Interest Rate Swaps & Bankruptcy

Interest Rate Swaps & Bankruptcy

Abstract

Interest rate swaps have become an essential tool for corporations and governments to hedge risk. The International Swaps and Derivatives Association (ISDA) facilitated their growth by creating simple bilateral agreements. Legislators also helped by giving creditors clarity regarding swaps in the U.S. bankruptcy code. “Safe harbor” provisions were added to protect swap creditors from their counterparty’s default. This counterparty risk would eventually be tested in the liquidation of large financial firms during the recent crisis. The Lehman Brothers bankruptcy was no different. Their failure resulted in numerous court deliberations of swap termination and liquidation rules. One major case, heard both in the U.S. and U.K. resulted in contradictory outcomes causing confusion among creditors. Adding to their confusion is the recently passed Dodd-Frank Act. This new legislation gives government agencies the power to control the liquidation process. No clarification has yet been given on how DFA will affect swap creditors in the case of bankruptcy. The bankruptcy code needs time to catch up with new regulations. Until then, swap creditors will have two choices; move away from bilateral swaps to central clearing, or charge more to cover the added uncertainty.

Preliminary Note

The US bankruptcy code defines “swap” in a broad manner. The word “Swap”, not only represents interest rate swaps but every type of swap, plus indexes, futures, and options. As if this were not broad enough, the 2005 amendment to the bankruptcy code significantly expanded the definition to specifically cover, among other things, equity and credit derivatives. This paper will focus on interest rate swaps where possible but much of the information on how swaps are treated in bankruptcy can be applied to most other derivative types. The Appendix lists all financial instrument types covered by the term, “swap” in the U.S. bankruptcy...