Safe Harbor and the Channels of Systemic Risk #1-8

By protecting banks from credit risk the bankruptcy amendments have the perverse effect of undermining the standard means by which banks protect themselves from risk.  The two most important tools traditionally used by banks to protect themselves are (i) a strong capital base to protect the bank from bankruptcy in the event of unexpected losses and (ii) the careful management of credit risk.  The safe harbor exemptions increase systemic risk by encouraging banks to view themselves as protected in the event of default – this encourages them to greatly increase their exposure to counterparty credit risk and to believe that unexpected losses are unlikely so that they do not need much capital and can operate with a high degree of leverage.

When the repo amendment was passed, it was precisely because dealers were highly leveraged that a bankruptcy could cause a chain of failures and disrupt the market.  Thus it is possible to view development of the repo market in the early 80s critically:  the development of a wholly unregulated financial market had led to excessive leverage and the risk of financial instability.  The market was in need of being protected by regulation in the form of capital and liquidity requirements.  Imposing such requirements on the repo market would, however, have restrained its growth and further increased capital requirements for banks that were already struggling.  There is no evidence that this policy was ever considered.

Instead, the 1984 repo amendment exempted repurchase agreements on Treasuries, Agencies and certificates of deposit from standard bankruptcy procedures.  By guaranteeing that these repos could not be tied up in bankruptcy the law reduced the risks faced by dealers who worked with small liquidity and capital margins and thus encouraged them to operate on a highly leveraged basis.

After the 2005 bankruptcy law was passed granting all repurchase agreements safe harbor, the leverage created by repurchase agreements soared.  Charles Munger describes the situation in an interview:

Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the “repo” system—one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome. The investment banks, to protect themselves, controlled, to some extent, the use of credit by customers that were hedge funds. But the internal hedge funds, owned by the investment banks, were subject to no effective credit control at all.[1]

Effectively after 2005, all securities became liquid assets.  Gary Gorton reports that up through April 2007 most repurchase agreements were not subject to any haircut at all, that is, they were for the full market value of the underlying collateral.[2] A dealer who owned – or borrowed – an investment grade security could use it to raise 100% of its value.  In short, every dealer bank had access to unlimited leverage, not only when investing in safe assets like Treasuries, but even when investing in bonds that were just one step away from junk.  They had speculative margin accounts with no margin.  This was only possible after the passage of the 2005 Bankruptcy Act.

In many ways what happened to the dealer banks in 2008 repeated precisely what had happened to stock market investors in 1929.  Asset values fell at the same time that margin requirements rose.  As borrowing levels became constrained, liquidity dried up and forced asset sales set off a vicious cycle.[3] The IMF explains that this dynamic played an important role in the failures of both Bear Stearns and Lehman Brothers.[4]

The safe harbor amendments not only encouraged financial institutions to become dangerously leveraged, they also encouraged them to become dangerously exposed to each other.  After the 1984 repo amendment was passed, the primary dealers’ financing in the repo market grew from $133 billion in 1984 to $834 billion ten years later, clearly increasing the exposure of the largest dealers to the market.[5] These trends continued at least up through 2007.

It is astounding to note that in 1999 the President’s Working Group recognized the fact that expansions of safe harbor had a tendency to encourage the market to grow bigger, but chose to focus on the benefits of “liquidity” and to ignore the possibility that increasing the exposure of market participants to counterparties could adversely affect systemic risk.  They write:

The ability to net may also contribute to market liquidity by permitting more activity between counterparties within prudent credit limits.  This added liquidity can be important in minimizing market disruptions due to the failure of a market participant.[6]

In short, the President’s Working Group assumed that market participants would keep exposures to a prudent level once safe harbor was in place, even though they had not done so in the absence of safe harbor protection.  After all, if prudent levels of exposure had been the norm before the bankruptcy exemptions were enacted, then the robust early growth of the repo and swaps markets demonstrated that these contracts did not need special treatment in bankruptcy to flourish.  The fact that these markets needed protection after they had already grown large was evidence that banks were not keeping credit within prudent limits before the passage of the laws.

In retrospect it is easy to see that neither repurchase agreements, nor certain derivatives were kept within prudent credit limits.  Bear Stearns was a beneficiary of the growth of repo markets.  The company’s quarterly report ending February 28, 2008, just days before it failed, states that total assets were $399 billion – and that $303 billion had been pledged to Bear as collateral.  Of this amount, Bear had “repledged or otherwise used” $211 billion.  In short, half of Bear Stearns’ balance sheet was financed using repurchase agreements.  That this lending was far from prudent was made clear in the second week of March when Bear was at the very edge of bankruptcy and was saved only by a shot-gun marriage with J.P. Morgan Chase and the assumption by the Federal Reserve of $29 billion worth of asset risk.

AIG is another example of a firm that failed because its counterparties were willing to take on excessive credit risk.  In the case of AIG the problem was credit default swaps.  In September 2008, AIG found that it could not afford to post the collateral required by its derivative contracts.  This failure to honor its contracts would have driven it into bankruptcy, had the government not stepped into the breach.  Given the Bear Stearns and AIG examples one can only conclude that, when the bankruptcy exemptions increased market liquidity, that increase was not tempered by the prudence of the counterparties.

The failures of Bear Stearns and AIG may have been exacerbated by the fact that the bankruptcy exemptions encourage counterparties to demand overcollateralization of their positions.  As the President’s Working Group observed in reference to the Long Term Capital Management (LTCM) collapse:

If its collateral holdings did not reflect potential future exposure, then a firm selling collateral provided by LTCM in the event of a default would still have been exposed to the difference between the value of the collateral and the value of the closed-out financial contract at the time the collateral was sold.[7]

In fact one of the recommendations of the report on LTCM is that banks should consider requiring that “potential future exposure” be collateralized – or in other words that current positions be overcollateralized.[8]

To understand the problem of overcollateralization it is important to recognize how profoundly bankruptcy law is weakened by the safe harbor exemptions.  Standard bankruptcy procedure guarantees that a secured lender gets the lesser of the amount due on the loan or the value of the collateral plus an unsecured claim for the remainder of the loan.  If a loan is overcollateralized the bankruptcy trustee has the right to reclaim the excess amount for the benefit of the other creditors.[9] By contrast, safe harbor protections allow the lender to seize collateral – and it’s not obvious that the trustee is in a position to determine whether or not excess collateral was posted.  While this already undercuts the very principles of bankruptcy, the safe harbor privileges go further:  even if the transfer of collateral was fraudulent, as long as it was received in good faith, the other creditors in a bankruptcy action have no rights to it.[10]

In short the safe harbor laws are deliberately structured to encourage counterparties to demand that their positions be overcollateralized – especially when the danger is growing that a firm will in fact declare bankruptcy.  The legal protection of overcollateralized derivative positions creates two problems:  first, it interferes with the principles of fairness that bankruptcy laws are designed to protect and, second, it may have systemic implications.

Consider what happened in each case when Bear Stearns, Lehman Brothers and AIG were about to fail.  Repo counterparties refused to roll over the contracts or derivative counterparties sought additional collateral.  It is precisely because of the strong protections for collateral that counterparties are so aggressive in their demands.  According to lawyers interviewed by the Financial Times “under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.”[11] In the modern financial regime, the demands of counterparties ensure that as soon as bankruptcy is suspected, failure becomes a certainty: no counterparty wants to be the one that didn’t demand collateral or withdraw its repurchase agreements fast enough.  Without the extraordinary privileges granted by the safe harbor protections, counterparties would be much more reluctant to force a firm into bankruptcy.


[1] Stanford Lawyer, Spring 2009, p. 17  http://www.law.stanford.edu/publications/stanford_lawyer/issues/80/pdfs/sl80_munger.pdf

[2] Gary Gorton, Dec 31 2008, “Information Liquidity and the (Ongoing) Panic of 2007,” p. 10. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1324195

[3] Gorton, 2009, pp. 33 – 38 has a thorough description of this process in the 2008 repo market.  For the 1929 crisis see J.K. Galbraith’s The Great Crash.

[4] IMF, “Assessing risks to global financial stability,” Global Financial Stability Report, Oct 2008, p. 25. http://www.imf.org/external/pubs/ft/gfsr/2008/02/pdf/chap1.pdf

[5] Data from Federal Reserve Bulletin.  Available at http://fraser.stlouisfed.org/publications/frb/page/31488 The number of dealers doubled from the 1960s to the late 80s and declined from the late 80s onward.  http://www.newyorkfed.org/aboutthefed/fedpoint/fed02.html

[6] PWG, p. 20.

[7] President’s Working Group on Fin. Mkts., Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (1999)  http://www.treas.gov/press/releases/reports/hedgfund.pdf, p. 21.

[8] PWG, p. 34

[9] Kettering, p. 1599-1600.

[10] PWG p. E4.

[11] Francesco Guerrera, Nicole Bullock and Julie MacIntosh, Oct 30 2008, “Wall Street ‘made rod for own back’” Financial Times.

Do the Safe Harbor Protections Increase Systemic Risk? #1-7

To analyze whether or not the safe harbor amendments increase systemic risk, let me present a model of systemic risk that differs from the one presented by the President’s Working Group in the quote above.  I assume that the banks are best suited to evaluate each other’s business practices. Then in order to reduce systemic risk, a regulator’s goal should be to take advantage of the banks’ superior knowledge of the business.

When banks lend to other banks on a secured basis, they are protected from losses and may be willing to do business with unsound counterparties.  By contrast, when banks lend to other banks on an unsecured basis, they are not protected from losses and will reduce exposure at the first sign that a counterparty is poorly managed.  Thus, when banks lend to each other on an unsecured basis, lending by the banking system to unsound banks will be small; and when banks lend to each other on a secured basis, lending by the banking system to unsound banks may be quite large.  Systemic risk will be much higher when the activities of banks that mismanage risk are not curtailed by counterparties but are in fact facilitated and allowed to grow.  Since the finance of unsound banks facilitates mismanaged risk, my model indicates that systemic risk will be high when secured interbank lending is the norm and will tend to be low when most interbank lending is unsecured.

The exemptions for financial contracts adopted in the 2005 Bankruptcy Act are extremely broad.  They guarantee to banks that, as long as they have required sufficient posting of collateral on their contracts, they are fully protected from loss.[1] This law would address the problem of systemic risk, only if it were the case that protecting the banking system from losses was the best way to protect it from systemic risk.  In fact, however, banks are specialists in managing credit risk and thus being exposed to losses due to credit risk is an essential aspect of the services a bank provides to the economy.  For this reason it is not clear that a policy of protecting banks from losses due to credit risk is consistent with the role played by banks in the economy.

In my model, unsecured interbank lending reduces systemic risk, because it increases the credit risk faced by banks and forces them to monitor their counterparties carefully.  Thus, this model is consistent with the view that a principal banking function is to manage credit risk.  This approach to banking indicates that the safe harbor exemptions to the bankruptcy code may have increased systemic risk by encouraging banks to lend to each other on a secured basis.  To test this model against the data, we would want to know, first, whether we see in the data an increase in secured lending after the safe harbor exemptions are passed and, second, whether there is any evidence to support the view that systemic risk increased after the passage of these laws and the increase in secured interbank lending.

The evidence indicates that the use of both repurchase agreements and of collateralized derivatives has increased dramatically since the passage of the safe harbor amendments.  In the 1983 hearings on safe harbor for repurchase agreements the market was estimated to be several hundred billion dollars daily with more than $100 billion in prime dealer repos.[2] More recently the repo market has been estimated to be about $12 trillion with the prime dealers accounting for $4.2 trillion in early 2008.[3] Thus, over the past 25 years the repo market has grown on average about 15% per year.

The swaps market also grew extremely quickly.  In 1989 interest rate and currency swaps totaled $2.5 trillion.  By the end of 2008 there were $403 trillion of these contracts outstanding.  The average annual growth rate over this 19 year period was more than 30%.  The growth rate of credit default swaps was, however, most astounding.  Data on credit default swaps was first reported in 2001 when they amounted to less than $1 trillion in notional value.  By the end of 2007 the market had grown to $62 trillion.[4] The size of the market for credit default swaps almost doubled every year for six years.   Given that these contracts barely existed in the 1970s, the rate of growth in the swaps market is truly remarkable.

While repurchase agreements are always collateralized, whether or not collateral is posted on derivatives contracts depends on the details of the contract in question.  Some parties have to post collateral to cover the full amount owed – hedge funds generally fall into this category.  Others post collateral only if the value of the contract moves against them by more than some threshold amount – the dealer banks are an example.[5] For example in November 2007 AIG had contracts with Merrill Lynch with thresholds of 8%, meaning that the value of the swap had to fall to 92% of the initial value before AIG had to post collateral.  At the same time Goldman Sachs had 4% thresholds on their swaps with AIG.[6]

Because the collateral terms of every derivative contract can differ, the use of collateral for derivatives contracts is estimated using surveys.  The results from these surveys are published by the ISDA.  From 2000 through 2006 collateral use grew along with the derivatives market itself.  However in 2007 and 2008 the use of collateral increased even as the derivatives markets themselves finally stopped growing.  The increased use of collateral in recent years is due in part to changes in the terms of the contracts themselves and in part to the fact that there have been dramatic shifts in the value of many contracts, thus increasing the number of contracts that have crossed a threshold for posting collateral.[7] We can safely conclude that there was indeed a large increase in secured interbank lending after the safe harbor amendments were passed both because of the growing use of repurchase agreements and because the use of collateral grew along with the derivatives market.

The evidence is also consistent with the view that systemic risk increased after the passage of the bankruptcy amendments:  after all the greatest financial crisis in three-quarters of a century took place just a few years after the 2005 amendment widened the scope of the bankruptcy exemptions dramatically.  While correlation is not causation, the sequence of events is indeed consistent with the view that the bankruptcy amendments caused a dramatic increase in secured interbank lending, which facilitated the operation of financial institutions that mismanaged risk.  It was the failure of these institutions – Bear Stearns, Lehman Brothers, AIG – that caused the crisis and set off the systemic risk event.


[1] Remarkably, they are protected even if the transfer of collateral was fraudulent as long as the collateral was received in good faith. (President’s Working Group on Fin. Mkts., Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (1999), p. E-4)

[2] 1983 repo data from Kettering, 2008, note 287.  Data on prime dealers from Federal Reserve Bulletin.  Available at http://fraser.stlouisfed.org/publications/frb/page/31488.

[3] Gary Gorton, Dec 31, 2008, “Information Liquidity and the (Ongoing) Panic of 2007,” p. 8 (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1324195) and Federal Reserve Bank of New York.

[4] http://www.isda.org/statistics/pdf/ISDA-Market-Survey-results1987-present.xls

[5] Gary Gorton, 2009, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007”, p. 11. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882&rec=1&srcabs=1404069

[6] AIG internal collateral memo:  http://www.cbsnews.com/htdocs/pdf/collateral_b.pdf

[7] ISDA  http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2009.pdf
In 2003 only 30% of over the counter derivatives contracts required that collateral be posted when the contract moved against the counterparty and by 2009 65% of the contracts were collateralized.

The Reasoning Behind the Safe Harbor Protections #1-6

In every case when a law was passed granting derivatives safe harbor from the Bankruptcy Code, the stated goal of the law was to protect the financial system from systemic risk.  The basic concern is that when collateral is locked up in a bankruptcy court, it cannot be sold.  This generates a major problem for financial firms, because the collateral pledged in derivatives contracts is not held in trust, but is treated as the temporary property of the recipient.[1] The recipient has the right to lend or sell the collateral and the obligation to replace the item with its equivalent.  Thus in financial markets collateral is a liquid asset.   For this reason the firm with a claim on collateral that is tied up in bankruptcy court will face not only the market risk that the collateral falls in value before it is sold, but also a decline in liquid assets while the collateral is tied up in bankruptcy.  The decline in liquid assets can cause a counterparty to be unable to pay its bills and thus the first bankruptcy may cause one or more subsequent bankruptcies.  Furthermore, there is some possibility that the decline in value of collateral while it is tied up in bankruptcy could cause losses that would bankrupt a firm.  In short, there is concern that standard bankruptcy procedure can cause a chain of failures in derivative and repo markets.

To understand why the repo amendment was passed in 1984, recall that in the early 1980s the banking system was not in robust health:  the high short-term interest rates of the previous years had decimated bank profitability, competition with new financial products like money market funds and junk bonds further reduced profits and the Latin American debt crisis left some of the largest banks with crippling losses.  Under the circumstances the Fed had a strong interest in avoiding any further stresses on the system.

Repurchase agreements were an important tool used by the banks to adjust to the new competitive environment where funds that had once flowed directly into bank deposits were going to money market funds instead.  One of the ways that the banks dealt with the funding drain was by borrowing from money market funds using repos.  Another was by issuing term deposits in the form of Certificates of Deposit (CDs).  Money market funds and firms that had tied their cash up at a bank for six months in a CD could have immediate access to the funds by using the CD as collateral in a repo.  Finally some of the larger banks earned fee income by acting as dealers in the repo market.  In short, in the absence of a growing market in repurchase agreements, the banks would have found it far more difficult to adapt to the challenge of competing with money market funds for deposits.

Thus constraining the growth of the repo trade in its early years would have undermined bank profitability at a time when banks needed profits to restore their financial health.  There was genuine concern that if a bankruptcy as large as Drysdale’s locked repo collateral up for weeks, some of the smaller dealers could be driven into default by the resulting liquidity squeeze. This could lock yet more collateral up in bankruptcy and the whole process could only hurt the banking system.  For these reasons, the Fed was the most influential advocate of safe harbor for repurchase agreements.

During the hearings on the repo amendment in 1983, an assistant secretary of the Treasury brought up the fact that safe harbor privileges are in conflict with a fundamental principle of bankruptcy law, that creditors be treated equally.[2] This concern was outweighed by Fed Chairman Paul Volcker’s testimony that the bankruptcy protections were necessary because the repo market was a critically important financial market which could be destabilized by a string of failures.[3] Volcker emphasized the importance of limiting the repo protections to those segments of the repo market that were large enough to be systemically important.[4] Thus, in 1984 a conscious decision was made to generate an injustice in the interests of protecting the greater good.  A factor that was, perhaps, overlooked at the time was that this decision set a precedent.  We find that these difficult issues are rarely raised in subsequent discussions of the bankruptcy exemptions.

While derivatives contracts also face the market and liquidity risk created by having collateral tied up in bankruptcy, the strongest argument in favor of special treatment for derivatives is that clearly defined netting procedures protect against systemic risk.  Under normal bankruptcy procedures, in theory, a judge could permit a receiver to look at the list of recent contracts between the bankrupt firm and a counterparty and choose to avoid all of the contracts on which the firm owes money and not those where the counterparty owes money.  In short, rather than netting the contracts an attempt could theoretically be made in bankruptcy to force a counterparty to honor all of its gross obligations.  Such an outcome would be highly likely to result in a chain of failures.  Thus, there can be little doubt that precise, legally enforceable netting procedures are essential to financial markets.  What is not clear, however, is that such clearly defined netting must take place beyond the supervision of a bankruptcy court.  If there is a defined procedure that every bankruptcy judge must approve, the solvent counterparty will be able to reliably calculate net exposure and market and liquidity risk will only affect this net exposure.

Recent arguments in favor of exempting swaps and other derivatives from bankruptcy leave it  far from clear that the principal concern is really systemic risk – there is a tendency to emphasize the fact that safe harbor protects the dealers from losses due to credit and market risk.  For example, Michael Krimminger, Senior Policy Advisor to the FDIC, states that, while the effects of safe harbor on systemic risk are open to debate, the real advantage of these laws is that they make it easier for financial institutions to manage risk.

Congress, regulators, and market participants have been concerned that if parties to these contracts are unable to enforce their rights to terminate financial market contracts in a timely manner despite their counterparty’s insolvency, to offset or net payment and other claims under the contracts, and to use pledged collateral to cover any amounts due, the resulting uncertainty and potential lack of liquidity could increase the risk of broader market disruption.

While these broader concerns can be debated, effective risk management of financial market contracts requires the ability to fix the credit and market risk through enforceable rights to terminate and net exposures at the time of insolvency. … [S]ince 1978 both the Bankruptcy Code and the FDI Act have gradually adopted broad protection for financial market contracts. Today the breadth of those protections provides confidence in market participants that their risk mitigation efforts can be successful to limit their risks even if insolvency of their trading partner occurs.[5]

This argument indicates that the sophisticated hedging strategies that are used by large financial institutions to manage risk would be rendered ineffective by having assets locked in bankruptcy proceedings (presumably because such hedging requires positions to be adjusted on a daily – or even hourly – basis).  On the other hand, it is not at all clear that making it easier for financial firms to manage risk is a legitimate purpose of the bankruptcy code.  After all easy risk management may induce firms to feel comfortable with lower levels of equity capital, thus reducing the firm’s ability to survive adverse events.  In short, easy risk management may increase rather than decrease systemic risk.

Further evidence that safe harbor exemptions are not really focused on protecting the economy from systemic risk is to be found in the President’s Working Group’s explanation of the exemptions:

[T]he U.S. Bankruptcy Code makes an exception to the automatic stay with respect to contractual rights to net and closeout positions in certain financial contracts in the event of default.… In the event of default, these rights, in general, contribute to the stability of markets as a whole by reducing the potential size of credit exposures and thus lowering the probability that the inability of one market participant to meet their obligations will cause others to be unable meet their obligations (i.e., domino effects). [6]

Here the regulators argue that every decrease in credit risk results in a decline in systemic risk.  It’s somewhat disturbing that there is no effort to focus on the larger participants in these markets or use other means to determine more precisely the characteristics of those losses that are likely to result in systemic risk.  After all it’s hard to believe that having a few contracts tied up in the bankruptcy of a trivial player in derivatives could result in a chain of failures – and yet current law grants counterparties to these transactions safe harbor.[7] Thus, the quote above implies that exemptions to the bankruptcy code are granted for the simple reason that they serve to protect financial institutions from losses due to credit risk.[8]

The regulators justify the bankruptcy exemptions by deploying an implicit model which posits a linear relationship between credit losses at financial institutions and systemic risk – without explaining the foundations of their belief in this relationship.  Edwards and Morrison conclude that this justification must be a red herring.[9] There is very little evidence that anyone was focusing his or her attention on the key questions:  What is the nature of systemic risk and how do we mitigate it?  Instead, the regulators simply assume that if they can keep the banks from experiencing losses, they will be addressing systemic risk.

This view is disturbing given the inequities created by the bankruptcy exemptions.  Neither Michael Krimminger nor the President’s Working Group on Financial Markets’ extensive analysis of the treatment of financial contracts in bankruptcy discusses explicitly the fact that safe harbor provisions grant financial institutions privileged treatment over other creditors.  This indicates that by 1999 when the Working Group’s report was published these privileges had become so established that they were the norm and that there was no longer any need to explain the injustices associated with them.


[1] To use technical language, the collateral can be rehypothecated.  In fact, this is true only of over-the-counter derivatives.  Collateral posted for exchange-traded derivatives is held in trust.

[2] Gary Walters, 1984, “Note: Repurchase Agreements and the Bankruptcy Code,” 52 Fordham Law Rev. p. 847.

[3] Gary Walters, 1984, “Note: Repurchase Agreements and the Bankruptcy Code,” 52 Fordham Law Rev. p. 847.

[4] Quoted in Kenneth Garbade, “The Evolution of Repo Contracting Conventions,” NYFRB Economic Policy Review, May 2006, p. 36.

[5] Michael Krimminger, 2006, “The evolution of US insolvency law for financial market contracts”  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=916345

[6] President’s Working Group on Fin. Mkts., Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (1999), p. 19.  This source is referenced to below as PWG.

[7] Franklin Edwards and Edward Morrison (2004) “Derivatives and the Bankruptcy Code:  Why the Special Treatment?” Columbia Law and Economics Paper no. 258, p. 8.  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=589261
Steven Lubben, 2008, “Derivatives and Bankruptcy: The Flawed Case for Special Treatment,” http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1265070 also struggles to understand the reasoning behind the breadth of the Bankruptcy Code’s exceptions for derivatives, although his focus is on the distinction between contracts used for speculation and those used for hedging. In his view in a typical Chapter 11 the exceptions “represent little more than a wealth transfer to the financial institutions that stand on the other side of these swaps.”

[8] Kenneth Kettering, 2008, “Securitization and its discontents,” Cardozo Law Review, p. 1651 makes the same point.

[9] Edwards and Morrison (2004), p. 4.

The No Derivative Left Behind Act of 2005 #1-5

With the 1998 failure of Long Term Capital Management the major derivatives dealers realized that there were still many limitations on their ability to keep derivatives transactions out of bankruptcy court.  In particular, the safe harbor privileges had been granted in separate laws and thus for each type of contract (i.e. futures, forwards, securities, repurchase agreements and swaps) there was a distinct right to offset a bankrupt individual’s margin against his obligations. Clearly safe harbor protections would be stronger if it were possible to offset the positions in the various derivative contracts against each other.  Thus an important purpose of the financial contracts section of the Bankruptcy Act of 2005 was to guarantee the right to set off obligations across different types of derivative contracts.

Protection for cross-product netting was achieved by adding master netting agreements to the list of contracts granted safe harbor.  Master agreements permit counterparties “to document a wide variety of securities contracts, commodities contracts, forward contracts, repurchase agreements and swap agreements” in a single contract.[1]

The fact that somewhat different protections were offered to each different type of derivative contract could also interfere with smooth operation of a cross-product netting process.  For this reason the Bankruptcy Act of 2005 broadened the specific safe harbor protections granted to the different contracts so that they would be uniform.  For example, the contractual rights that were exempt from bankruptcy were expanded for futures, forwards and securities to include the broader rights that had been granted to repos and swaps, that is, rights arising “under common law, under law merchant, or by reason of normal business practice.”[2]

Another obstacle that could interfere with cross-product netting was the development of new derivatives.  The financial industry was concerned that the law would always be a step behind the process of financial innovation and thus that yet-to-be-developed derivatives would be left out of the cross-product netting regime.  For this reason, two clauses in the 1990 definition of a swap contract that made it very broad were added to the definitions of commodities, forward, repurchase and securities contracts.  Thus, the definition of each contract incorporates “any other agreement or transaction that is similar to an agreement or transaction referred to” in the definition and “any combination of the agreements or transactions referred to” in the definition. [3]

The 2005 Bankruptcy Act also expanded the safe harbor protections for repurchase agreements dramatically.  Recall that since 1984 safe harbor had been granted only to repos on Treasuries, Agencies, CDs and bankers’ acceptances.  Now, any repo on a stock, bond, mortgage or other securities contract is defined to be a securities contract and thus eligible for safe harbor as a securities contract.[4] Furthermore, the definition of a repurchase agreement was expanded to include repos on “mortgage related securities”.  This latter revision makes repos on synthetic mortgage assets – in other words repackaged swaps that reference one or more mortgages – eligible for safe harbor.

While each of the individual changes to the categories of derivatives exempt from the bankruptcy code appeared minor, in aggregate the changes are dramatic.  Prior to 2005, safe harbor for securities was only available if the contractual right in question was granted by the rules and bylaws of a self regulating organization.  After 2005 any right negotiated bilaterally in a securities contract was granted safe harbor and the term securities contract was redefined to include the purchase and sale of residential mortgages and repurchase agreements on stocks, bonds and mortgages.  These changes granted safe harbor to huge swathes of over-the-counter transactions that had never before had this protection including:  cash CDOs, mortgage backed securities and repurchase agreements on securities contracts.  The breadth of the definitions made it easy to develop new financial products that would also be protected from the bankruptcy code.  Furthermore, because the term repurchase agreement was redefined to include mortgage related assets, even repos on synthetic mortgage backed securities and synthetic CDOs with mortgage exposure were granted safe harbor.  The House report on the bill gives no indication that Congress understood that safe harbor was being expanded to repos on synthetic assets.

Pause for a moment to think about the implications of these changes.  Repurchase agreements are a standard component of any broad measure of the money supply.  It is now possible for a bank to write a swap that functions like an insurance contract on the returns of a mortgage security, to package that swap into a synthetic security and then to use the synthetic security as collateral to borrow money in a repurchase agreement.  Thus, the 2005 law encourages the monetization of synthetic and cash securities in repo markets, because if the bank goes bankrupt, then the repo counterparty’s claim has far greater privileges in bankruptcy than that of a bondholder – with careful management of collateral the repo counterparty can be all but certain of being paid in full.  It isn’t clear that anybody in Congress gave much thought to the consequences of monetizing derivatives contracts – or for that matter of monetizing junk bonds.

It’s unfortunate that no statistics are collected on the size of the private sector repo market, because it seems likely that the market grew at an astounding pace after the 2005 Bankruptcy Act was passed, granting safe harbor protections to repos on over-the-counter securities and synthetic assets.

The breadth of the expansion of safe harbor in 2005 cannot be understated.  For example, the definition of securities contract now includes “any margin loan.”  This is explicated in the House report as follows:

The inclusion of “margin loans” in the definition is intended to encompass only those loans commonly known in the securities industry as “margin loans,” such as … arrangements where a financial intermediary—a stockbroker, financial institution, financial participant, or securities clearing agency—extends credit in connection with the purchase, sale, carrying, or trading of securities.  “Margin loans” do not include, however, other loans that happen to be secured by securities collateral. [5]

Notice that the only distinction between a “margin loan” that qualifies for safe harbor and an economically equivalent loan that does not qualify is the terminology used by the securities industry.  In other words, Congress has ceded to members of the financial industry the right to determine which secured contracts qualify for exemption from bankruptcy laws.  We find a similar problem with swaps.

The 2005 Act clarified the definition of a swap agreement by explicitly including equity, credit and total return swaps.  Presumably others noticed that the definition of a swap was quite broad, because the text that read “or any other similar agreement” was deleted and replaced with the following:

[Swap agreement means]… any agreement or transaction that is similar to any other agreement or transaction referred to in this paragraph and that (I) is of a type that has been, is presently, or in the future becomes, the subject of recurrent dealings in the swap markets … [and (II) has a value that depends on a future rate, price or other contingency.][6]

The simple fact is that all financial contracts involve some kind of future payment and thus all of them have a value that can be viewed as contingent on future money market rates.  Given that total return swaps, for example, can mimic the returns of any financial asset, it is unlikely that any financial asset will fail to be “similar” to some kind of swap.  And we are left with a single criterion to distinguish a swap agreement from any other financial asset:  whether it is the “subject of recurrent dealings in the swap market”.  In the 2005 Bankruptcy Act definition of a swap, the dealer-banks have been granted the authority by Congress to exempt from the bankruptcy laws just about any financial contract.  The only requirements are that they call the contract a swap and that there are enough interested dealers to make a market in it.[7]

The House report on the bill shows some recognition that the definition of a swap is overbroad.

The definition of “swap agreement” in this subsection should not be interpreted to permit parties to document non-swaps as swap transactions. Traditional commercial arrangements, such as supply agreements, or other non-financial market transactions, such as commercial, residential or consumer loans, cannot be treated as “swaps” under … the Bankruptcy Code because the parties purport to document or label the transactions as “swap agreements.”[8]

It is remarkable, however, that the only concern evidenced in the report is that the swap definition could be used to exempt non-financial market transactions from the bankruptcy code.  The fact that the biggest players in the financial industry will be able to exempt whatever transactions they so choose from bankruptcy is apparently acceptable to Congress.

Based on this evidence, Michael Krimminger, Senior Policy Advisor to the FDIC, concludes that “since the purpose of the special protections is to prevent systemic risk from the interconnected nature of actively traded markets, … the substance of the transaction – whether the agreement is a financial market contract rather than a commercial or normal credit transaction – matter[s] in defining protected contracts.”[9] Setting aside the unusual use of the term “substance” in a manner that ignores the economic substance of the transaction,[10] Krimminger makes it clear that there is a population of individuals who think that policy should exempt financial market contracts from bankruptcy law.  What is most interesting about this approach is that it is completely inconsistent with the purpose of the initial 1978 bankruptcy exceptions.  Special protections were granted to exchange traded derivatives and commercial contracts for future delivery.  Forward contracts were included precisely because they were not financial in nature.  In fact, at the time the 1978 bankruptcy law was passed, financial contracts for future delivery had to be traded on an exchange; otherwise they violated the terms of the Commodities Exchange Act.

We have transitioned over a period of thirty years from an environment where over the counter trade in financial contracts for future delivery was illegal to an environment where the same contracts are granted privileged status under the Bankruptcy Code.  What motivated this change?


[1] Hance, p. 756 quoting the House Report on BAPCPA, H R Rep no 109-31, p. 131.

[2] House Report on BAPCPA, H R Rep no 109-31, p. 133.

[3] The Bankruptcy Code with revisions marked is available here:  http://www.law.ttu.edu/lawlibrary/library/research/BAPCPA_Library/code-01.htm#101.50
http://www.law.ttu.edu/lawlibrary/library/research/BAPCPA_Library/code-07.htm#741.7

[4] Note that forward contracts included repos on commodities before the 2005 amendment.  The House Report (No 109-31, p. 130) indicates that the stated purpose of the incorporation of repos into securities contracts was to eliminate any doubt “as to whether a repurchase or reverse repurchase transaction is a purchase and sale transaction or a secured financing”.  The comments do not reflect the fact that this is a dramatic expansion of safe harbor protections.

[5] H R Rep No 109-31 p. 130  http://www.law.ttu.edu/lawlibrary/library/research/BAPCPA_Library/house-report-109-31-001-010.htm

[6] Available here:  http://www.law.ttu.edu/lawlibrary/library/research/BAPCPA_Library/code-01.htm#101.50
Quoted in Hance, p. 755.

[7] Others have noted this problem:  From Edward Morrison and Joerg Riegel, 2005, “Financial Contracts and the New Bankruptcy Code,” 13 American Bankruptcy Institute Law Review, p. 664:  “Equally important, the amendments limit judicial discretion to assess the economic substance of financial transactions, even those that resemble ordinary loans or that retire a debtor’s outstanding debt or equity.”  Kettering, p. 1712 states “Read literally this language cedes the content of the definition to the players in the market.”

[8] H R Rep No 109-31 p. 128-129, cited in Hance, p. 755 and in Kettering, p. 1712.

[9] Michael Krimminger, 2006, “The evolution of US insolvency law for financial market contracts”, p. 21.  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=916345

[10] Other commentators describe this differently:  “Judges are discouraged from engaging in ‘substance over form’ analysis. The new definitions are pure form; they protect transactions that fit within formal definitions developed in the marketplace. The role of the judge is to identify these industry definitions. If the contract fits the form, it’s protected.”  (Edward Morrison and Joerg Riegel, 2005, “Financial Contracts and the New Bankruptcy Code,” 13 American Bankruptcy Institute Law Review, p. 664.)

Extending Safe Harbor to Swaps #1-4

Through the 1980s the market in a new type of derivative called a swap was growing.  The first swap was a currency swap:  IBM was receiving regular payments in Swiss francs which it needed to convert to dollars, while the World Bank was receiving dollar payments and had obligations in Switzerland.  The two parties contracted to exchange their Swiss francs for dollars and vice versa.

The most common swap contract both in the 80s and today is the interest rate swap, where one party pays a floating interest rate (which can change and is based on a money market rate) on a regular basis over a period of years and receives regular payments from the other party based on a fixed rate that is set at the start of the contract.  Such contracts are very useful for banks that have sold fixed rate loans and wish to protect themselves against the possibility that the money market rate rises.

The defining characteristic of a swap contract is the trade of a fixed stream of payments for a stream of payments that will be determined by future prices or events in financial markets.  Swaps were considered a new category of financial contract that did not fall directly under the jurisdiction of any of the existing self regulatory organizations supervised by the SEC.

Instead of extending the purview of one of the existing self regulatory organizations to cover swaps, a consortium of dealer banks chose in 1985 to create a new trade group to coordinate swap policy, the International Swap Dealers Association or ISDA.  Thus, through the 1980s the swaps market was unregulated:  they were not, for the most part, considered securities by the SEC, and the CFTC allowed them to fall through the forward contracts exemption of the Commodities Exchange Act.  Their unregulated status was confirmed in 1993 by formal CFTC exemption from regulation. [1]

The repo amendment to the Bankruptcy Code had established the principle that the imprimatur of a self regulatory organization was not necessary for a financial contract to receive safe harbor; exemption from bankruptcy was possible even for unregulated financial contracts.  Thus when the financial industry sought safe harbor privileges for swaps contracts they did not seek the status of a national securities association for the ISDA – which would have granted swaps the same privileges as other securities under the 1982 amendment.[2] Instead the ISDA lobbied Congress to pass an exemption from the Bankruptcy Code specifically for swaps.  The ISDA and other lobbyists argued that the law favored exchange traded derivative contracts by granting them privileges that were not available to over the counter derivatives like swaps.[3] In short, they called for unregulated financial derivatives to receive the same treatment as regulated financial derivatives.

In 1990 the swaps amendment to the Bankruptcy Code was passed.  As with the repo amendment the safe harbor protection for swaps employed extremely broad language:  the amendment extended to any contractual right arising “under common law, under law merchant, or by reason of normal business practice, whether or not evidenced in writing.”[4] From 1990 on swap market participants were, thus, permitted to seize the margin posted by a bankrupt counterparty, to sell off the counterparty’s positions and to set off the value of the bankrupt’s margin against the obligations owing to the swap participant.  The broad terms of the amendment granted a large class of financial contracts special status in bankruptcy.

After the 1990 amendment was passed, the swaps market grew steadily for the next decade and a half.  In 2008 the dollar amount of interest rate and currency swaps had grown to more than 400 times what it had been in 1987. [5] The swaps market also grew as new products were developed that simulated the returns of tradition financial contracts.  Credit default swaps are synthetic bonds:  one party receives regular interest payments in exchange for paying out the value of an underlying bond if it goes into default.  These swaps can function as bond default insurance, since the other side of this trade makes regular payments in exchange for a guarantee that the face value of the bond will be paid even after the bond goes into default.  Equity swaps are synthetic stocks:  one party receives a payment (or periodic payments) based on the performance of a stock or stock index and makes payment(s) based on the money market interest rate.  The other equity swap counterparty then gets the return of a short seller, he will lose the value of any increase in the value of the stock and gets the proceeds from investing the cash gained by selling borrowed stock in a money market account.  Total return swaps are similar but can be used to simulate the returns of any asset.

While these swaps are often called synthetic assets, there is an important difference between a synthetic asset and a real asset:  real assets require an upfront payment to purchase the asset, whereas synthetic assets have no upfront payment and involve instead a promise to make payment in the future.  Thus while an investor in a real bond must come up with, say $10,000, to purchase the bond, the investor in a synthetic bond pays nothing unless the underlying bond defaults – at which point the investor will have to pay the $10,000.  In theory, then, synthetic assets are infinitely leveraged investments (that is, the investor puts no money down at all).  In practice every investor – with the exception of the dealer banks – is required to post margin when entering into a synthetic investment and this reduces, but by no means eliminates, the degree of leverage involved in the transaction.  It remains unclear to what degree the dealer banks post margin on their trades – which leaves open the possibility that their positions in the swaps market are extremely leveraged.

Another concern raised by swap market developments is that when one considers the variety of swaps that have been created to date – currency swaps, interest rate swaps, credit default swaps, total return swaps, equity swaps – one realizes that there are few financial contracts that cannot fit under the umbrella term “swap”.  It is true that traditional investments like stocks, bonds and mortgages require a large upfront payment, rather than the large tail end payment that is common in the swaps market;  however, given that extremely asymmetric payments are an integral part of the swaps market, it’s far from clear why the time sequence of asymmetric payments should be sufficient to preclude the reclassification of traditional investment vehicles as swaps.  Furthermore, if the distinction is that with stocks and bonds one party has no future obligation to make payments, then the simple expedient of either allowing settlement to take place one week after the trade date or of offering to sell the stock or bond on an installment basis (adjusted, of course, by the money market rate) will turn the traditional asset into a swap.[6]

Given the fact that the overarching term “swap” can apparently encompass most financial contracts, the legal definition of a “swap” is a matter of some importance.  This definition was amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, discussed below.


[1] However in a regulatory action in 1994 against Bankers Trust Securities Corp. the SEC did claim that some swaps were securities.  This position was very much the exception rather than the rule.  (Carolyn Jackson, 1999, “Have you hedged today?” 67 Fordham Law Review, p. 3223)

[2] The definition of a security in the Securities Acts of 1933 and 1934 is broad enough to include swaps, if the swaps dealers had wanted the designation.  (Olander and Spell, “Interest rate swaps,” 45 Maryland Law Review, 1986, p. 53)  However, since that would subject them to regulation by the SEC, they argued that swaps were not securities and the Gramm-Leach-Bliley Act  (2000) explicitly amended the Securities Acts to exclude swaps from the definition of securities.

[3] “Over the counter” refers to trade that takes place in a decentralized manner and is coordinated by dealers.  Karen Ramdhanie, “Derivatives contracts of insolvent companies,” 18 New York Law School Journal of International and Comparative Law, 1999, p.299

[4] Hance, p. 746.

[5] Data from ISDA http://www.isda.org/statistics/pdf/ISDA-Market-Survey-results1987-present.xls.

[6] Note that even spot transactions have a settlement several days in the future, so all financial transactions are in some sense forward transactions.  Furthermore, the definition of swaps contract has always explicitly included spot foreign exchange agreements.  The text of the law with revisions indicated is available here:  http://www.law.ttu.edu/lawlibrary/library/research/BAPCPA_Library/code-01.htm#101.50

Extending Safe Harbor to Repos #1-3

The first unregulated financial contract to be granted safe harbor was the repurchase agreement (or repo).  Two parties enter into a repurchase agreement when a security is sold and simultaneously the parties agree to reverse the transaction at a specific future date and price.  Thus, a repo transaction is comparable to a secured loan; in fact, repo contracts typically include a mark-to-market clause requiring additional margin if the value of the security falls below the value of the loan.  On the other hand, the repo transaction is like a sale, because the buyer-lender has complete control over the collateral including the right to sell it on to somebody else:  this process is called rehypothecation.  The buyer-lender’s only obligation is to replace the rehypothecated collateral with an equivalent security by the date of the repurchase contract.

Repos were used by the New York Federal Reserve Bank starting in the early years of the 20th century and also by other firms that faced restrictions on secured lending.  Since the 1950s the Federal Reserve used repurchase agreements as a principal tool when implementing monetary policy.  For this reason, the repo market was a crucial concern of the Fed.

The private sector repo market did not grow large until the 1970s when short-term interest rates rose to unprecedented levels.  This phenomenon drove firms and local governments – which often were not authorized to lend – to place funds in the repo market as way of earning interest income.[1] The use of repos by the private sector grew from $2.8 billion of outstanding repos in 1970 to $45 billion by 1979 to hundreds of billions in 1983.[2]

The problem with repos in the 70s and early 80s was that there was a strong likelihood that they would be considered secured loans under the terms of Article 9 of the Uniform Commercial Code, which applies to “any transaction (regardless of form) which is intended to create a security interest in personal property.”[3] If repos are secured loans, then in bankruptcy they are subject to the automatic stay:  in other words, the counterparties to a bankrupt firm cannot dispose of the collateral they hold as it is the property of the bankrupt estate.

In 1982 when a small government securities dealer, Lombard Wall, declared bankruptcy, the bankruptcy judge found that Lombard Wall’s repo contracts were secured loans.  While the status of repos had been uncertain before, market participants in the past had held out the hope that “friend of the court” briefs from the Federal Reserve and major investment banks would convince bankruptcy judges not to risk disrupting this huge market.  Lombard Wall made it clear that some judges were not swayed by these arguments.   Buyer-lenders in the repo market risked finding that collateral that had been pledged by a bankrupt firm had suddenly become a frozen asset, and, if the price of the collateral moved quickly, this illiquidity could lead to losses.[4] Lombard Wall, however, was a small affair and the collateral was released within days, so it did not involve significant losses.

Whether this ruling had any quantitative effect on the repo market is very difficult to determine, because it followed less than three months after the failure of Drysdale Government Securities – a large bankruptcy which made it clear that contemporary repo market practices could be gamed and which led to major changes in the market.  Thus, while there is evidence that the rate of growth of the repo market slowed between June 1982 and May 1983,[5] it is not at all clear that this slowdown can be attributed to the Lombard-Wall ruling.

In the absence of safe harbor protections for repurchase agreements, buyer-lenders were exposed to more credit risk than they would be if they controlled the collateral free and clear.  The repo dealers believed that the best solution to this state of affairs was for Congress to amend the Bankruptcy Code and expand the safe harbor provisions to repo contracts.  In their pursuit of a legislative solution the dealers had an impressive ally: the Federal Reserve.

In 1984 the repo amendment to the Bankruptcy Code was passed.  The amendment applied only to the most common repurchase agreements, specifically those that were backed by Treasury and Agency securities, bank certificates of deposit and bankers’ acceptances.  Repo traders were now permitted to seize collateral, liquidate it and net the proceeds against the bankrupt counterparty’s obligations without interference from a bankruptcy trustee, as long as the collateral fell into one of the protected categories.

Because the rules of repo were not established by a self-regulatory organization, the contractual rights that were exempt from bankruptcy had to be broader than those granted in 1982.  Specifically the repo amendment states that it applies to contractual rights including any right “whether or not evidenced in writing, arising under common law, under law merchant or by reason of normal business practice.”[6] Thus the 1984 law set a precedent for the expansion of safe harbor provisions to unregulated financial contracts.[7]


[1] Kenneth C. Kettering, March 2008, 29 Cardozo L. Rev. 1553  “Securitization and its discontents:  the dynamics of financial product development”, p. 1640

[2] Norman Bowsher, “Repurchase Agreements,”  Federal Reserve Bank of St Louis Review, Sept. 1979, p. 19 and for the 1983 data Kettering, 2008, note 287 quoting Peter Sternlight, Executive Vice President of the Federal Reserve Bank of New York statement for Bankruptcy Reform: Hearings Before the Senate Judiciary Comm., 98th Cong. 328 (1983).

[3] Jeanne Schroeder, “Repo Madness: The characterization of repurchase agreements under the bankruptcy code and the UCC,” 46 Syracuse Law Review, 1996, p. 1007.

[4] Kenneth Garbade, “The Evolution of Repo Contracting Conventions,” NYFRB Economic Policy Review, May 2006

[5] Kenneth Garbade, “The Evolution of Repo Contracting Conventions,” NYFRB Economic Policy Review, May 2006, p. 37.  Raw data on repos is available here:  http://fraser.stlouisfed.org/publications/frb/page/31488.

[6] Hance p. 743.

[7] Of course, the 1978 Bankruptcy Act also granted an unregulated market safe harbor, but forward contracts were exempt from regulation, because they were commercial — not financial — contracts.  (Ramdhanie, p. 277).

The First Safe Harbor Exemptions #1-2

In 1978 the Bankruptcy Act of 1898 was thoroughly revised.  The revised Act granted special privileges to both commodity brokers and forward contract merchants in the event of a customer bankruptcy.[1] Commodity brokers dealt in exchange traded derivative contracts and had been subject to regulation since the Commodities Exchange Act of 1936.  Forward contract merchants, by contrast, did not trade in derivatives; they traded in goods where the contract had a settlement date in the future – that is they traded in commercial contracts for future delivery. [2]

The privileges granted by the 1978 Bankruptcy Code to commodity brokers and forward contract merchants were the following: they were exempt from the automatic stay that prevents creditors from seizing and liquidating collateral, they were protected from the bankruptcy trustee’s power to avoid recent pre-bankruptcy transactions and they were permitted to offset claims against debts.  Thus, they were allowed to seize margin funds (i.e. collateral), close out customer positions and net the value of margin against the customer’s holdings.[3]

Overall the effect of the 1978 Bankruptcy Code was to give special protection to two categories of contracts:  exchange traded commodity contracts and commercial contracts for future delivery.  In order to understand why these privileges were granted, we need to understand how these markets operated.

An exchange sets rules for a market to ensure that every trader can honor his obligations.  Typically the value of every position is calculated on a daily basis in a process called mark to market, and traders are required to post margin sufficient to cover their obligations under the contract at current prices.  Since the margin posted against exchange traded contracts is the property of the trader who posted it, in the absence of special bankruptcy procedures these margin payments could easily be tied up in bankruptcy proceedings.  Furthermore, the obligations of a bankrupt party are frozen at the date bankruptcy is declared, so standard bankruptcy procedure disrupts the process of marking and margining contracts.

Another complication is that exchanges are central counterparties.  Thus, all trade on the market is trade with the exchange.  Because the exchange is backed by a partnership of the largest dealers in the market, everyone can trade on the market with confidence that every contract will almost certainly be honored.

Standard bankruptcy procedure can easily impose significant losses on the exchange, particularly if a large trader fails and triggers the failure of a few smaller traders.  To minimize the possibility that large losses could destabilize an exchange the 1978 bankruptcy law allows brokers to close out a bankrupt’s position, seize any margin posted and determine the net obligation without delay.  In this way, bankruptcy law validates the process of marking and margining contracts, by permitting the margin funds to be used to settle the debts against which they have been posted in a timely manner.  Sometimes these provisions of the Bankruptcy Code are called “safe harbor” provisions.

While these rights were only written into the bankruptcy code in 1978, the fact that exchanges were self regulatory organizations (SROs) may well have served as an informal mechanism protecting margin payments from inclusion in bankruptcy estates in earlier years:  as long as no claim was made on a bankruptcy court, there may have been no obligation to resolve margin payments through bankruptcy.  This view is supported by the fact that in 19th century Britain the law viewed the resolution of a defaulter’s Stock Exchange accounts as determined by the rules of the Stock Exchange and thus protected from the trustee of the bankruptcy estate.[4] It seems plausible that a similar system may have been in effect in the United States prior to the 1978 law.  If this speculation is correct, we may also speculate that commercial contracts for future delivery were granted the same treatment because there was a tradition of allowing forward contract merchants to seize and liquidate the margin posted by bankrupt counterparties in a timely manner.

In 1982 safe harbor privileges were also granted to securities brokers and clearing agencies, thus expanding the bankruptcy exemptions to securities-based derivatives.  The 1982 amendment was careful to specify that the exemption from the automatic stay only applied to contractual rights “set forth in a rule or bylaw of a national securities exchange, a national securities association or a securities clearing association.”[5] In other words, the 1982 amendment was designed to protect practices sanctioned by the rules of self regulatory organizations, not the terms of individually negotiated contracts.[6]

In short, after 1982 derivatives subject to regulation by self regulatory organizations and commercial contracts for future delivery, as well as the margin payments related to these contracts, were formally excluded by acts of Congress from resolution in bankruptcy court.  It is possible that this represented nothing more than the codification of existing norms.  Whether this special treatment was a continuation of past procedures or not, the fact that it was written into the law may have encouraged the growth of exchange-traded derivatives.


[1] Note that forward contracts were carefully defined in the Commodities Exchange Act to include only transactions where future delivery is intended (i.e. they are commercial rather than financial transactions).

[2] Karen Ramdhanie, 1999, “Derivatives Contracts of Insolvent Companies”  18 NY Law School J of Intl and Comp Law, p. 277.  If the intent of a contract was to exchange in cash the difference between the spot price on the settlement date and the contracted price, the contract did not qualify as a forwards contract.  In fact, such contracts were unlawful under the terms of the Commodity Exchange Act.
Because the meaning of the term “forward contract” has changed, I am going to adopt the modern usage in this paper.  Thus, from this point on the contracts referred to as “forward contracts” in the 1978 law will be called “commercial contracts for future delivery,” and the term “forward contract” will be reserved for a derivative contract that may be settled in cash.

[3] Ramdhanie, p. 284 – 288.

[4]The settlement of debts incurred on an exchange separately from the settlement of a bankruptcy estate was upheld under the law in 19th c. Britain.   Ex parte Grant re Plumbly (1880) is explained in The Law Relating to Betting, Time-bargains and Gaming, George Herbert Stutfield, Waterlow & Sons, 1884, p. 78 – 79.

[5] Jonathan Hance, 2008, “Derivatives at Bankruptcy:  Lifesaving knowledge for the small firm” 65 Washington & Lee Law Review p.  741.

[6] The Securities Exchange Act of 1934 recognized that self regulatory organizations played an essential role in American markets and made them the partners of the SEC.

The Legal Foundations of Financial Collapse (Intro) #1-1

As economists, financiers, journalists and many others struggle to understand the financial crisis with which the 21st century opened, derivatives inevitably enter the conversation.  Unfortunately derivatives – especially those that are traded only through dealers on what are called “over the counter” markets – are not well understood outside the financial industry.  Perhaps, the fact that regulators and legislators permitted the development of markets that they did not understand is an important cause of the crisis.

Starting in the early 80s, the financial industry lobbied aggressively for legislation that favored youthful markets in repurchase agreements and derivatives.  Initially the industry was supported by the Federal Reserve, because the financial system was already fragile and there was genuine concern that losses in these new markets could be destabilizing.  In later years, the industry was careful to frame its requests for special privileges under the law in the same terms:  the stability of the financial system could only be ensured if these privileges were granted.  Neither regulators nor legislators were willing to challenge the expertise of the financiers.[1]

In 1984, in 1990 and in 2005 Congress passed laws exempting certain financial contracts from the standard provisions of the bankruptcy code.  In each case, the effect of the law was to protect collateral securing the contract from those provisions of the bankruptcy code that allow a judge to review the claims of secured creditors and to protect the interests of other creditors whenever necessary.  By granting derivative counterparties special treatment under the law, these exceptions guarantee that no contract is more secure than a repurchase agreement or an over the counter derivative – this guarantee comes at the expense of other secured creditors and bondholders.  In short, in modern bankruptcies, there is one class of claimant that doesn’t even need to show up in court to prove its claim – the counterparties to collateralized derivative contracts.

The introduction of inequitable treatment into the bankruptcy code would be acceptable, if in fact the financial contract exemptions worked to protect the stability of the financial system.   Recent experience indicates, however, that the special treatment granted to repurchase agreements and over the counter derivatives tends to reduce the stability of the financial system by encouraging collateralized interbank lending and discouraging careful analysis of the credit risk of counterparties.  The bankruptcy exemptions also increase the risk that creditors will run on a financial firm and bankrupt it.  Thus, the bankruptcy code has been rewritten to favor financial firms and this revision of the law has had a profoundly destabilizing effect on the financial system.


Introduction to the Bankruptcy Code

The Bankruptcy Code is designed to distribute the assets of a firm that cannot meet all of its obligations as equitably as possible across the firm’s creditors.  Thus, as soon as a firm files for bankruptcy, creditors are prohibited from collecting on the firm’s debts, and recent payments made by the firm may be recalled by the trustee of the estate.  The principle is that the trustee needs to take the time to realize the value of the firm’s assets and evaluate the full extent of creditor claims.  Only after the trustee has the whole picture of assets and liabilities can the bankrupt estate be distributed fairly to creditors.  Because payments made just prior to bankruptcy can potentially have the effect of favoring one creditor over another, the trustee has broad powers to void such transactions.

The prohibition against collecting on a bankrupt firm’s debts is called the automatic stay.  The trustee’s power to cancel recent transactions is called avoidance.  Prior to the special exemptions enacted by Congress over the counter derivatives were subject to the same treatment in bankruptcy as all other contracts.  The automatic stay ensured that netting of offsetting derivatives and termination of derivatives could only take place after receiving the approval of the bankruptcy court.  Furthermore, collateral that had been posted against derivative contracts over the last 90 days was subject to avoidance – and could thus be reclaimed as the property of the estate.  Collateral that had been posted over the previous year could be avoided if the transaction had an adverse effect on the equitable distribution of the estate.

In general, the purpose of the bankruptcy exemptions enacted by Congress was to ensure that participants in the markets for over the counter derivatives and repurchase agreements were not subject to the automatic stay or to the avoidance powers of the trustee.  The bankruptcy exemptions guarantee that over the counter derivatives and repurchase agreements can be netted and terminated instantly when bankruptcy is declared.  Any collateral can be seized and sold, free and clear of encumbrances.  Effectively under current law once collateral is posted against a derivative or repurchase agreement, it cannot be touched by a bankruptcy trustee – unless the recipient of the collateral was aware that the transfer was fraudulent.

Before examining the effects of these changes to the bankruptcy code, we will outline the history of the changes and then analyze why the exemptions were put in place.  Understanding the reasoning behind these bankruptcy provisions is essential to any discussion of the role that derivatives and repo markets played in destabilizing the financial system.


[1] There were exceptions amongst the regulators, such as Brooksley Born.  They were, however, unsuccessful in their endeavors.