Derivatives’ Bankruptcy Priorities

by Mark Roe, for The Harvard Law School Forum at Harvard Law School, December 16, 2009.

A lot is happening in the financial regulatory overhaul bill that moved swiftly from committee through the US House of Representatives this week. But one vital reform is not locked in yet, although it is reportedly percolating in the Senate and a stripped-down version made it into the House bill passed last Friday.

Derivatives, repos and financial swaps – the huge financial market in protection against foreign exchange and interest rate fluctuations, in liquidity-enhancing transactions, and in guarantees against loan defaults – are treated extremely favourably in bankruptcy law. It has been a successful lobbying effort for this part of the American financial industry: priority treatment is important for the industry, but not well enough understood to engage much public attention beyond the financial press.

But derivatives, repos and swaps should not be so favoured. Yes, they are valuable in managing risk and enhancing liquidity: a derivative allows a company that is sensitive to interest rate changes to trade a fluctuating interest rate for a fixed one, while a repo allows a financial institution with a fixed, illiquid asset to sell it for cash today, by promising to buy it back a week later, thereby getting cash for that week. But they are favoured so much that financial players can set up deals so that they beat all other creditors if the other side of the deal goes bankrupt…(continue reading)


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