Narrowing the Bankruptcy Safe Harbor for Derivatives to Combat Systemic Risk

Abstract:     
Bankruptcy law establishes proceedings designed to rehabilitate debtors while protecting creditors, but a series of safe harbors effectively exempts from bankruptcy proceedings certain financial contracts known as derivatives. Accordingly, when a party to a derivative contract goes bankrupt, the counterparty may terminate the contract and seize what it is owed from the debtor’s assets. Congress enacted these safe harbors to combat the risk of systemic failure by maintaining liquidity in troubled markets; in doing so, however, they allowed counterparties to engage in opportunistic behavior and inefficiently consume a debtor’s limited assets. Because these two consequences may harm the debtor and its creditors, the safe harbors may merely substitute one kind of systemic risk for another.

This Note argues that these safe harbors might more effectively combat systemic risk if they did not permit counterparties to terminate derivatives that are more valuable to the debtor. This is likely true of an insurance-like derivative known as the credit default swap (CDS). Just as insurance contracts may not be terminated — because maintaining insurance is crucial both to debtor rehabilitation and creditor protection — certain CDSs should not be eligible for termination under the safe harbors. Narrowing the safe harbors might help eliminate unnecessary costs arising from bankruptcy and thereby better reduce systemic risk.

Number of Pages in PDF File: 42

Keywords: Bankruptcy, Systemic Risk, Derivatives, Markets

Accepted Paper Series