Working paper series / Johann-Wolfgang-Goethe-Universität, Institute for Law and Finance
Systemic risks, regulatory powers and insolvency law : the need of an international instrument on the private law framework for netting
- This study examines the legal environment of netting agreements covering financial contracts. It concludes that an international instrument should be developed capable of improving the effectiveness of netting agreements in mitigating systemic risk. To this end, two different aspects of the enforceability of netting agreements are considered: (i) the general enforceability of netting, and (ii) the possibility of precluding the operation of netting a mechanism by way of a regulatory moratorium for considerations of systemic stability. The first part of the study presents the use of netting and the various forms it may take before going on to explain the benefits and drawbacks of enforceable netting agreements. Benefits for individual firms consist in lower counterparty risk and more favourable capital requirements. Benefits for the financial market as a whole flow from greater financial market stability since the contagion of systemically relevant institutions by the default or insolvency of another institution is limited, thus helping to avoid systemic effects. Additionally, the use of netting arrangements can improve overall market liquidity. A potential drawback of enforceability of netting, in certain situations, is that the operation of a netting mechanism could actually work against the purpose of systemic stability where the transfer of parts of the business of an insolvent financial institution to a solvent bridge entity would enhance or maintain value to a greater extent than the operation of a netting agreement would. Regulatory authorities are considering under which conditions a moratorium to halt the netting mechanism until the situation is solved could avoid this threat to systemic stability. The second part of the study examines whether there is the potential to support the purpose of enhanced systemic stability by way of international harmonisation of private and insolvency law. As regards the issue of general enforceability, the global picture of netting legislation is heterogeneous. Given the great practical relevance of the matter, an international instrument could be very useful. As to the issue of private law consequences of regulatory moratoria, the absence of a harmonised framework appears to lead to actual cross-border inconsistency and legal uncertainty as regards financial contracts that are governed by a foreign law. Taking these to aspects into account, this paper recommends that work on developing an international instrument be undertaken. The final part of the study suggests a set of preliminary guidelines for the development of suchan instrument. In the light of the findings of the previous sections, a mixed, two-step approach is recommended. First, a non-binding instrument could be developed, serving as a benchmark and reservoir of legal solutions in respect of the relevant issues. Secondly, isolated aspects relating to both the general enforceability of netting and the accommodation of a regulatory moratorium in foreign private and insolvency law could be dealt with in an international Convention, in particular where cross-border situations involving netting require uniformity of applicable legal rules.