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Derivatives industry under the gun to amend contracts

Martin Gruenberg, chairman of the Federal Deposit Insurance Corporation, gestures as he testifies before a Senate Banking, Housing and Urban Affairs Committee hearing on "Mitigating Systemic Risk Through Wall Street Reforms" on Capitol Hill in Washington July 11, 2013. REUTERS/Yuri Gripas

By Huw Jones

LONDON (Reuters) - Central bankers and regulators have increased the pressure on the $630 trillion derivatives industry to alter how it operates to avoid a repeat of the mayhem seen after Lehman Brothers collapsed.

Markets went into meltdown in September 2008 as it was unclear who was exposed to the stricken U.S. lender's derivatives holdings.

Credit default swaps, interest swaps and other off-exchange derivatives are written according to the International Swaps and Derivatives Association's (ISDA) "master agreement".

Bank of England Governor Mark Carney and U.S. Federal Deposit Insurance Corporation Chairman Martin Gruenberg have called on the trade body to amend its documentation to allow for a "short-term" delay in closing out a contract if a big bank has gone bust.

This would give regulators time to take steps such as transferring the contracts to someone else to minimize the "disorderly unwinding of such contracts", the letter released to the media said.

The letter, also signed by Elke Koenig, president of German regulator BaFin and Patrick Raaflaub, chief executive of the Swiss Financial Market Supervisory Authority, said ISDA has the opportunity to "play a pivotal role" to help them deal with failing big financial firms.

ISDA said on Tuesday it has already explored alternatives to suspending early termination rights, such as both sides of the contract agreeing to a short-term delay.

"We are committed to working with supervisors and regulators around the world to achieve an appropriate solution that will contribute to safe, efficient markets," it said.

Edmund Parker, co-head of derivatives at law firm Mayer Brown, said the change, if it happened, would shift the market towards a bail-in style regime emerging at banks whose debt can be converted to equity to bolster capital when in trouble.

"There is nothing in the letter concerning how to go about it, how long the delay would be. It's the start of a long dialogue process," Parker said.

In the past, regulators have called for speedy, automatic termination of contracts to offer clarity to markets.

"Now it is proposed that there will be a tandem approach delaying close-out to create a moratorium to give the firm the best chance of survival and minimal disruption to markets," Parker said.

The letter ratchets up pressure on ISDA to work faster but critics say buyers of derivatives won't give up rights to rapid close-outs of contracts without a change in the law.

Legal rulings in Britain and the United States - the two main centers for derivatives trading - have also been contradictory on the right to early terminations.

"The closing of ranks with three other supervisors from important financial centers shows how seriously we are pursuing the goal of being able to wind down even large and highly interconnected banks without damaging the public good," BaFin's Koenig said.

(Reporting by Huw Jones; editing by David Evans)