Should Derivatives Be Privileged in Bankruptcy?

• DOI: http://doi.org/10.1111/jofi.12201
• Date: 01 December 2015
• Author: MARTIN OEHMKE,PATRICK BOLTON
• Published date: 01 December 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 6 •DECEMBER 2015

Should Derivatives Be Privileged in Bankruptcy?

PATRICK BOLTON and MARTIN OEHMKE∗

ABSTRACT

Derivatives enjoy special status in bankruptcy: they are exempt from the automatic

stay and effectively senior to virtually all other claims. We propose a corporate finance

model to assess the effect of these exemptions on a firm’s cost of borrowing and in-

centives to engage in derivative transactions. While derivatives are value-enhancing

risk management tools, seniority for derivatives can lead to inefficiencies: it trans-

fers credit risk to debtholders, even though this risk is borne more efficiently in the

derivative market. Seniority for derivatives is efficient only if it provides sufficient

cross-netting benefits to derivative counterparties that provide hedging services.

DERIVATIVE CONTRACTS ENJOY special status under U.S. bankruptcy law: deriva-

tive counterparties are exempt from the automatic stay, and—through netting,

closeout, and collateralization provisions—they are generally able to imme-

diately collect payment from a defaulted counterparty.1Taken together, these

special provisions make derivative counterparties effectively senior to almost all

other claimants in bankruptcy. The costs and benefits of this special treatment

are the subject of considerable debate and disagreement among legal scholars,

policy makers, and regulators, which is reflected in substantial differences in

the bankruptcy treatment of derivatives across jurisdictions.2

∗Patrick Bolton is at Columbia University, NBER, and CEPR. Martin Oehmke is at Columbia

University.For helpful comments and suggestions, we thank two anonymous referees, an Associate

Editor, Viral Acharya, Jun Kyung Auh, Ulf Axelson, Ken Ayotte, Mike Burkart, Doug Diamond,

Darrell Duffie, Yaniv Grinstein, Oliver Hart, Gustavo Manso, Ed Morrison, David Scharfstein,

Ken Singleton (Editor), Jeremy Stein, Suresh Sundaresan, Vikrant Vig, Jeff Zwiebel, and semi-

nar participants at Columbia University,the UBC Winter Finance Conference, Temple University,

University of Rochester, the Moody’s/LBS Credit Risk Conference, LSE, LBS, Stockholm School

of Economics, Mannheim, HEC, INSEAD, CEU, the 2011 ALEA meetings, the 4th annual Paul

Woolley Conference, the 2011 NBER Summer Institute, ESSFM Gerzensee, the 2011 SITE Con-

ference, ESMT Berlin, Harvard Law School, Harvard Business School, Chicago Booth, University

of Amsterdam, EPF Lausanne, Stanford GSB, Berkeley, the NY Fed workshop on the automatic

stay, the 2012 WFA meetings, Wharton, and Boston University. Both author have no conflicts of

interest with respect to The Journal of Finance disclosure policy.

1Similarly, under FDIC receivership, there is essentially no stay on derivative contracts. If not

transferred to a new counterparty by 5 pm EST on the business day after the FDIC has been

appointed receiver, then derivative, swap, and repo counterparties can close out their positions

and take possession of collateral. See, for example, Summe (2010, p. 66).

2For example, under current bank resolution law in the United Kingdom and Germany,closeout

and netting provisions may not always be enforceable (see Hellwig (2011)).

DOI: 10.1111/jofi.12201

2353

2354 The Journal of Finance R

In this paper, we provide the first formal analysis of the economic con-

sequences of the privileged treatment of derivative contracts in bankruptcy.

The fundamental observation underlying our analysis is that (effective) senior-

ity for derivatives does not eliminate default risk—rather, it transfers default

risk from derivative counterparties to other claimholders, particularly cred-

itors. The desirability of seniority for derivatives thus depends on whether

default risk is more efficiently borne in the derivative market or the debt

market.

Toaddress this question, we extend the standard incomplete contracts frame-

work in corporate finance,3in which debt contracts are insufficiently state-

contingent, by introducing derivative contracts that allow the firm to arrange

state-contingent transfers with a separate derivative counterparty.Specifically,

derivatives allow for payments tied to publicly observable and verifiable events

that are correlated with the firm’s unobservable (or unverifiable) cash flow out-

comes. Derivatives are supplied by derivative counterparties that are subject

to moral hazard, which is mitigated via collateral requirements as in Biais,

Heider, and Hoerova (2012). Within this framework, we characterize the condi-

tions under which the current privileged bankruptcy treatment of derivatives

is desirable (or undesirable).

Our baseline model considers a single firm that undertakes a positive net

present value (NPV) investment, which is financed with debt. Cash flow from

operations is risky so that the firm does not always have sufficient funds to

meet its debt obligations. As a result, the firm is exposed to default risk, which

gives rise to a demand for derivatives as hedging tools. By allowing for transfers

of cash from states of the world correlated with high-cash flow realizations

to states correlated with low-cash flow realizations, derivative contracts help

reduce—and possibly even eliminate—the risk of default and inefficient early

liquidation.4

The main novelty of our analysis is that it considers how the bankruptcy

treatment of derivatives affects these hedging benefits. The conventional wis-

dom is that effective seniority for derivatives lowers a firm’s cost of hedging

and should thus be beneficial overall. We show that this argument is at best

incomplete. Although the privileged treatment of derivatives reduces counter-

party risk in derivative markets, it increases credit risk for the firm’s creditors,

who now face larger losses in default. In frictionless financial markets `

ala

Modigliani and Miller, this transfer of risk between different claimants would

have no effect on the firm’s overall cost of capital. In our incomplete contracting

framework, however, the priority ranking of debt relative to derivatives mat-

ters because it affects endogenous contractual frictions in derivative and debt

markets.

3See, in particular, Grossman and Hart (1986), Bolton and Scharfstein (1990,1996), Aghion

and Bolton (1992), and Hart and Moore (1994,1998).

4This result mirrors classic findings in the literature on corporate risk management, such as

Smith and Stulz (1985) and Froot, Scharfstein, and Stein (1993).

Should Derivatives Be Privileged in Bankruptcy? 2355

A net cost of providing hedging services arises endogenously in our frame-

work because derivative writers (counterparties) must post costly collateral

to back up their promises. When a derivative contract moves against the

derivative writer, it must post collateral to prevent it from engaging in risk-

shifting actions that increase counterparty risk, as in Biais, Heider, and Ho-

erova (2012). This posting of collateral is costly because it means giving up

other, more productive uses of the counterparty’s capital. Thus, the priority

ranking of derivatives relative to debt affects the net costs of hedging services

because it affects the amount of costly collateral that providers of derivatives

have to post.

Our analysis reveals that the impact of the priority ordering of derivatives

on the overall deadweight costs of hedging depends on the interaction of three

main effects. The first effect, which is commonly stressed by practitioners, is

that, once the firm has issued its debt, it is (ex post) optimal to hedge default risk

with a derivative that is senior to existing debt. Derivative writers thereby get

maximum protection against default by the firm on its derivative obligations,

which reduces the stand-alone cost of the hedge.

Ex ante, however, the firm’s creditors anticipate the resulting subordination

of their claims to derivative counterparties, which leads to a second and coun-

tervailing effect: creditors demand higher promised repayments to compensate

for the higher credit risk they face. The higher required debt payments, in

turn, increase the firm’s demand for hedging, so much so that the benefits of

seniority for derivatives are wiped out by the concomitantly higher collateral

requirements for the derivative counterparty.In addition, when derivatives are

senior and hedging positions are entered only after debt has been issued, the

firm may have an incentive to dilute existing debtholders by overhedging or

by taking risky bets in derivative markets. Such ex post dilution is inefficient,

unless it is strictly required to induce the firm’s shareholders to undertake

a value-increasing hedge (i.e., a hedge that is beneficial to shareholders and

debtholders combined).5,6

The third effect arises when we extend our firm-level analysis to a mul-

tifirm setting. When derivative counterparties deal with many firms, the

cross-netting benefits to derivative writers from being a senior claimant in

bankruptcy can make seniority for derivatives efficient, even when there is

5Under some parameter values (e.g., when the firm’s continuation value is relatively low), the

ability to dilute ex post is necessary to sustain a value-enhancing hedge: when the firm’s continua-

tion value is low, the beneficiaries from ahedge are disproportionately the firm’s debtholders. But,

when debt has seniority over derivatives, the costs of the hedge are mostly borne by shareholders.

In such a situation, reversing the priority order so that derivatives are senior to debt can provide

an efficient incentive for shareholders to hedge.

6Another related distortion produced by the privileged treatment of derivatives in bankruptcy is

that firms have an incentive to masquerade debt as derivatives to protect creditors against dilution

by derivatives. If debt can easily be dressed up as a swap and thereby obtain the same treatment

as derivatives in bankruptcy, the overall effect of the exemption for derivatives is to hollow out

the stability provided by the automatic stay.Although we do not explicitly model this distortion, it

is likely to be another important unintended consequence of the special bankruptcy treatment of

derivatives.