On August 22, the ISDA 2018 U.S. Resolution Stay Protocol (the Protocol) was opened for adherence by the International Swaps and Derivatives Association Inc. (ISDA).1 The Protocol will be used to amend a range of swaps, other derivatives, short-term funding transactions, securities lending transactions and other qualifying financial contracts (QFCs).
We have prepared the following Q&A to answer basic questions regarding the Protocol and the related rules adopted by three U.S. federal banking agencies, which are applicable to large banking organizations in the United States (the QFC Rules).2 This Q&A supplements a Sidley Update prepared in October 2017, which described the QFC Rules in detail and discussed the regulatory underpinnings for the Protocol.3 Additional information regarding the Protocol is available in the form of FAQs that ISDA has posted on its website.4
1. Who will adhere to the Protocol?
There will be two categories of adherents to the Protocol:
- “Regulated Entities”: Regulated Entities are (i) global systemically important U.S. bank holding companies (U.S. GSIBs) and their subsidiaries5 and (ii) the U.S. operations of global systemically important foreign banking organizations (non-U.S. GSIBs).6
- “Adhering Parties”: Adhering Parties are counterparties of Regulated Entities under QFCs (as defined below). Buyside market participants will be Adhering Parties.
2. How will the Protocol be used?
Regulated Entities will use the Protocol to amend a range of QFCs that they have entered into with Adhering Parties. Regulated Entities will amend those QFCs in order to comply with the QFC Rules.
There will be an alternative (non-protocol-based) means by which Regulated Entities may comply with the QFC Rules (discussed in the answer to Question 14). That alternative means, when compared with the Protocol, will entail certain advantages and disadvantages for buyside market participants (discussed in the answer to Question 15).
3. Why are Regulated Entities being required to amend QFCs?
Federal banking authorities adopted the QFC Rules to promote the orderly resolution of financially distressed GSIBs. As discussed below, the amendments to QFCs required by the QFC Rules will contractually limit certain counterparty rights related to certain GSIB resolution and bankruptcy proceedings.
4. Do the QFC Rules impose a direct obligation on buyside counterparties to amend QFCs?
No. The QFC Rules impose regulatory obligations on Regulated Entities; they do not impose regulatory obligations directly on buyside counterparties. However, the QFC Rules will not permit a Regulated Entity to enter into a QFC with a given counterparty unless that counterparty agrees to amend outstanding QFCs between the Regulated Entity and the counterparty.
5. When will buyside counterparties be expected to adhere to the Protocol?
By the end of 2018. The QFC Rules include a phase-in mechanism that, in theory, gives Regulated Entities until July or December 2019 (depending on the counterparty in question) to amend QFCs.7 However, other provisions of the QFC Rules (discussed in response to Question 8) will create regulatory risks for any Regulated Entity that, by the end of 2018, has not ensured compliance with the QFC Rules for QFCs with all counterparties with which it expects to continue to trade in 2019.
6. Will the Protocol cover all types of QFCs?
The Protocol will cover all QFCs that are “in scope” under the QFC Rules. Because “in scope” is broadly defined, most swap, repurchase and securities lending transactions subject to industry-standard master agreements will be covered by the Protocol. In contrast, spot foreign exchange transactions, though they are QFCs, will not be in scope if they are not subject to explicit terms restricting transfers or providing default rights.8
7. Will existing QFCs between a Regulated Entity and an Adhering Party be grandfathered?
No. For example, amendments to an ISDA Master Agreement resulting from adherence to the Protocol will apply to all existing swap transactions under that Master Agreement (as well as to future swap transactions under the Master Agreement).
8. Why isn’t there any grandfathering?
The QFC Rules were fashioned to ensure that a large portion of the existing in-scope QFCs of large banking organizations in the United States will be amended. A banking organization that is subject to the QFC Rules may not, after December 31, 2018, trade QFCs of any kind (including spot foreign exchange) with a given counterparty or its affiliates unless all existing in-scope QFCs with that counterparty are amended. Thus, if a QFC (whether or not in scope) is executed on or after January 1, 2019, between (i) a Regulated Entity (or any affiliate that is a Regulated Entity) and (ii) a counterparty (or any of its affiliates), then all existing in-scope QFCs between the first Regulated Entity and the counterparty (and any of the counterparty’s affiliates) must be amended.9 That mechanism effectively obviates the phase-in schedule noted in the answer to Question 5, because any QFC executed after January 1, 2019 will trigger regulatory obligations.10
Moreover, adhering to the Protocol will amend QFCs between an Adhering Party and all Regulated Entities (i.e., an Adhering Party will not be able to pick and choose, on a dealer-by-dealer basis, the Regulated Entities with which it amends QFCs under the Protocol). In other words, adherence will be universal.
Thus, for a buyside market participant to avoid amending existing in-scope QFCs with a particular Regulated Entity, (i) the buyside market participant (and all of its affiliates) must stop trading QFCs with that Regulated Entity (and all of its affiliates), and (ii) the buyside market participant (and all of its affiliates) must amend existing in-scope QFCs with other Regulated Entities (with which they will continue to trade) via alternative bilateral (non-Protocol) means (discussed in response to Questions 14 and 15 below).
9. What kinds of amendments to QFCs will the Protocol effect?
The Protocol will effect two kinds of amendments to QFCs. The first kind of amendment will result in Adhering Parties “opting in” to certain U.S. and non-U.S. bank resolution regimes under which Regulated Entities may be resolved in the event of future financial distress. The second kind of amendment will restrict the ability of Adhering Parties to exercise certain cross-default rights under QFCs with Regulated Entities.
- Opt-ins with respect to certain bank resolution regimes:
- The first kind of amendment results in an Adhering Party’s agreeing that if a Regulated Entity becomes subject to certain U.S. or non-U.S. resolution regimes — referred to in the Protocol as “Identified Regimes” — the Adhering Party will be subject to certain requirements of the applicable resolution regime. The requirements in question relate to transfers of, and restrictions on, the exercise of default rights under, the amended QFCs when a Regulated Entity becomes subject to resolution.
- The first kind of amendment may be thought of as effecting an express choice of law, which ensures the enforceability of Identified Regimes on a cross-border basis. In effect, the amendments result in Adhering Parties “opting in,” by contractual agreement, to the applicability of each Identified Regime, without regard to whether a court in a given jurisdiction (other than the jurisdiction of the Identified Regime) would enforce the Identified Regime’s requirements. The Identified Regimes are the principal bank resolution regimes in six countries.11
- For example, if (i) a non-U.S. domiciled Adhering Party and a Regulated Entity are parties to an ISDA Master Agreement governed by non-U.S. law, and (ii) the Regulated Entity becomes subject to bank resolution proceedings under the Federal Depository Insurance Act (FDIA), the first kind of amendment will result in the Adhering Party agreeing to be bound by actions of the FDIC under the FDIA in respect of the Regulated Entity (without regard to whether a non-U.S. court would enforce the FDIA under the non-U.S. governed ISDA Master Agreement).12
- Limitations on certain cross-default rights:
- The second kind of amendment results in an Adhering Party’s being prohibited from exercising certain cross-default rights under a QFC with a Regulated Entity that are related, directly or indirectly, to an affiliate of the Regulated Entity’s becoming subject to U.S. insolvency proceedings, including under Chapter 11 of the Bankruptcy Code.
- The second kind of amendment may be thought of as a means by which the safe harbor from the automatic stay under Chapter 11 is varied contractually. That safe harbor protects nondefaulting parties to QFCs from Chapter 11’s automatic stay on termination and closeout rights. The Protocol overrides the safe harbor contractually by requiring Adhering Parties to delay the exercise of certain cross-default rights that they would otherwise have under the QFCs that are amended.
- However, the override applies only to termination and closeout rights that are triggered by the insolvency of an affiliate of the Regulated Entity; it does not affect termination rights triggered by the Regulated Entity’s direct default (including a default that results from such Regulated Entity becoming directly subject to bankruptcy proceedings). In other words, “direct default rights” are unaffected.
- For example, if (i) an Adhering Party trades with a Regulated Entity that is the U.S. broker-dealer subsidiary of a large U.S. parent bank holding company that guarantees the Regulated Entity’s QFCs, and (ii) the parent becomes subject to Chapter 11 bankruptcy proceedings (at a time when the Regulated Entity continues to perform its obligations and is not itself subject to bankruptcy proceedings), then any cross-default triggered by the parent’s bankruptcy will be contractually stayed as a result of the amendments effected by the Protocol.
- Questions 10 and 11 address the length of the contractual stays on cross-default rights effected by the second kind of amendment.
10. How long are the contractual stays on affiliate-related cross-defaults?
Forty-eight hours or one business day, whichever is longer. However, in certain circumstances that short-term contractual stay may be extended, even permanently.
11. In what circumstances may the short-term contractual stay on an affiliate-related cross-default be extended?
It depends on whether the affiliate that becomes subject to U.S. insolvency proceedings is a credit support provider for the Regulated Entity with which the Adhering Party has traded.
- No affiliate credit support provided. If the affiliate subject to U.S. insolvency proceedings is not a credit support provider for the Regulated Entity, the stay is permanent. For example, if the affiliate were only a “Specified Entity” under an ISDA Master Agreement — that is, the affiliate did not provide a guarantee or other credit support for the Regulated Entity — then the Adhering Party may never exercise any termination and closeout rights triggered by the affiliate’s insolvency.
- Affiliate credit support provided. If the affiliate is a credit support provider, the stay may be extended (even permanently) if certain creditor protections are in place. Thus, the Protocol includes certain provisions that are referred to as “creditor protections” (though the Protocol itself does not use that phrase). The short-term stay may be extended if the applicable creditor protection conditions are satisfied. Here are key examples:
- In connection with an affiliate’s Chapter 11 proceeding where the credit support is not transferred, the short-term stay may be extended only if the bankruptcy court enters an order by the end of the short-term stay period providing supported parties with increased creditor priority in the bankruptcy proceedings.
- In connection with an affiliate’s Chapter 11 proceeding where the credit support is transferred (e.g., to a bridge entity), the short-term stay may be extended only if the bankruptcy court enters an order confirming that the affiliate credit support provider’s assets (or net proceeds therefrom) have been transferred to the transferee, and the transferee meets certain other conditions.
In effect, the contractual stay would provide a bankruptcy court a short window during which to resolve the affiliate of the Regulated Entity without the Regulated Entity’s being subject to widespread terminations of its QFC transactions (in the manner of the QFCs of Lehman’s guaranteed subsidiaries when the Lehman parent filed for Chapter 11 protection in 2008). Of course, as noted above, if the Regulated Entity itself were subject to insolvency proceedings or otherwise directly defaults, the Adhering Party would be permitted to exercise any termination and closeout rights that it has.
12. How will adherence to the Protocol work generally?
The adherence mechanisms for the Protocol (e.g., means for submitting an adherence letter) are similar to those for other ISDA protocols. However, an adherent will be required to indicate whether it is adhering as a Regulated Entity or as an Adhering Party. Buyside counterparties that are not directly subject to the QFC Rules will be Adhering Parties.
13. How will adherence work for an asset manager that trades on behalf of multiple buyside clients?
An asset manager that adheres (as agent) on behalf of its funds and/or other clients (as principals) must choose one of three adherence mechanisms. Thus, the asset manager may adhere on behalf of
- all clients listed in each QFC between the asset manager (as agent) and each Regulated Entity;
- all clients listed in each QFC between the asset manager (as agent) and each Regulated Entity, except any client that the asset manager specifically names or identifies as excluded from adherence; or
- each client represented by the asset manager (as agent) that the asset manager specifically names or identifies.13
In the case of the second and third adherence mechanisms, an asset manager may identify one or more clients — that is, as excluded in the case of the second mechanism, or as included in the case of the third mechanism — through the online ISDA Amend platform.
As noted in the answer to Question 8, adherence to the Protocol is intended to operate on a universal basis, rather than a dealer-by-dealer basis. Accordingly, each asset manager that adheres to the Protocol on behalf of a given client by identifying that client to one Regulated Entity (as described above) will be deemed to represent that it has communicated the identity of that client to each other Regulated Entity with which the asset manager has entered into one or more QFCs on behalf of such client. In effect, the asset manager will be required, when it adheres to the Protocol on behalf of a given client, to adhere on behalf of that client with all Regulated Entities.
14. Will there be an alternative means by which the required amendments may be effected?
Yes. ISDA is expected to prepare template documentation that may be used by a Regulated Entity to amend QFCs with individual buyside counterparties bilaterally.
15. Will there be significant differences between QFC amendments that are effected by the Protocol and those that are effected bilaterally?
Yes. By design, the QFC Rules require different kinds of amendments depending on whether QFCs are amended by the Protocol or are amended bilaterally. As discussed at greater length in the Sidley Update referred to in our introduction, when the alternatives are considered from a buyside perspective (Protocol versus bilateral amendments), there will be advantages and disadvantages associated with each.
The principal disadvantage for a buyside counterparty that adheres to the Protocol, rather than amending QFCs bilaterally with individual Regulated Entities, is that adherence is not permitted on a dealer-by-dealer or static basis but is universal and dynamic. By adhering to the Protocol, a buyside market participant will amend its covered QFCs with all Regulated Entities, including those that adhere to the Protocol in the future.14
The principal advantage to a counterparty that adheres to the Protocol, rather than amending QFCs bilaterally, is that the amendments that result from adherence will provide greater creditor protections to a counterparty than those that will result from bilateral adherence. In brief:
- The Protocol will limit cross-default rights principally in connection with affiliate insolvencies under Chapter 11 of the Bankruptcy Code and the FDIA.15 In contrast, bilateral amendments will limit cross-default rights in respect of a broad category of generically defined types of affiliate insolvencies.
- The Protocol will condition any continued suspension of cross-default rights (beyond a one-business day/48-hour stay period) on bankruptcy court involvement for the benefit of creditors. In contrast, the related creditor protections resulting from bilateral amendments will be neither as specific nor as robust as those provided for in the Protocol.
- The Protocol’s creditor protections will be available whether or not the affiliate support provider is itself a Regulated Entity. In contrast, creditor protections resulting from bilateral amendments will be limited to “covered affiliate support providers” (i.e., affiliates that are themselves Regulated Entities). Thus, for example, if the Regulated Entity is a U.S. subsidiary of a non-U.S. GSIB, and the parent of the non-U.S. GSIB (which is not a Regulated Entity) provides a guarantee supporting the U.S. subsidiary’s QFCs, certain creditor protections will not be available.16
1 See ISDA, ISDA 2018 U.S. Resolution Stay Protocol (Open from August 22, 2018), available at https://www.isda.org/protocol/isda-2018-us-resolution-stay-protocol/.
2 The three agencies are the Board of Governors of the Federal Reserve System (Federal Reserve), the Office of the Comptroller of the Currency, U.S. Treasury Department (OCC) and the Federal Deposit Insurance Corporation (FDIC).
The three agencies published substantively equivalent versions of the QFC Rules, each version of which applies to the banking organizations supervised by the respective agency. See Federal Reserve, Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions, 82 Fed. Reg. 42882 (September 12, 2017), available at https://www.gpo.gov/fdsys/pkg/FR-2017-09-12/pdf/2017-19053.pdf; OCC, Mandatory Contractual Stay Requirements for Qualified Financial Contracts, 82 Fed. Reg 56630 (November 29, 2017), available at: https://www.occ.treas.gov/news-issuances/federal-register/82fr56630.pdf; and FDIC, Restrictions on Qualified Financial Contracts of Certain FDIC-Supervised Institutions; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions, 82 Fed. Reg. 50228 (October, 30 2017), available at https://www.fdic.gov/news/board/2017/2017-09-27-notice-sum-b-fr.pdf.
We refer to the adopting release of the Federal Reserve cited above as the “Adopting Release.” References in this Sidley Update to “Rule” sections are to the QFC Rules as adopted by the Federal Reserve.
3 See Sidley Update, Federal Reserve Adopts Rule Requiring GSIBs to Amend QFC Transactions to Limit Termination Rights of Counterparties (October 26, 2017), available at https://www.sidley.com/en/insights/newsupdates/2017/10/federal-reserve-adopts-rule-requiring-gsibs-to-amend-qfc-transactions.
4 See ISDA, ISDA 2018 U.S. Resolution Stay Protocol (ISDA U.S. Stay Protocol): FAQs, available at https://www.isda.org/a/8FjEE/ISDA-2018-U.S.-Protocol-FAQs-Final.pdf.
5. In this Sidley Update, “U.S. GSIB” means any U.S. bank holding company (BHC) that is identified as a global systemically important BHC pursuant to Federal Reserve rules. See Rule Section 252.82(b)(1). There are currently eight U.S. GSIBs: Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley Inc., State Street Corporation and Wells Fargo & Company. See Adopting Release at 42892.
6 In this Update, “non-U.S. GSIB” means a global systemically important foreign banking organization meeting the criteria set forth in the QFC Rules. See Rule Section 252.87.
7 A Regulated Entity’s compliance date for a given QFC will be determined by the regulatory status of the counterparty to the QFC, as follows:
|Other covered entity or excluded bank
|January 1, 2019
|July 1, 2019
|January 1, 2020
The definition of “financial counterparty” in the Rule is similar to the definition of “financial end user” in the Federal Reserve’s margin rules for noncleared swaps. The Rule definition includes (i) bank holding companies or an affiliate thereof; (ii) savings and loan holding companies; (iii) certain U.S. intermediate holding companies; (iv) nonbank financial companies supervised by the Federal Reserve; (v) certain depository institutions; (vi) certain banking organizations that are organized under the laws of a foreign country; (vii) certain institutions that function solely in a trust or fiduciary capacity; (viii) certain credit or lending entities; (ix) certain swap dealers and major swap participants; (x) certain securities holding companies; (xi) certain securities brokers or dealers; (xii) certain investment advisers; (xiii) certain investment companies and entities that would be investment companies but for certain exemptions; (xiv) certain private funds; (xv) certain commodity pools, commodity pool operators and commodity trading advisors; (xvi) certain futures commission merchants and other commodities market professionals; (xvii) certain employee benefit plans; and (xviii) certain insurance companies. See Rule Section 252.81.
The definition expressly excludes sovereign entities, multilateral development banks and the Bank for International Settlements.
8 However, caution is warranted even for such transactions, because the overall trading relationship between an Adhering Party and a Regulated Entity may be subject to a broadly worded master agreement or other umbrella trading documentation that covers, for example, simple spot foreign exchange transactions.
9 For each side of a trading relationship, affiliate status is determined differently. On the Regulated Entity side, “affiliate” is defined by reference to the “control” definition in the Bank Holding Company Act of 1956 (the BHCA). On the counterparty side, only “consolidated affiliates,” as defined in the QFC Rules, must be considered. The BHCA definition of “control” results in there being affiliates of a Regulated Entity beyond those entities that are consolidated with the Regulated Entity under generally accepted accounting principles (GAAP). In contrast, the QFC Rules’ definition of “consolidated affiliate” is limited to those entities that are consolidated with one another on financial statements prepared in accordance with GAAP (or that would have been so consolidated if GAAP had applied).
10 As noted above, an in-scope QFC that is executed by a Regulated Entity after January 1, 2019, is not grandfathered, even if there is later compliance phase-in date for the relevant counterparty); moreover, in-scope QFCs that were executed by the Regulated Entity and the counterparty before January 1, 2019, are not grandfathered. Thus, for example: If a Regulated Entity and a financial counterparty execute a QFC on February 1, 2019, neither that QFC nor any existing QFC between the two parties must comply with the Rule on that date because it is before July 1, 2019 (the phase-in compliance date for financial counterparties). But if that QFC is an in-scope QFC, it will be a covered QFC when it is executed (regardless of the compliance phase-in date). Moreover, whether or not it is an in-scope QFC, the execution of that QFC on February 1 will result in all in-scope QFCs between the Regulated Entity and the financial counterparty’s becoming covered QFCs automatically (and, as noted, there are knock-on effects for affiliates). Thus, when July 1, 2019, arrives, each of those covered QFCs will be required to comply with the Rule (e.g., by being amended pursuant to a U.S. Protocol). Accordingly, a Regulated Entity will have an incentive, before trading any QFC (whether or not in-scope) with any counterparty after January 1, 2019, to know how the Regulated Entity will comply with the QFC Rules when the compliance phase-in date arrives for the respective counterparty (and its consolidated affiliates). As a consequence, Regulated Entities are likely to seek to have revised trading documentation (whether via the Protocol or otherwise) in place with each of its QFC counterparties by the beginning of 2019 even if that documentation does not take effect until the respective phase-in date.
11 The United States, the United Kingdom, Germany, France, Switzerland and Japan.
12 Although we have chosen a U.S. bank resolution regime for our example, the Protocol effects a similar opt-in with respect to Identified Regimes in five non-U.S. countries. As a consequence, if a Regulated Entity were subject to a non-U.S. Identified Regime — for example, because it is a U.S. subsidiary of a large non-U.S. GSIB that subject to resolution under the non-U.S. resolution regime — the Adhering Party would have agreed to be bound by the actions of the non-U.S. resolution authority in respect of the Regulated Entity (without regard to whether a U.S. court would enforce those actions).
13 There is also a fourth mechanism, which permits an asset manager to adhere in respect of one or more “umbrella” agreements that do not cover any clients at the time of adherence but to which the asset manager may add new clients in accordance with the Protocol.
14 In addition, bilateral amendments related to resolution regime “opt ins” (as contrasted with those related to cross-defaults) will be limited to the orderly liquidation authority (OLA) under Title II of the Dodd-Frank Act and the FDIA. In contrast, adherence to the Protocol will (as discussed) effect an opt-in with respect to each of the six Identified Regimes. However, it is not clear how significant a consequence that would be because (i) the Identified Regimes other than OLA and the FDIA may have limited application with respect to many Regulated Entities (e.g., U.S.-domiciled entities within U.S. GSIB groups) and (ii) where they do apply (e.g., where the Regulated Entity is a non-U.S. subsidiary of a U.S. GSIB or is a U.S. subsidiary of non-U.S. GSIB), any applicable Identified Regime in a non-U.S. jurisdiction may be enforceable against the counterparty whether or not the counterparty has opted in through adherence to the Protocol.
15 If the affiliate is not a credit enhancement provider (as defined in the Universal Protocol), the restrictions also apply (and are not subject to creditor protection exceptions) under Chapter 7 of the Bankruptcy Code and proceedings under the Securities Investor Protection Act.
16 See Adopting Release at 42906 (discussing the unavailability of creditor protections with respect to “non-U.S. affiliate credit supporter providers”).
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