The stability of the global financial system rests on a delicate balance. The extreme interconnectedness between banks, investment firms and market infrastructures means that the failure of a single player can potentially trigger a devastating chain reaction. To prevent this risk, described as systemic, the legislator has put in place special legal mechanisms designed to isolate and contain crises. These mechanisms, which are often technical, create an exceptional regime that protects vital financial operations from the hazards of conventional collective proceedings. This article deciphers these legal 'firewalls', which are part of the global framework for managing the difficulties of regulated companiesand explains how they ensure the continuity of financial flows, even in times of crisis.
The vulnerability of the financial system to systemic risk
The modern financial architecture, while efficient, is intrinsically exposed to the risk of rapid contagion. The failure of a major financial institution is not limited to its own losses; it immediately impacts its counterparties, who in turn may find themselves in difficulty, spreading the shock to the entire system.
Understanding systemic risk
Systemic risk refers to the risk that a single event, such as the failure of a major bank, could cause a domino effect of failures across the entire financial sector, paralysing the real economy. The example of Lehman Brothers in 2008 was a spectacular illustration of how the close links between financial institutions can transform an isolated problem into a global crisis. Cross-loans and cross-debts, exchanged guarantees and common exposures act as risk transmission belts. To counter this peril, regulators have developed preventive strategies, including resolution and recovery strategies for financial institutionsThe aim is to manage the failure of a systemic entity without contaminating the entire market.
The importance of financial markets and payment systems
Financial markets and payment systems form the vital infrastructure of the economy. The markets enable companies to raise finance and investors to invest their savings. Payment systems ensure the circulation of money between economic agents, from employee salaries to payments between suppliers. Any disruption to these circuits would have immediate and serious consequences: credit would freeze, it would be impossible to make payments, and there would be a widespread loss of confidence. It is to safeguard these essential functions that the law gives these systems exceptional legal protection, enabling them to continue to operate even when one of their members is in receivership. Alongside these measures to secure markets, it is essential to understand how bank and insurance customers are protected in the event of financial failure.
Financial market protection mechanisms
To guarantee market stability, the law has erected a veritable legal shield around transactions in financial instruments. This special regime allows transactions to be finalised and the associated guarantees to be put in place, while neutralising the rules of ordinary insolvency law that could paralyse their completion.
Financial obligations and close-out netting
The Monetary and Financial Code defines a scope of transactions and players that benefit from enhanced protection. These are mainly transactions in financial instruments, foreign exchange or precious metals, when one of the parties is a professional in the financial sector (bank, investment firm, clearing house, etc.). For these transactions, the law validates so-called "close-out netting" clauses. In practical terms, if one party to a master agreement is the subject of insolvency proceedings, the other party has the right to terminate all outstanding transactions immediately. Rather than managing a multitude of individual receivables and debts, the parties calculate a single net balance. As set out in article L. 211-36-1 of the French Monetary and Financial Code, this set-off is enforceable against third parties, including the liquidator, even if the claims are not related, thereby departing directly from bankruptcy law.
Financial guarantee contracts
To secure these financial obligations, the parties exchange collateral. Article L. 211-38 of the French Monetary and Financial Code sets out a highly protective regime for these financial collateral arrangements. Collateral may take the form of a pledge of securities or sums of money, or a transfer of full ownership by way of security (similar to a security trust). The effectiveness of these securities is formidable. If the collateral provider defaults, the beneficiary can realise the collateral (sell the securities, appropriate the sums) without waiting and without going through the conventional procedures for realising a pledge. This realisation option is maintained even if the collateral provider enters into safeguard, receivership or liquidation proceedings. The beneficiary of the guarantee thus escapes the suspension of proceedings and the ban on payments that apply to all other creditors.
The security of interbank settlement and delivery-versus-payment systems
Beyond market operations, protection extends to the heart of the financial reactor: the systems that enable money and securities to be transferred between banks. These infrastructures, such as the TARGET2 system for euro payments or Euroclear for securities settlement, benefit from specific rules to guarantee the integrity of flows.
The final nature of the settlement
The cornerstone of the security of these systems is the principle of finality of settlement, derived from European Directive 98/26/EC and transposed into Article L. 330-1 of the Monetary and Financial Code. This principle is simple but powerful: once a payment or securities delivery order is accepted by the system and becomes irrevocable according to the system's rules, it is final and binding on all parties. It cannot be cancelled, even if the institution that issued the order goes into receivership one minute later. This rule, known as the "finality" rule, is designed to prevent a "backtracking" effect that would sow chaos in payment chains. It constitutes a major exception to the principle that payments made during the suspect period are null and void, thereby protecting the validity of transactions processed by the system prior to the official announcement of the default.
Guarantees in payment systems
To secure their transactions, participants in a settlement system must provide collateral to the system operator. In accordance with article L. 330-2 of the French Monetary and Financial Code, this collateral (often securities or cash) is used to cover obligations within the system. Like financial collateral on the markets, these assets are protected. If a participant defaults, the system operator can use this collateral to honour the defaulting member's commitments and ensure that the clearing day is properly settled. No other creditor, even a privileged one, can claim a right on these guarantees. They are exclusively dedicated to the security of the system, forming a common pot that is impervious to individual collective proceedings.
Derogations from ordinary insolvency law
Together, these mechanisms form a body of special rules that derogate from several fundamental principles of the law governing companies in difficulty, as set out in Book VI of the French Commercial Code. The aim is to create a watertight sphere for financial transactions in order to prevent contagion. These specific features of judicial insolvency proceedings applicable to companies regulated under French law The main consequence is that the universality of collective proceedings, which would require all the debtor's assets to be seized and all his creditors to be treated equally, is set aside.
The most significant exceptions are the neutralisation of the "suspect period" and the prohibition on payment of prior claims. Under ordinary law, transactions entered into between the date of cessation of payments and the opening judgment may be annulled. The mechanisms of finality of settlement and enforceability of netting prevent such annulment for qualified financial transactions. Similarly, the principle of the prohibition on payment of claims arising prior to the opening of insolvency proceedings is disregarded, since the realisation of collateral and set-off effectively enable a counterparty to "pay" itself out of the assets of its defaulting counterparty. These derogations raise complex issues, particularly when the proceedings have a cross-border dimension, a central aspect in the management of the difficulties of regulated companies within the EU.
The robustness of these security measures is essential, but their implementation and linkage with insolvency law require detailed analysis and technical expertise. For a expert legal advice on implementing financial guarantees, securing your transactions on markets and payment systems, and protecting your interests in the face of systemic risk and the specific features of insolvency proceedingscontact our office.
Sources
- Monetary and Financial Code
- Commercial code
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