Mike Krimminger is a Senior Policy Analyst with the Federal Deposit Insurance Corporation. The views expressed in this article are solely those of the author and should not be construed as representing the policies or views of the FDIC or other governmental entities. Part one of two. The second portion will run next week. A clear understanding of legal and contractual rights if your counterparty defaults on a derivative contract and becomes insolvent is critical to effective risk management, creditor strategies, and market responses in today’s turbulent financial environment. The importance of clear rules is illustrated by the questions surrounding the recent near collapse of Long Term Capital Management and the roiling of Asian and Latin American markets. Currently, while American rules for financial market bankruptcies are sound, there are variations between the bankruptcy laws for banks and non-banks and ambiguities in how those laws apply to some newer transactions. Clarifying and updating those laws is an important step to maintain American leadership in the financial markets.

The President’s Working Group on Financial Markets, chaired by Treasury Secretary Robert Rubin, and with representatives of the Treasury Department, the Federal Reserve, the Office of the Comptroller of the Currency, the Commodities Future Trading Commission, the Securities and Exchange Commission, the Federal Reserve Bank of New York, and the FDIC has crafted statutory proposals that update and harmonize insolvency laws while reducing the risk of a system-wide disruption in the financial markets.

One year ago, Rubin submitted the proposals to Congress, where they won general agreement from the industry and key committees. A version of the Working Group’s proposal was included in the Financial Contract Netting Improvement Act of 1998, which was introduced by Rep. James Leach. Sen. Charles Grassley introduced similar legislation in the Senate. Although Congress adjourned before final action on the legislation could be completed, it is expected that the legislation will be reintroduced shortly. Discussion drafts of the bill are circulating on Capitol Hill now.