Banks accept derivatives rule change to end 'too big to fail' scenario

A trader works on the floor of the New York Stock Exchange September 15, 2008 in New York City.
Getty Images

The $700 trillion financial derivatives industry has agreed to a fundamental rule change from January to help regulators to wind down failed banks without destabilizing markets.

The International Swaps and Derivatives Association (ISDA) and 18 major banks that dominate the market will now allow financial watchdogs to apply temporary stays to prevent a rush to close derivatives contracts if a bank runs into trouble, the ISDA said on Saturday.

A delay would give regulators time to ensure that critical parts of a bank, such as customer accounts, continue smoothly while the rest is wound down or sold off in an orderly way.

Read MoreDodd-Frank not final chapter on reform: Dodd

That would help to avoid the type of market chaos sparked by the collapse of Lehman Brothers in 2008 and also end the problem of banks being considered too big to fail.

The Financial Stability Board (FSB), a regulatory task force for the Group of 20 economies (G20), had asked the ISDA to make the changes with the aim of ending the too-big-to-fail scenario in which banks are propped up with taxpayer money to avoid market disruption.

Under the new contract terms, default clauses in derivatives contracts such as interest rate or credit default swaps would be suspended for a maximum of 48 hours.

Evolutionary process

"Ending too-big-to-fail is going to be an evolutionary process, but the agreement of the first wave of banks to sign the protocol is a big step forward," ISDA Chief Executive Scott O'Malia said.

The ISDA template for millions of derivatives trades will now include the possibility of stays on both new and existing contracts, with the 18 leading players—including the likes of Credit Suisse and Goldman Sachs —agreeing to change their contracts from January. Many derivatives are traded among banks.

"Well over 90 percent of the outstanding derivatives notionally held by the G18 banks will be covered with stays, which will give regulators some time to deal with a resolution of a bank in an orderly way," O'Malia said.

Read MoreDerivatives get damning verdict at Davos

More banks are expected to follow suit as regulators across the G20 countries introduce new rules next year to require counterparties to derivatives trades to accept stays.

Mandatory rules will also mean that another big user of derivatives, the asset management industry, will have little choice but to accept stays.

Asset managers have resisted so far, arguing that they have a legal duty to their clients not to delay getting their money back from a failed bank and that agreeing to stays voluntarily could leave them open to lawsuits.