Background
U.S. prudential regulators issued the U.S. QFC Resolution Stay Regulations as part of a broader set of regulations devised to tackle the “too big to fail” problem arising from the 2008 financial crisis. The regulations improve the resolvability and resilience of Global Systemically Important Banks (GSIBs) by mitigating the risk that arises from the destabilizing closeouts of qualified financial contracts (QFCs). This article takes a closer look at QFCs, the origins of the U.S. Resolution Stay Regulation, and the remediation options available to firms as regulators ramp up efforts to prevent taxpayer-funded bailouts of GSIBs. A sensible starting point to understand the purpose of this regulation is to analyze the collapse of Lehman Brothers Holdings, Inc. on September 15, 2008.
The Lehman Problem
The absence of Resolution Stay Regulations in 2008 added fuel to the fire when Lehman entered Chapter 11 bankruptcy and began to rapidly unravel. The provisions in the final rules would have equipped U.S. regulators with the authority to impose a suspension — or “stay” — on those counterparties looking to immediately terminate their QFCs or to exercise their cross-default rights (Exhibit A) in response to Lehman entering receivership proceedings.
Despite a large number of Lehman’s subsidiaries remaining solvent and operational, regulators could only look on as counterparties to these subsidiaries began to aggressively exercise their cross-default rights. A liquidity spiral ensued, fire sales were rife, and a severe reduction in capital levels spelled the end for Lehman, sending shockwaves throughout the global banking system.
Scope and Timelines for the U.S. QFC Resolution Stay Regulation
The U.S. Resolution Stay Regulation was introduced as a supplement to Title II of the Dodd-Frank Act, which exists to prevent a disorderly Lehman-type scenario from reoccurring. Regulators are focusing on QFCs because they capture a majority of capital markets transactions that account for the exposure concentrations between large banks. The definition of a QFC is rather broad, but it generally encompasses securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements, and other commonly used financial contracts. The definition of a covered QFC (i.e., in-scope of U.S. QFC Resolution Stay Regulations) excludes agreements where a bank acts in an agency role only and agreements that govern short-term transactions such as FX spot and cash securities deals. Due to sheer volume of covered QFCs, most GSIBs have turned to technology and developed in-house software tools to determine whether a QFC is in scope. For QFCs that are in scope, the tools automate the extraction of relevant terms (governing law, contact details, booking entity, etc.) from the contract. These terms equip a firm’s front office staff to shape their client remediation strategy, ensuring that as many clients as possible remain compliant and eligible to enter into QFC agreements and related transactions.
A firm’s client remediation strategy hinges on the phased-in compliance dates introduced by the regulators in 2017, which places counterparties into three distinct buckets. These counterparties and their respective compliance dates are described in Exhibit B.
Exhibit B
The regulation mandates that if an institution subject to U.S. Resolution Stay Regulations enters into any new QFC with a counterparty on or after January 1st, 2019, remediation on all legacy QFCs is triggered immediately, regardless of any later remediation deadline that may be applicable to that specific counterparty type. As seen in Exhibit B, the regulation allowed another six months to conform covered QFCs with non-GSIB financial counterparties (July 1st, 2019) and one year to conform in-scope QFCs with non-financial counterparties (January 1st, 2020). These compliance dates are staggered to promote an orderly remediation effort and to prioritize the remediation of QFCs between GSIB counterparties, which pose the highest systemic risk. With the first two compliance dates having now passed, all eyes are on non-financial counterparties and January 1st, 2020.
Remediation Options
There are two options for counterparties to remediate their QFCs: (i) bilaterally amend specific QFCs to include compliant U.S. Stay provisions or (ii) take advantage of the ISDA-published 2018 U.S. Resolution Stay Protocol that serves as an “all-in-one” solution for compliance with what is a rather complex regulation. It is worth noting, however, that counterparties have and will continue to be incentivized to pursue the Protocol rather than the bilateral route for two major reasons: 1) signing up is an extremely straightforward process that automatically amends all QFCs and 2) the Protocol offers counterparties some added benefits (think enhanced creditor protections) that will simply not be available to those negotiating bilateral amendments to cherry-picked QFCs. No matter what route is chosen, it is important that all firms seek the advice of counsel concerning the most prudent course of action.
Reflections and the Road Ahead
With GSIBs and financial counterparties having reached their respective compliance dates, non-financial (corporate) counterparties are next up with a January 1st, 2020 compliance date. Until then, however, GSIBs and financial counterparties will have to make a risk-based decision as to whether or not they continue to enter into QFCs with corporate counterparties who have yet to adhere but have made clear their intention to do so before their mandatory compliance deadline. Although there is no single blueprint for achieving U.S. Resolution Stay compliance, firms learned important lessons about their processes and systems used to negotiate, track and monitor QFC agreements. Successful institutions will incorporate these experiences when tackling large-scale legal agreement remediation efforts. Given the pending replacement of LIBOR reference rates, the opportunity to showcase these newly acquired skills may arise very soon.
Why Monticello?
Monticello Consulting Group assists clients across the financial services industry in implementing the necessary infrastructure to ensure compliance and reduce regulatory risks. This experience, coupled with our deep understanding of this regulation’s intricacies and complexities, uniquely positions Monticello to guide financial institutions in the adoption and implementation of the U.S. QFC Resolution Stay Regulations.
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Louis Kassam
Manager