The Board of Governors of the Federal Reserve System (Fed Reserve) recently issued a final rule entitled “Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions” (hereafter the “Final Rule” and available here.  The Final Rule would impose restrictions on contractual certain default  (and cross default) rights contained in certain repo, derivative and securities lending agreements. 

The following is intended to be a Buy Side guide to the Final Rule (the Buy Side will generally be referred to as the “counterparty” in this post):

What Is the Purpose of the Final Rule?

The overarching goal of the Final Rule is to:

  • Facilitate the orderly resolution of global systematically important banking organizations (GSIBs) by limiting the ability of trading counterparties to terminate their contracts with the GSIB immediately upon entry of the GSIB or one of its affiliates into a resolution regime;

In order to achieve the overarching goal the Final Rule seeks to:

  • Reduce the risk that a foreign court would disregard statutory provisions (e.g. orderly liquidation authority under Dodd Frank or FDIC receivership) that would stay the rights of a counterparty to a failed GSIB to terminate their contracts with the GSIB immediately upon the entry of the GSIB into a special resolution framework for failed financial firms.
  • Facilitate the resolution of a large financial entity under the U.S. Bankruptcy Code by ensuring that a counterparty to a solvent affiliate of the failed entity cannot trigger default rights under the contract solely based upon failed entity’s enter into resolution (e.g. cross-default to failed entity).

What type of financial contracts are subject to the Final Rule?

The restrictions are imposed on “qualified financial contracts” (QFCs), which include derivative, repo, reverse repo, securities lending/borrowing contracts, commodity contracts and forward agreements entered into with a “covered entity”.

A QFC specifically does not include the following:

  • A QFC that has no transfer restrictions or default rights;
  • Transactions with certain central clearing counterparties and financial market utilities (FMU);
  • Advisory contracts with retail advisory customers if only transfer restrictions are those imposed by Investment Advisers Act of 1940;
  • Warrants evidencing a right to subscribe or to otherwise acquire a security of a covered entity or its affiliate; and
  • Any other contract exempted by the Federal Reserve Board upon request for an order.

Which of my dealers are Subject to the Rule?

The Final Rule applies to trades with GSIBs and their subsidiaries and with the U.S. operations of global systemically important foreign banking organizations and their U.S. subsidiaries, U.S. branches and U.S. agencies (“Foreign GSIBs” and collectively “Covered Entities”).[1]

As of the date of the Final Rule GSIBs consisted of the following:  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.

As of November 2016 Foreign GSIBs consisted of the following:  Agricultural Bank of China, Bank of China, Barclays, BNP Paribas, China Construction Bank, Credit Suisse, Deutsche Bank, Groupe BPCE, Groupe Crédit Agricole, Industrial and Commercial Bank of China Limited, HSBC, ING Bank, Mitsubishi UFJ FG, Mizuho FG, Nordea, Royal Bank of Scotland, Santander, Société Générale, Standard Chartered, Sumitomo Mitsui FG, UBS, and Unicredit Group.

What Contractual Provisions does the Final Rule require?

The Final Rule would require a covered QFC with a covered entity to provide in the contract: 1.  that the transfer of the QFC from the covered entity to a transferee would be effective to the same extent it would be under the U.S. special resolution regimes (FDI Act and Title II of Dodd Frank) if the covered QFC were governed by the laws of the United States; 2.  that the QFC’s default rights that could be exercised by the counterparty against a covered entity could be exercised to no greater extent than they could be exercised under the U.S. special resolution regimes if the covered QFC were governed by the laws of the United States.

The Final Rule would also prohibit a QFC from containing a default provision that is tied, directly or indirectly, to an affiliate of the direct party to the QFC becoming the subject to receivership, insolvency, liquidation, resolution, or similar proceeding.  The Final Rule release notes that the use of “indirectly” was purposeful and could capture a credit rating downgrade default that is a result of the affiliate going into a resolution regime.  Additionally, a QFC cannot  prohibit the transfer of any credit enhancement provided by an affiliate to the direct party to a transferee upon the entry into resolution of an affiliate of the direct party unless the transfer would result in the counterparty being the beneficiary of a credit enhancement that is violation of a law applicable to counterparty.

A primary purpose for these restrictions is to facilitate the resolution of a GSIB under the U.S. Bankruptcy Code (e.g. outside of Title II resolution regime).  For example, in a single point of entry (SPOE) resolution, the GSIB’s parent entity would enter resolution.  If such entry led to the mass exercise of cross-default provisions by the subsidiaries’ QFC counterparties then the subsidiaries to the parent could themselves experience financial distress as a result of the cross defaults.  The release notes that these restrictions does not affect a counterparty’s rights under the U.S. Bankruptcy Code and accordingly a counterparty to a covered entity that has entered into bankruptcy proceedings would be able to exercise default rights to the extent permitted under the applicable bankruptcy safe harbors.

Will I Need to Amend My Trading Documentation?

Likely yes, if you are a counterparty that is trading a covered QFC with a covered entity.  However, note the significant exceptions outlined below.

The Final Rule states that adherence to the ISDA 2015 Universal Resolution Stay Protocol by the parties to a covered QFC would constitute compliance with the contract requirements of the Final Rule.  It notes that such parties can adhere to the Protocol or they can incorporate the terms of the protocol into their contract(s).  The Final Rule also states that parties can utilize the “U.S. protocol” which is defined as the Universal Protocol with some permitted changes to the attachment to the Universal Protocol.

A covered QFC is not required to be conformed to the contractual requirements of the Final Rule if:

  1. Each party to the QFC, other than the covered entity, is incorporated, organized or has principal place of business in the United States; and
  2. The covered QFC explicitly provides that it is governed by the laws of the United States or a state of the United States; and
  3. The covered QFC does not explicitly provide that one of both of the U.S. special resolution regimes is excluded from the laws governing the QFC.

Implications:  Accordingly, a U.S. domiciled mutual fund with a repo or ISDA agreement with a US GSIB that is governed by U.S. law and does not explicitly exclude a U.S. special resolution regime would not have to be amended.

Treatment of Overnight Repo:  In response to a request from a commenter that overnight repo be specifically excluded from the scope of a covered QFC the release states:  “Although the final rule does not exempt overnight repo transactions, the final rule may have limited if any effect on such transactions.  As described below, the final rule provides a number of exemptions that may apply to overnight repo and similar transactions.  Moreover, the restrictions on default rights . .  do not apply to any right under a contract that allows a party to terminate the contract on demand or at its option at as specified time, or from time to time, without the need to show cause.  Therefore, [Final Rule section] does not restrict the ability of QFCs, including overnight repos, to terminate at the end of the term of the contract.”  (See, Footnote 110).

The Final Rule also expressly permits certain contractual provisions (e.g. certain default rights after stay period).  These will be explored in a future post.

Good Day.  DR2.


[1] U.S. national banks, Federal savings associations, Federal branches, Federal agencies are technically not included in the definition of “covered entity” under the Final Rule because they will be covered by a separate but largely identical rule passed by the applicable banking regulators. The OCC is expected to issue a substantially identical rule that would apply to covered banks.