After The Big Bang: The New Credit Default Swap Landscape

Tuesday, March 31, 2009 - 01:00

The Big Bang bell has sounded for participants in the credit default swaps industry. As part of an effort to enhance the infrastructure of the CDS market, increase transparency, foster operational efficiency and, last but not least, promote asset fungibility, market participants have developed significant amendments to the contractual provisions governing credit derivative products. The far-reaching amendments have been referred to by ISDA (International Swaps and Derivatives Association, Inc.) and market participants as the "Big Bang" protocol.

This article describes (i) the key changes to the market standard terms and provisions governing CDS contracts, (ii) how and when those changes will be implemented, (iii) which CDS contracts will be affected by the changes, and (iv) actions that market participants may consider taking in light of such changes. This article also addresses changes made by the industry to certain trading conventions for CDS transactions referencing North American credits.

Key Changes To The CDS Contracts

The three principal changes to most CDS contracts are: (i) the adoption of the auction methodology as the primary means to settle CDS; (ii) the creation of a contractual statute of limitations for exercising contractual rights with respect to Credit and Succession Events and (iii) the formation of Credit Derivatives Determination Committees (each, a "Determination Committee") that will make certain binding determinations on all market participants that have incorporated the new provisions into their agreements.

1. Auction Settlement and Fallback Settlement Methods

The CDS auction settlement procedure will move away from its current voluntary protocol process for each auction, and auction settlement will be established as the default mechanism for settling most CDS contracts and calculating amounts due by the parties following a Credit Event. Integration of the auction settlement process directly into CDS contracts has commonly been referred to as "auction hardwiring" in the financial press and CDS industry. The auction methodology will generally adopt the procedures established in recent auctions. Certain specific auction terms (auction date, times, quotation amount, deliverable obligations, etc.) will be set by the applicable Determination Committee. If the Determination Committee decides not to conduct an auction, the CDS contracts will physically settle (unless the parties have bilaterally agreed to fallback to a Cash Settlement method in their CDS confirmation).

The auction settlement terms include a few changes recently made to stand-alone auctions, including (i) a foreign currency rate conversion mechanism preventing a protection buyer from taking advantage of currency fluctuations and (ii) subject to the counterparties' consent, a mechanism enabling multiple physical settlements of a loan to occur through a unique physical settlement between the ultimate protection buyer and protection seller (with cash settlement applying to the trades in between).

2. Credit and Succession Events - Rolling "Look-back" Periods

Under the new regime, a credit derivative transaction can only be subject to a Credit Event or a Succession Event if the Determination Committee finds that such event took place within 60 calendar days (for a Credit Event) or 90 calendar days (for a Succession Event) prior to the date the Determination Committee receives a request to convene in relation to the putative event, regardless of whether such event took place before or after the CDS contract was entered into. Otherwise, such events will be considered stale and will not affect the applicable transaction. A request that the relevant Determination Committee make such a determination may be made by any market participant. The look-back periods have been referred to in the industry as the "statute of limitations" for Credit and Succession Events.

The principal purpose of these backstop dates is to foster consistency between transactions and fungibility: all existing trades will have the same effective date for Credit Events and the same effective date for Succession Events no matter when such trades are entered into. These changes are intended to eliminate basis risk between a participant's offsetting transactions.

3. Determination Committees and External Review Panels

The industry is designing Determination Committees which will, among other things, decide whether a Credit Event or a Succession Event has occurred and make determinations on any substitute reference obligations. The Determination Committee will also determine whether to hold an auction and the specific terms of the auction (including acceptable deliverable obligations). There is also a catchall provision enabling the Determination Committee to make determinations in respect of events relevant to the credit derivatives market generally. The role of the calculation agent will be amended accordingly. To start the determination process, any party to a CDS trade incorporating the new provisions may request a Determination Committee to be convened to address a question and at least one member of the applicable Determination Committee must agree to consider the question.

There will be one Determination Committee in each region (Americas; Japan; EMEA [Europe, the Middle East and Africa]; Asia [excluding Japan]; and Australia-New Zealand) and each Determination Committee will resolve issues that are relevant to credit derivatives markets as a whole in that Determination Committee's region. Each Determination Committee will consist of ten voting dealer members; five voting buy-side members; two global non-voting members (one dealer and one buy-side) that will sit on each regional committee; and ISDA will act as a non-voting secretary and coordinate the process.

To become a dealer member, a dealer institution must have been a participating bidder in previous auctions, have adhered to the "Big Bang" protocol and meet notional trade volume criteria as reported by DTCC (Depository Trust and Clearing Association). Dealers will be chosen in order of highest trading volume of credit derivative transactions. Eligible buy-side members are eligible if they have at least $1 billion in both assets under management and notional single-name CDS trade exposure and are approved by one-third of the then-current committee of buy-side members (which will initially be composed of the non-dealer ISDA members that actively participated in the ISDA meetings regarding the drafting of the new provisions). Buy-side members are then randomly selected from such buy-side pool and will serve for staggered one-year terms. All buy-side members will have a chance to serve before any one institution serves a second term.

If the Determination Committee shall fail to achieve an 80 percent supermajority consensus in respect of any determination, the determination will be automatically referred to an external review panel. External reviewers are selected for each question from a pool determined by the relevant Determination Committee. If a vote of the Determination Committee reached less than a 60% majority, two out of the three external reviewers can overturn the result. If a vote of the Determination Committee was greater than 60% but less than 80%, all three external reviewers are required to overturn the decision. Members of the Determination Committee will be able to present arguments to the reviewers in support of their position.

All resolutions by a Determination Committee or external reviewers will be published by ISDA and will be binding on all market participants that have incorporated the new provisions into their agreements.

How And When Will These Changes Be Implemented?

The changes will be implemented through the adoption by counterparties to CDS transactions of the 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement Supplement to the 2003 ISDA Credit Derivatives Definitions (the "Supplement"). In other words, the Supplement applies to CDS transactions going forward, provided that the relevant confirmations incorporate the Supplement. The Supplement will be automatically incorporated into any new CDS transaction incorporating the most recent version of ISDA's Credit Derivatives Physical Settlement Matrix (except for transactions referencing U.S. municipal entities) (the "Matrix").

Parties to existing credit derivative transactions may, by adhering to the 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement CDS Protocol (the "Protocol"), agree to amend their transactions with all other adhering parties to implement the amendments incorporated by the Supplement. Market participants will have until 5:00 p.m., New York time, on April 7, 2009 (or such later date specified by ISDA, the "Adherence Deadline") to deliver an adherence letter to ISDA, with changes going into effect the following day. ISDA has the discretion to extend the Adherence Deadline or to re-open the Protocol for adherence at a later date but currently has no plans to do so.

Adhering to the Protocol will enable market participants to eliminate distinctions in their book between transactions entered into before the Adherence Deadline and those entered into after that date. If an adhering market participant does not wish to incorporate the terms of the Supplement into a trade, it will need to specify in the confirmation or in a side agreement with its counterparty that the trade is not covered by the Supplement.

Which Transactions Are Covered By The Protocol?

The Protocol will cover the same types of derivative transactions that generally have been included in the CDS auctions held to date, as well as certain transactions that are not typically included in the CDS auction. The latter transactions will incorporate the Supplement, but 'Auction Settlement' features will not be applicable.

Trades excluded from the Protocol include loan-only CDS, U.S. municipal CDS, credit derivative transactions on asset-backed securities, fixed recovery transactions as well as transactions designated by the parties as excluded (as recorded in a confirmation or in a separate side agreement).

The Protocol covers not only previously existing (or legacy) transactions entered into prior to April 8, 2009, but, in contrast to previous CDS Protocols, prospective trades entered into between two adhering parties on or after April 8, 2009 having a Trade Date on or before January 31, 2011 will also be covered. This is intended to allow time for industry standard documentation that may not be amended before the Adherence Deadline to be updated with the appropriate changes. Similarly, the Protocol covers novations of any covered CDS transaction entered into between April 8, 2009 and January 31, 2011, where the transferee and remaining party to the novation have both adhered to the Protocol, even if the transferor has not adhered.

To Adhere Or Not To Adhere: That Is The Question

Market participants should prepare an inventory of their outstanding trades as well as the CDS strategy that they want to implement in the future and determine whether adherence to the Protocol is desired.

In making that determination, market participants should consider the following factors:


By adhering to the Protocol, all covered CDS trades existing between two adhering parties as of the Adherence Deadline will incorporate the Supplement. If market participants want to carve out certain trades, they can do so by way of a bilateral negotiated agreement with the applicable counterparty.


Because the Protocol applies Auction Settlement terms to legacy trades and the Supplement allows the parties to select Auction Settlement terms for future trades, there will no longer be a need for specific stand-alone CDS auction protocols with respect to a particular Reference Entity. If a party does not adhere to the Protocol, it will need to bilaterally settle its CDS trades in accordance with the Settlement Method specified in the confirmation, unless the parties incorporate the changes made by the Protocol by way of individually negotiated agreement.


Future regulation may require that all CDS transactions be cleared through a central clearing counterparty. As only more liquid and fungible CDS trades may be eligible to be cleared through such a clearing platform, incorporating the Supplement will facilitate counterparties' participation in a market in which CDS have to be cleared through a central counterparty.

New Trading Conventions For North American Corporate Transactions - The 100/500 Contract

In order to standardize trading conventions for North American CDS contracts, the derivatives industry has agreed to a new "Standard North American Corporate" transaction type and ISDA has added the new transaction type to its Matrix. The pre-existing North American Corporate transaction type is still available and market participants will have the choice between those two transaction types for their North American Corporate trades. Market participants that have not adhered to the Protocol may still enter into this new "Standard North American Corporate" CDS.

The new trading conventions applying to the "Standard North American Corporate" transaction type are as follows:


Fixed Scheduled Termination Date - the Scheduled Termination Date will always match one of the four quarterly roll dates (March 20, June 20, September 20 or December 20 [matching the roll dates for CDX indices]);


Fixed Coupons - Fixed Amounts will still be reflected as a percentage per annum and are expected to be 1 percent (100 bps) for investment grade Reference Entities and 5 percent (500 bps) for high yield Reference Entities;


Accruals - Regardless of the Effective Date, accruals will begin on the roll date immediately preceding the Effective Date. All settlements will be full coupons and the initial payment will take into account any accruals occurring prior to the Trade Date; and


No Restructuring - Restructuring will be eliminated as an optional Credit Event.

Conclusion

These market initiatives should enhance the infrastructure of the CDS market, increase transparency and promote fungibility of credit derivatives. They pave the way for a number of industry priorities, including reduction of notional values through trade compression and the central clearing of credit derivatives.

Howard T. Spilko has a diverse transactional-based practice including domestic and cross-border mergers and acquisitions, joint ventures and alliances, finance, including derivatives transactions, and general corporate matters. Fabien Carruzzo 's practice focuses on mergers and acquisitions, private equity/venture capital, structured finance and derivatives transactions.

Please email the authors at hspilko@kramerlevin.com or fcarruzzo@kramerlevin.com with questions about this article.