On April 8, 2009, documentation and market practice for credit default swaps ("CDS") will change dramatically as part of the most aggressive initiative to date to improve the functioning and efficiency of the CDS market. The changes will be implemented by (i) the International Swaps and Derivatives Association, Inc. ("ISDA") through a set of revisions to CDS documentation, and (ii) CDS dealers by modification of current market practice for North American Corporate CDS.

These changes are part of a market-wide effort to add certainty, reduce systemic risk and increase transparency in the CDS market " they anticipate further regulatory and product changes, including centralized clearing.¹ Taken together, the changes to documentation and market practice create a more standard CDS product by resolving issues that have created transaction, settlement and basis risk in the current market in a manner intended to improve liquidity and transparency of the product.

The documentation changes are expected to apply to CDS transactions entered into on or after April 8, 2009. In addition, market participants may voluntarily incorporate the documentation changes into existing transactions by adhering to ISDA's "Big Bang Protocol" described below. The adherence period for amending existing transactions begins on March 12 and ends on April 7, 2009.²

The 2009 Supplement to the Definitions

On March 12, 2009, ISDA published in final form a supplement and accompanying documentation (the "2009 Supplement") intended to supplement and amend the 2003 ISDA Credit Derivatives Definitions (the "Definitions") by (i) establishing the framework for "Determinations Committees," (ii) hardwiring auction settlement provisions to facilitate prompt cash settlement after a credit event, and (iii) creating a market-wide, uniform and truncated "look-back" period for credit events and succession events. The documentation is available on the ISDA website (http:// www.isda.org/).

1. Determinations Committees

The 2009 Supplement establishes a "Credit Derivatives Determinations Committee" framework. Under the new framework, "Determinations Committees" will make market-wide, uniform and binding determinations relating to credit events, auctions, succession events, substitute reference obligations and other issues needed for efficient functioning and greater transparency of the maturing CDS market. Each Determinations Committee will be (i) convened as needed (e.g., at the time of a potential credit event or succession event) and (ii) comprised of a mix of dealer and buyside representatives selected from a pool of eligible ISDA members based on criteria including notional trade volume or trade exposure in credit derivatives transactions.

Most important Determinations Committee decisions will require a supermajority (80%) vote, and other determinations will require a majority vote. Certain key decisions that receive less than 80% approval will be subject to external review by individuals selected by the relevant Determinations Committee. All decisions resulting from this Determinations Committee process will be binding on all CDS transactions that have incorporated the 2009 Supplement. The creation of the Determinations Committee framework will help ensure consistent and timely application of the Definitions and transaction terms to a relevant event, facilitate trade compression and centralized clearing, and ultimately enhance confidence and liquidity in the CDS product.

2. Hardwired Cash Settlement through an Auction

The auction mechanism has been one of ISDA’s most successful settlement efficiency initiatives. Beginning in 2005 with the bankruptcy of Collins & Aikman and continuing through the recent period of increasingly frequent credit events, ISDA has championed the evolution of a robust auction methodology, which generates a trusted price at which all covered CDS transactions can be cash settled with certainty after a credit event on a voluntary basis.³ Under the 2009 Supplement, all covered CDS transactions will be required to cash settle in accordance with the auction mechanism, which will promote the efficient settlement of all CDS contracts after a credit event. In addition to making auction settlement mandatory for all covered CDS transactions, the 2009 Supplement improves the existing auction technology by clarifying terms applicable to the delivery of loans (as opposed to bonds) for purposes of the auction-generated, physically-settled transactions, as well as modifying the rules regarding currency conversions. The additional clarity will more precisely define the "representative auction-settled transaction" that is the subject of bids and offers in the auction.

3. Credit Event and Succession Event Backstop Dates

In the current CDS market, it is impossible to achieve a perfect hedge for an existing CDS transaction by entering into a new CDS transaction on a later date. This is because credit events or succession events that are ultimately found to occur in the "gap period" after the effective date of the first transaction but before the effective date of the second transaction are only covered under the first transaction. The 2009 Supplement introduces a new rule intended to eliminate that basis risk and thereby promote the more complete fungibility of CDS transactions. Under the 2009 Supplement, a credit event or a succession event will not affect a CDS transaction unless it occurs within 60 days (in the case of a credit event) or 90 days (in the case of a succession event) prior to the date of notice of the event to ISDA, as secretary of the Determinations Committee. The 60th day before the notice date is called the "Credit Event Backstop Date," and the 90th day the "Succession Event Backstop Date." By focusing on the notice date in respect of an event, rather than the multitude of different effective dates for CDS transactions in a certain reference entity, all standard CDS transactions identifying the same reference entity will provide coverage for the same potential credit events and succession events, no matter when a CDS transaction is first effective. By setting the Credit Event Backstop Date at the 60th day prior to the notice date, and Succession Event Backstop Date at the 90th day, the market will attain certainty that dated potential credit and succession events will no longer impact a CDS transaction.

4. Modifying Existing CDS Transactions through the Big Bang Protocol

The Big Bang Protocol is available on the ISDA website (http://www.isda.org/index.html) and should be reviewed by parties intending to update their existing CDS transactions to incorporate the changes contained in the 2009 Supplement.4 If both parties to an existing CDS transaction "adhere" to this protocol, the relevant covered transaction will be deemed to be amended as provided in the protocol. The adherence period will end on April 7, 2009.

New Standard North American Corporate CDS

Simultaneously with ISDA"s publication of the 2009 Supplement, CDS dealers have agreed to make certain changes to the market practice in North American Corporate CDS to create a new "standard" product. These changes are not reflected in the Big Bang Protocol, therefore adherence to the protocol will not incorporate these changes into existing North American Corporate CDS transactions. Many of the market practice changes will take effect on April 8, 2009, while others may ultimately take effect at a later date.

1. 100/500 Coupon

Effective on April 8, 2009, the CDS dealers will quote the standard single-name North American Corporate CDS transactions on the basis of a standard coupon of either 100 basis points (generally for CDS referencing investment grade companies) or 500 basis points (generally for CDS referencing non-investment grade companies). This practice will bring pricing conventions for single-name CDS transactions in line with most CDS index transactions. The relevant standard coupon will be used to calculate the annual "fixed amount," or premium, payable by the protection buyer. To the extent the prevailing running spread in the market at the time of the trade differs from this fixed coupon, the protection buyer will either make or receive an upfront payment. The standard coupon pricing methodology will facilitate trade compression and trade matching as well as unwind and novation valuations, again leading to enhanced fungibility and liquidity of CDS transactions.

2. Full First Coupon

The new market practice for the standard North American Corporate CDS changes the existing convention for the due date and calculation of the first premium payment. Currently, the first coupon payable by protection buyer will reflect the accrual from the effective date of the transaction through the first payment date, but the first payment date may be either the first or second quarterly premium payment date (March 20, June 20, September 20 and December 20) after the relevant trade date, depending on when the trade date occurs. The existing practice results in different initial premium payment amounts and payment dates under transactions with different trade dates. The new practice will standardize the initial payment for all CDS transactions " no matter when the trade date occurs, the first premium payment will be calculated for the full quarterly period and made on the first quarterly premium payment date following the trade date.

3. No Restructuring

Currently, single-name CDS transactions referencing investment grade North American corporate entities typically include "restructuring" as a credit event, with limitations on deliverable obligations if protection buyer triggers a restructuring credit event (commonly referred to as "Mod R"). The definition of restructuring is complex and often difficult to satisfy, while the "Mod R" limitations reduce the utility of such a credit event to the protection buyer. In addition, restructuring is not a credit event under North American CDS index trades, resulting in a basis risk for a party who buys protection under a CDS index trade to hedge its risk as a protection seller under a single-name CDS trade. To resolve these issues, CDS dealers intend to remove "restructuring" as a credit event under new standard North American Corporate CDS contracts.5

Continuing Freedom to Execute Non-Standard or Bespoke Transactions

The implementation of the changes discussed above will promote standardization, fungibility and liquidity for standard CDS trades while enhancing operational efficiency and simplifying risk management for the majority of the CDS market. Most importantly, CDS market participants will continue to have freedom to negotiate non-standard CDS transactions tailored to specific trading or hedging needs. These "bespoke" transactions may ultimately constitute a minority of transactions in the CDS market, but they will continue to be offered, negotiated and traded by the CDS dealers.

Conclusion

Market participants should promptly review the 2009 Supplement and the documentation governing adherence to the Big Bang Protocol. The ideas behind the changes may be straightforward, but a smooth transition to the new standard contract will require market participants to master many details. In particular, not all of the current changes are governed by legal documentation" some rely on modifications to current practice " and not all of the changes will begin on April 8, 2009, even if both counterparties adhere to the Big Bang Protocol. Taking a longer view, market participants should begin to anticipate opportunities in the changing derivatives markets. April 8, 2009 will see far-reaching, yet evolutionary, changes in CDS documentation and market practice. These changes, however, do not represent an end to the evolution of the CDS product, or even a stable resting place. The next several years promise continued change in (i) the regulations governing CDS, (ii) the systems designed to clear and report CDS transactions, and (iii) the legal framework and market practice designed to reduce counterparty credit risk.