Regulators need help from hedge funds to make sure a bankfailure in the future doesn't roil markets the way Lehman BrothersHoldings Inc. did. The problem is that hedge funds don't see what'sin it for them.

The Federal Reserve, Federal Deposit Insurance Corp. (FDIC), andBank of England have met with representatives for firms such asCitadel LLC, D.E. Shaw & Co., BlackRock Inc., and PacificInvestment Management Co. (Pimco), to try to persuade them to waitbefore canceling contracts with a collapsing lender, said threepeople with knowledge of the matter.

The purpose is to give regulators more time to resurrect afailed bank so derivative trades and lending arrangements thatunderpin the global financial system don't have to beterminated.

Money managers who account for trillions of dollars of swapstrades are resisting because they're concerned that giving up theirright to quickly kill contracts with a bankrupt firm could stickthem with losses and violate a requirement that they act in theirinvestors' best interests.

“What you're giving up is, in many cases, not your own money;it's your client's money,” said Darrell Duffie, a finance professorat Stanford University who has studied derivatives markets.

Spokesmen for the Fed, FDIC, and Bank of England declined tocomment.

“We continue to have serious concerns about efforts to suspendrights that protect customers during U.S. bankruptcy proceedings,”said Nick Simpson, a spokesman for the Managed Funds Association.The Washington-based trade group represents hedge funds.

Late last year, regulators resolved the issue for an estimated90 percent of the swaps market when they persuaded theInternational Swaps and Derivatives Association (ISDA) to changeits legal documents for transactions directly between banks.

Under that agreement with the industry's main standard-setterfor derivatives, lenders will wait as long as 48 hours before pulling collateralfrom failed lenders and canceling transactions. The delay, ifall goes well, would negate the need to terminate contracts becausethe failed firm would return to health.

In private discussions, including one last month in New York,regulators have urged big money managers to adopt similar policies,said the people who asked not to be named because they weren'tauthorized to speak publicly.

Rules Coming from Fed and FDIC

While the Fed and FDIC lack direct authority to write rules forhedge funds, the agencies plan to use their power over banks to tryto get what they want.

The regulators can insist that any contract with a bank beallowed to stand for some period of time during a failure, andthey've said they'll propose a rule in the coming months thataffects the entire financial industry.

The Fed and FDIC's efforts are clashing with current bankruptcylaw, which allows traders to end deals immediately. Regulatorsargue that changing contracts for derivatives trades and short-termfunding transactions—including repurchase agreements and securitieslending—is crucial to resolving insolvent banks.

The goal is preventing a recurrence of what happened afterLehman's 2008 bankruptcy. The bank's clients either rushed toterminate swaps trades or haggled over the value of deals,exacerbating the broader market panic.

“What people talk about with Lehman is how much value Lehmanlost because of the absence of a stay,” said David Skeel, aUniversity of Pennsylvania law professor who studies bankruptcylaw. A wave of terminations caused a “significant loss ofliquidity,” coupled with a spike in collateral demands that helpedcripple the firm, he said.

At the New York gathering, regulators made their case again toseveral dozen lawyers and executives, including representatives forCitadel, D.E. Shaw, Pimco, BlackRock, and other trade groups forbanks and funds.

The June 25 meeting irked some money managers, who felt therewasn't enough discussion about whether it made sense for funds tochange their policies, two of the people said. Instead, regulatorsfocused on technical issues for revising financial contracts, thepeople said.

Spokesmen for Citadel, D.E. Shaw, Pimco, and BlackRock declinedto comment on the meeting.

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