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Bankruptcy and Closeout Isda

Bankruptcy and Closeout Isda

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Published by: api-1743401 on Sep 15, 2008
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Derivatives and Systemic Risk:Netting, Collateral, and Closeout
 Robert R. Bliss and George G. Kaufman
   F  e   d  e  r  a   l   R  e  s  e  r  v  e   B  a  n   k  o   f   C   h   i  c  a  g  o 
WP 2005-03
Derivatives and Systemic Risk:
Netting, Collateral, and Closeout
Robert R. Bliss
F. M. Kirby Chair in Business ExcellenceCalloway School of BusinessWake Forest UniversityandFederal Reserve Bank of Chicago(336) 758-5957rbliss@gsbalum.uchicago.edu and
George G. Kaufman
John F. Smith Professor of Finance and EconomicsLoyola University ChicagoandFederal Reserve Bank of Chicago(312) 915-7075gkaufma@luc.edu 10 May 2005JEL Classifications: G18, G28, G33The authors wish to thank participants at the Associazione Guido Carli and the
 Journal of Financial Stability
conference on
 Derivatives and Financial Stability
at Luiss University(Rome) and in particular George Benston, our discussant, and at workshops at WakeForest University and the Federal Reserve Bank of Chicago for their helpful commentsand suggestions on earlier versions of this paper. We thank our research assistant, JustinWalter, for his diligent assistance. The views expressed in this paper do not necessarilyreflect those of the Federal Reserve Bank of Chicago or the Federal Reserve System.
Derivatives and Systemic Risk:
Netting, Collateral, and Closeout
In the U.S., as in most countries with well-developed securities markets, derivativesecurities enjoy special protections under insolvency resolution laws. Most creditors are“stayed” from enforcing their rights while a firm is in bankruptcy. However, manyderivatives contracts are exempt from these stays. Furthermore, derivatives enjoy nettingand close-out, or termination, privileges which are not always available to most othercreditors. The primary argument used to motivate passage of legislation granting theseextraordinary protections is that derivatives markets are a major source of systemic risk in financial markets and that netting and close-out reduce this risk. To date, theseassertions have not been subjected to rigorous economic scrutiny. This paper critically re-examines this hypothesis. These relationships are more complex than often perceived.We conclude that it is not clear whether netting, collateral, and/or close-out lead toreduced systemic risk, once the impact of these protections on the size and structure of the derivatives market has been taken into account.

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