided not by the common good, but with its creators’ private benefit.
The Commodity Futures Modernization Act (CFMA) is a set of rules implemented by the Congress to order the derivatives market. The objective of the Congress was to ensure transactions and to avoid systemic risks in the economy. The Southern District of New York (SDNY) court is known as a public means of influence on the derivatives market due to the fact that this region was the basic jurisdiction for disputes on derivatives. Partnoy considers SDNY as a tool of regulation and states that “Judges (from the SDNY) might create rules resembling certain default rules of contract law; such rules would create incentives for derivatives dealers to attempt to contract out of those rules or add arbitration clauses to their ISDA documentation” (Partnoy, 2002, p.36-37).
The Commodity Futures Modernization Act (CFMA)
The CFMA was one of the first ex-ante legal public acts that regulated the derivatives industry based on concepts of government. The significance of the CFMA establishment included a variety of advantages which received a government in control of the market of financial instruments. Since the derivatives market has already achieved phenomenal size and is important in today’s economy, there was an obvious need to establish a uniform set of rules. The objects and advantages of the law were:
· encouraging parties’ engagement in regulatory arbitrage;
· termination of competition between private companies in the creation of market’s regulation methods;
· liquidation of the situation in which private “regulators have created valuable property entitlements, which then further distort financial markets” (Partnoy, 2002, p.16);
· amplification of legal certainty for derivatives transactions;
· reduction of systemic risk and development of greater stability to markets during times of market disorder (D’Souza, Ellis, Fairchild, 2010, p. 493).
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The Dodd-Frank Act and European Market Infrastructure Regulation (EMIR)
The Dodd-Frank Act (DFA) is a legislative tool that affects the current regime of financial instruments’ adjustment. Among the major changes introduced by law, regulating the entrance of derivatives, Morrison & Foerster law company includes: changes to the resolution procedure for financial companies, creation of the Financial Stability Oversight Council (FSOC) to watch financial institutions, increase of control over the market of derivatives, implementation of the Volcker Rule, and significant changes in the securitization market (Morrison & Foerster, 2010, p. 3). The FSOC provided more efficient tools for identifying and responding to the U.S. financial stability risks and encouraged market discipline among financial institutions. The DFA reduced a range of entities, which have not previously been subjected to regulation by state, through the creation of new regulatory agencies and transfer of control functions to the Federal Reserve. The DFA also facilitated the realization of the securitization reform, which afforded reduction of the risks of operations with derivatives. The Volcker Rule limited speculative trading in financial instruments, as this was a threat to financial stability.
In general, EMIR contains principles which are similar to the ideas of the DFA. The differences between the approaches of these institutions to the derivatives regulation are “restrictions on bank proprietary trading, the separation of derivatives business from banking, mandatory exchange trading, and clearing organization ownership rules” (Janda & Rausser, 2011, p. 5). The EU law does not restrict speculative trading in financial instruments. It also does not include exchange trading requirement for derivatives (Janda & Rausser, 2011, p. 5). EMIR also differs in clearing organization ownership rules, which also affect the characteristics of the derivatives regulation (Janda & Rausser, 2011, p. 5).
The Marking to Market and the Trading of Future Contracts Promotion
Marking to market is the evaluation process whose purpose is to determine the futures’ prices at the end of each day. Later profit and loss are settled between the long and the short. This operation allows participants of the market to estimate the perspectives of the futures’ contract from both short- and long-term perspectives. In this case, the parties can choose a trading strategy in the futures market and recognize possible perspectives and risks of different behaviours.
The Central Counterparties (CCPs) for Over-the-Counter Derivatives
The development of central counterparties is intended to reduce the counterparty risks and improve the transparency of financial transactions. The counterparty risk is a serious factor of stability for the market participants and the economy as a whole (Stulz, 2010, p.81). The counterparty risk can be reduced by cleaning operations. Two types of cleaning are CCP and bilateral cleaning (Janda & Rausser, 2011, p. 3). The CCP mitigates the counterparty risk “by interposing itself between counterparties to contracts traded in financial markets” (Elliott, 2013, p. 4). The CCP plays a role of a mediator to oversee the activities of contractors to guarantee their obligations. It performs the multilateral netting, summing each participant’s bilateral net positions with the results of his partners (Cecchetti, Gyntelberg, & Hollanders, 2009, p. 49). The multilateral character of the CCP allows it to mutualize market risk, spreading it among counterparties. The initial margin procedure and the default fund allow CCP to secure counterparties in a situation of the bankruptcy of one of them (Elliott, 2013, p. 5-6).
Another important aspect of the CCP activity is the improvement of the transparency of the derivatives. The transparency aims to “provide regulators with a clearer view of what is going on in the market, enabling them to identify potential problems earlier than before” (Hull, 2014, p. 6). The position of a CCP enables it to stimulate the growth of transparency in relations between counterparties. This position allows CCP to collect “high-frequency market-wide information on market activity, transaction prices and counterparty exposures for market participants who rely on them” (Cecchetti, Gyntelberg, & Hollanders, 2009, p. 51). When CCP centralizes such information, it can provide market players, scholars, and policymakers with data, which will help them to define the development of the financial market and potential risks for its participants. Thereby, providing market transparency by collecting data from the participants, the CCP also reduces the financial and counterparties risks.