Risk of Japan derivatives default unknown-analysts
By Satoko Terasawa
TOKYO, Sept 2 (Reuters) - Experts say they are uncertain whether the derivatives market would be severely roiled if a major Japanese bank failed and was declared a ''bridge bank,'' a process that has been proposed by the government to wind up failed banks while keeping healthy borrowers afloat.
''It is possible a financial institution would choose to cancel all derivatives in an orderly manner so that there wouldn't be confusion in the market, although it would take some time to work this out,'' one financial analyst said.
Analysts said Japanese regulations did not cover all the contingencies and participants of derivatives trades, so it was difficult to foresee the risks involved should a major bank fail.
In most over-the-counter (OTC) derivatives transactions, such as interest-rate swaps, foreign currency swaps and bond options, banks normally use a master agreement formalised by the International Swaps and Derivatives Association (ISDA) as a contract form.
Should a bank fail and the bridge bank scheme be used, the government would appoint a financial administrator, or receiver, to supervise it. This would mean default for derivatives market players, as the ISDA agreement says that when a receiver is appointed to a bank ''the master agreement is terminated.''
A legal expert said: ''When a financial administrator is appointed, the master agreement is terminated and lenders can exercise their rights against borrowers.''
The ISDA master agreement also includes a cross-default clause that stipulates default of any single derivative transaction with any counterparty would automatically enable all the other derivative transactions with all counterparties involved to be deemed in default.
Analysts said markets could become chaotic if all trade counterparties with a bridge bank tried to collect their assets from a failed bank based on the cross-default clause.
''The event of default itself would not directly lead to upheavals in the markets. But if anybody triggered a cross-default clause, it certainly would,'' said a financial source.
But some remained sceptical about the possibility of market disorder. ''Market participants all know the danger of activating the cross-default clause, so they would be reluctant to do so unless others did it,'' a financial source said.
But one derivatives trader said: ''I don't know what will happen until it actually happens, but I think there is too big a risk to try.''
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