The aftermath of the COVID-19 pandemic, the ongoing Russia/Ukraine conflict, and rising inflation and interest rates have exacerbated a slowdown in the world economy. Many borrowers have availed themselves of low-cost debt in the decade since the financial crisis, and some may encounter challenges in servicing or refinancing this debt in a harsher economic climate.
As we move from a historically low default rate environment to what is expected to be a higher default rate environment, it would be prudent for entities with Credit Default Swap ("CDS") exposure to ensure that they understand the terms of their CDS and, should a Credit Event occur, are able to manage the outcome of settlement.
This briefing may be of interest to asset managers who run credit strategies, institutional investors, financial institutions, income funds and other entities that have purchased or sold credit protection.
What is a CDS and how is it typically documented?
A CDS is a derivatives transaction between two parties, where one of the parties purchases protection against the occurrence of a number of pre-determined events (so-called "Credit Events") in respect of an underlying entity (the "Reference Entity"). The Reference Entity is not a party to the CDS.
An asset manager may use CDS to buy or sell protection on a set of debt obligations of a Reference Entity or a basket of Reference Entities. This briefing focusses on the protection seller.
A CDS is typically documented under: (i) an ISDA Master Agreement; (ii) a trade confirmation ("Confirmation"); (iii) the 2014 ISDA Credit Derivatives Definitions (the "ISDA Credit Definitions"); and (iv) where relevant, the ISDA Credit Derivatives Physical Settlement Matrix (together the "CDS Documentation").
Depending on how they are documented, these transactions may be considered "standard" or "non-standard". This will have an impact on the lifecycle of the CDS, including the settlement process that applies to the transaction upon the occurrence of a Credit Event.
The regulatory treatment of CDS is complex and beyond the scope of this briefing. The status of the counterparties to the CDS, and where they are based, will be relevant. EU and UK market participants should note however that "naked" or uncovered CDS on sovereign debt are prohibited by the Regulation on Short Selling and Credit Default Swaps (EU 236/2012).
Has there been a Credit Event?
A number of events can trigger a Credit Event under a CDS. These are set out in the CDS Documentation and include:
(a) Bankruptcy – not only "hard" insolvency events involving the Reference Entity (such as formal insolvency processes) but also other events leading up to an insolvency scenario. The full scope of the standard Bankruptcy Credit Event can be found in the ISDA Credit Definitions.
(b) Failure to Pay – where the Reference Entity fails to make a payment when due on one or more "Obligations", in excess of a pre-defined threshold. This event will typically be triggered following the expiry of an applicable grace period. The term "Obligations" covers borrowed money, bonds and/or loans and so will depend on the type of CDS that is in place, and the terms of the CDS Documentation.
Other events will apply and some may be bespoke (potentially making the CDS non-standard), as agreed between the parties in the Confirmation. The CDS Documentation will therefore need to be reviewed in detail when assessing whether a specific Credit Event has occurred.
Do protection sellers need to go it alone?
While it is clearly essential for protection sellers to understand the terms of the transactions that they have entered into, what is known as the Credit Derivatives Determinations Committee (the "DC") will, in most cases, play an important role in determining whether a Credit Event has occurred in respect of a Reference Entity and, if so, the date on which such event has occurred.
Market participants may (on an anonymised basis, if they wish) ask the DC to confirm whether a Credit Event has occurred in respect of a specific Reference Entity. Details of requests and decisions made by market participants and the DC, respectively, are available on the DC website.
What happens following a Credit Event?
Timing is crucial, because certain actions must be performed within prescribed time periods. This includes the exchange of notices and the provision of certain information. Protection sellers are advised to have processes in place to ensure that they can meet all necessary deadlines.
The occurrence of a Credit Event will typically lead to termination and settlement of the CDS. This can happen in different ways, depending on: (i) the type of CDS that is in place; (ii) the type of Credit Event that applies; and (ii) how the CDS is documented.
If it is determined that Bankruptcy or Failure to Pay has occurred in respect of a Reference Entity, all CDS in relation to that entity will be terminated automatically, resulting in a net settlement between the protection buyer and the protection seller.
Bespoke Credit Events may require further analysis and may be triggered by the parties to the CDS themselves – it is important to understand how such bespoke Credit Events are intended to operate and consider the applicable drafting carefully.
Auction vs. physical settlement
Following the occurrence of a Credit Event, a standard CDS will typically settle through an auction process. This auction process is run by the DC and establishes the price at which the CDS should be settled for all CDS market participants who elect to participate in the process. The auction process is complex and should be assessed on a case-by-case basis upon occurrence of a Credit Event and following the determinations of the DC.
If an auction is not held, the CDS will settle in accordance with the fallback method specified in the CDS Documentation – this will typically be through physical settlement. Where physical settlement applies, usually the protection buyer will be entitled to deliver to the protection seller any of the pre-agreed "Deliverable Obligations" of the Reference Entity to settle the transaction. This would involve delivery of a Deliverable Obligation with a face value equal to the notional amount of the CDS in exchange for a payment which would usually equal the notional amount. The Deliverable Obligations are commonly specified in the ISDA Matrix and will be subject to certain minimum criteria, such as being transferable, and not being subordinated or contingent.
Upon the occurrence of a Credit Event, the protection seller should consider the settlement mechanics in detail to:
(i) ensure that it is able to receive any Deliverable Obligations – e.g. that there are no regulatory or governance restrictions that may affect its ability to receive/hold such obligations;
(ii) determine if holding such Deliverable Obligations would cause any impact on its investments/investors, and what it will do with the Deliverable Obligations when received (hold or trade); and
(iii) any accounting or tax implications.
CDS have proven to be effective tools allowing protection buyers to protect themselves against default risks to which they are exposed and protection sellers to generate income.
Now is the time for entities with CDS exposure to ensure that they understand the terms of their CDS and, should a Credit Event occur, are able to manage the outcome of settlement.
Entities with CDS on bespoke terms should be particularly mindful of the need to understand their documentation, as well as being alive to increased dispute/litigation risk if the circumstances surrounding the occurrence of the Credit Event are less clear cut.