REPORT - archives-financialservices.house.gov

1 59 006105 THCONGRESSREPT. 105 688"!HOUSE OF REPRESENTATIVES2d SessionPart 1 financial CONTRACT NETTING IMPROVEMENT ACT OF1998 AUGUST21, 1998. Ordered to be printedMr. LEACH, from the Committee on banking and FinancialServices, submitted the followingREPORT[To accompany 4393][Including cost estimate of the Congressional Budget Office]The Committee on banking and financial services , to whom wasreferred the bill ( 4393) to revise the banking and bankruptcyinsolvency laws with respect to the termination and netting of fi- nancial contracts, and for other purposes, having considered thesame, REPORT favorably thereon without amendment and rec-ommend that the bill do 4393, the financial Contract Netting Improvement Act of1998 (Act)

2 , contains legislative proposals forwarded to Congress bythe nation s financial regulators in order to guard against systemicrisk to the nation s financial system. Except for Section 14, the pro-visions of this Act are based on recommendations made by thePresident s Working Group on financial Markets following a re-view of current statutory provisions governing the treatment ofqualified financial contracts and similar financial contracts uponthe insolvency of a counterparty. The Working Group consists ofthe Securities and Exchange Commission; the Commodity FuturesTrading Commission; the Federal Deposit Insurance Corporation;the Department of the Treasury, including the Office of the Comp-troller of the Currency; the Board of Governors of the Federal Re-serve System; and the Federal Reserve Bank of New York.

3 The rec-ommendations of the Working Group were transmitted to Congressby Treasury Secretary Rubin in his role as Chairman of the Work-ing Group on March 16, provisions, forwarded by Secretary Rubin, amend the Code; the Federal Deposit Insurance Act (FDIA), asamended by the financial Institutions Reform, Recovery, and En-forcement Act of 1989 (FIRREA); the payment system risk reduc-tion and netting provisions of the Federal Deposit Insurance Cor-poration Improvement Act of 1991 (FDICIA); and the Securities In-vestor Protection Act of 1971 (SIPA). These amendments addressthe treatment of certain financial transactions following the insol-vency of a party to such transactions.

4 The amendments are de-signed to clarify and improve consistency between the applicablestatutes and to minimize risk of a disruption within or between fi- nancial markets upon the insolvency of a market 14 of 4393 incorporates an amendment to the Fed-eral Reserve Act transmitted to the Committee on banking and Fi- nancial services (the Committee) on July 30, 1998, by Alan Green-span, Chairman of the Board of Governors of the Federal ReserveSystem. This section expands the kinds of assets that the FederalReserve can use as collateral to back currency. In his transmittalletter to the Committee, Chairman Greenspan stated that the cur-rent limitations on eligible currency collateral could become poten-tially problematic for the implementation of monetary policy underunusual circumstances , citing as an example problems stemmingfrom the century date ANDNEED FORLEGISLATIONINSOLVENCY PROVISIONSS ince its adoption in 1978, the Bankruptcy Code has beenamended several times to afford different treatment for certain fi- nancial transactions upon the bankruptcy of a debtor.

5 As comparedwith the treatment of other commercial contracts and amendments were designed to further the policy goal ofminimizing the systemic risk potentially arising from certain inter-related financial activities and markets. Similar amendments havebeen made to the FDIA and FDICIA, and both the Federal DepositInsurance Corporation (FDIC) and the Securities Investor Protec-tion Corporation (SIPC) have issued policy statements and lettersclarifying general issues in this risk is the risk that the failure of a firm or disruptionof a market or settlement system will cause widespread difficultiesat other firms, in other market segments or in the financial systemas a whole. If participants in certain financial activities are unableto enforce their rights to terminate financial contracts with an in-solvent entity in a timely manner, or to offset or net their variouscontractual obligations, the resulting uncertainty and potential lackof liquidity could increase the risk of an inter-market Committee and Congress have taken steps in the past to en-sure that the risk of such systemic events is minimized.

6 For exam-ple, both the Bankruptcy Code and the FDIA contain provisionsthat protect the rights of financial participants to terminate swapagreements, forward contracts, securities contracts, commodity con-tracts and repurchase agreements following the bankruptcy or in-solvency of a counterparty to such contracts or agreements. Fur-thermore, other provisions prevent transfers made under such cir-3cumstances from being avoided as preferences or fraudulent con-veyances (except when made with actual intent to defraud). Protec-tions also are afforded to ensure that the netting, set off and collat-eral foreclosure provisions of such transactions and master agree-ments for such transactions are addition, FDICIA, was enacted in 1991 to protect the enforce-ability of close-out netting provisions in netting contracts between financial institutions.

7 FDICIA states that the goal of enforcingnetting arrangements is to reduce systemic risk within the bankingsystem and financial markets. In simple terms, netting occurswhen money payments, entitlements, or obligations arising underone or more contract or a clearing arrangement are all offsetagainst each other leaving one net orderly resolution of insolvencies involving counterparties tosuch contracts also is an important element in the reduction of sys-temic risk. The FDIC allows the receiver of an insolvent insurancedepository institution the opportunity to review the status of cer-tain contracts to determine whether to terminate or transfer thecontracts to new counterparties. These provisions provide the re-ceiver with flexibility in determining the most appropriate resolu-tion for the failed institution and facilitate the reduction of sys-temic risk by permitting the transfer, rather than termination, ofsuch only does this Act update legislation initiated by the Com-mittee in 1989 and 1991 but it also builds on recommendationsfirst contained in a comprehensive REPORT (Part 3 of Committeehearing record 103 88) on derivatives issued on October 28, 1993,by the minority staff of the Committee under the direction of thenRanking Minority Member, Representative Leach.

8 During prepara-tion of the REPORT , the staff submitted a series of questions to Fed-eral financial regulatory bodies concerning the adequacy and con-sistency of the netting provisions contained in the BankruptcyCode, FIRREA, and FDICIA. In sum, all agencies stated that thenetting provisions should be amended and conformed to providegreater certainty to the market. The agencies stated that the dif-ferences in coverage provided by the various acts have created legaluncertainty, emanating mainly from the definitional sections ofFIRREA and the Bankruptcy Code which limit netting to specifictypes of contracts expressly summary, the insolvency provisions of the Act are designed toclarify the treatment of certain financial contracts upon the insol-vency of a counterparty and to promote the reduction of systemicrisk.

9 These provisions further the goals of prior amendments to theBankruptcy Code and the FDIA on the treatment of those financialcontracts and of the payment system risk reduction provisions inFDICIA. The insolvency provisions of the Act have four principalpurposes:To strengthen the provisions of the Bankruptcy Code and theFDIA that protect the enforceability of termination and close-out netting and related provisions of certain financial agree-ments and harmonize the treatment of these financial agreementsand transactions under the Bankruptcy Code and the amend the FDIA and FDICIA to clarify that certainrights of the FDIC acting as conservator or receiver for a failedinsured depository institution (and in some situations, rights ofSIPC and receivers of certain uninsured institutions)

10 Cannot bedefeated by operation of the terms of make other substantive and technical amendments toclarify the enforceability of financial agreements and trans-actions in bankruptcy or these changes are designed to further minimize systemic riskto the banking system and the financial COLLATERAL REQUIREMENTC urrent law requires that the Federal Reserve collateralize Fed-eral Reserve notes when they are issued. The list of eligible collat-eral includes Treasury and Federal agency securities, gold certifi-cates, Special Drawing Right certificates, and foreign currencies. Inaddition, the legally eligible backing for currency includes discountwindow loans made under section 13 of the Federal Reserve the years, sections were added to the Act that permit lendingunder provisions other than section 13 and against a broader rangeof collateral than allowed under section 13.