CAMBRIDGE – Four of the world’s most important financial regulators – the Bank of England, Germany’s Federal Financial Supervisory Authority (BaFin), the US Federal Deposit Insurance Corporation, and the Swiss Financial Market Supervisory Authority – recently asked the world’s derivatives industry to change the way it does business. The question now is whether the regulators can make that happen with a request, as opposed to something more substantial. That will not be easy.The regulators’ tersely worded letter to the International Swaps and Derivatives Association (ISDA) asked it to renounce a core component of the industry’s multi-decade effort to exempt itself from financial debtors’ bankruptcy – an exemption that worsens not only the debtor’s stability, but also that of the global economy. Many observers believe that these exemptions hit the world’s financial system especially hard when Lehman Brothers collapsed in 2008.The regulators are focusing on an important feature of derivatives contracts that allows the derivatives industry to close out their dealings abruptly with a financially distressed entity, thereby making the institution incapable of recovering. Other creditors typically cannot do that; in a US bankruptcy, for example, they must first wait for a court to decide whether the debtor company can be restructured. Only then can they collect their debts.Regulators around the world have worked hard to make the financial system safer. With the recent missive to the derivatives industry, they are now starting to deal with bankruptcy – and well they should.Until now, bankruptcy has played a second-tier role in reform efforts, even though bankruptcy law does for industrial firms much of what regulators want for financial firms. By restructuring a failed industrial firm’s debts, saving its profitable businesses, and selling its loss-making ones, bankruptcy can minimize a failed firm’s knock-on costs for its creditors and the economy as a whole.But, though US bankruptcy law usually does a good job of restructuring industrial firms, it cannot restructure financial firms, because bankruptcy’s basic rules – which allow the court to consolidate the firm’s assets, redeploy them, and sell the rest – do not apply to most financial contracts, like derivatives. So, bankruptcy is both part of the problem and part of the hoped-for solution – if it can be fixed and made to work for financial firms.Consider the collapse of Lehman Brothers. When then-US Secretary of the Treasury Henry Paulson decided not to bail out Lehman, the firm filed for bankruptcy and quickly sold off its brokerage operations. But, ominously, it could not sell its large portfolio of derivatives contracts – deals based on movements of interest and currency rates. By most accounts, Lehman’s derivatives portfolio was a winner when it went bankrupt, but bankruptcy exemptions for derivatives allowed Lehman’s counterparties to close out their positions rapidly, in ways that were costly for Lehman, chaotic for financial markets, and damaging to the real economy.The derivatives market is exempt from rules that stop creditors from grabbing collateral and terminating their contracts when the debtor files for bankruptcy. They are also exempt from rules that impede better-informed creditors from seizing assets and running off just before a bankruptcy, even if their positions are needed, say, to sell a portfolio intact to another business, and even if the fleeing creditor would eventually be paid in full, with interest.Regulators’ push for sounder finance has so far focused on requiring more capital, creating safer products, and establishing more resilient business structures. These are indeed the right priorities. But the US Congress and regulators have said all along that bankruptcy is the preferred way to restructure failed financial firms. If a judicial bankruptcy process could work, the thinking goes, it would minimize the likelihood of taxpayer-financed bailouts and disruption of financial markets and the real economy.The regulators’ letter to the ISDA asked the derivatives industry to rewrite its standard contracts, so that a bankrupt firm’s portfolio is not ripped apart as soon as it files. This is a big step in the right direction. But, as regulators reflect further, they will recognize that they cannot rely on the derivatives industry to revise its contracts any more than industrial bankruptcy relies on creditors’ contracts to stop failed firms from being ripped apart. Many simply will not use the contract terms.Perhaps regulators will find that they must require that the regulated have the desired contract provisions. That solution will be incomplete, however, because not all derivatives traders are regulated financial institutions, and because many creditors would find ways to circumvent the contract and the requirement. If the coverage is not complete, one can expect the regulated to complain that they have been placed at a competitive disadvantage.Regulators may well need to turn to bankruptcy laws to fix the problem. The regulators’ call to the ISDA for voluntary action will not amount to much if it is just a request to the derivatives industry to act against its own financial interests. But it does start the regulators down the road to more serious reform.Mark Roe, a professor at Harvard Law School, is an expert on securities law and financial markets. Copyright: Project Syndicate