Derivatives Markets in Bankruptcy

18 Pages Posted: 17 Apr 2012 Last revised: 9 Jun 2013

Date Written: April 16, 2012

Abstract

By treating derivatives and financial repurchase agreements much more favorably than it treats other financial vehicles, American bankruptcy law subsidizes these arrangements relative to other financing channels. By subsidizing them, the rules weaken market discipline during ordinary financial times in ways that can leave financial markets weaker than they would be otherwise, thereby exacerbating financial failure during an economic downturn or financial crisis emanating from other difficulties, such as an unexpectedly weakened housing and mortgage market in 2007 and 2008. Moreover, and perhaps unnoticed, because the superpriorities in the Bankruptcy Code are available only for short-term financing arrangements, they thereby favor short-term financing arrangements over more stable longer term arrangements. While proponents of superpriority justify the superpriorities as reducing contagion, there’s good reason to think that they in fact do not reduce contagion meaningfully, did not reduce it in the recent financial crisis, but instead contribute to runs and weaken market discipline. A basic application of the Modigliani-Miller framework suggests that the risks policymakers might hope the favored treatment would eliminate are principally shifted from inside the derivatives and repurchase agreement markets to creditors who are outside that market. The most important outside creditor is the United States, as de jure or de facto guarantor of too-big-to-fail financial institutions.

Keywords: safe harbors, bankruptcy, financial crisis, contagion, bank run, qualified financial contracts, derivatives, orderly liquidation authority

JEL Classification: G20, G28, G32, G33, G38, K22

Suggested Citation

Roe, Mark J., Derivatives Markets in Bankruptcy (April 16, 2012). Available at SSRN: https://ssrn.com/abstract=2040864 or http://dx.doi.org/10.2139/ssrn.2040864

Mark J. Roe (Contact Author)

Harvard Law School ( email )

Griswold 502
Cambridge, MA 02138
United States
617-495-8099 (Phone)
617-495-4299 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
418
rank
67,307
Abstract Views
2,751
PlumX Metrics