Today, the International Swaps and Derivatives Association (ISDA) issued its Credit Derivatives Determination Committees and Auction Settlement Supplement to the 2003 ISDA Credit Derivatives Definitions (the “March 2009 Supplement”) and opened its “Big Bang” Protocol to implement significant changes to the credit default swap (CDS) market. The changes will address certain commitments made to regulators, improve market liquidity, and incorporate related changes to documentation for CDS transactions. Among other changes, an auction settlement process for CDS will be hardwired into CDS contracts.

Substantive changes are contained in the March 2009 Supplement. Going forward, parties to CDS can explicitly include the March 2009 Supplement in the documentation for their transactions. For existing transactions, the March 2009 Supplement will be incorporated into documentation if both parties sign onto ISDA’s Big Bang Protocol. The Protocol will also cover CDS entered into before January 31, 2011 using market standard documentation.

Market participants will be able to sign onto the Protocol until April 7, 2009. The Protocol comes into effect on April 8, 2009.

Key changes to the CDS market are as follows:

  • Determinations Committees. ISDA will establish Determinations Committees to decide certain issues for the CDS market, including whether a credit event on a particular reference entity has occurred, the date of the credit event, whether an auction will be held to settle out CDS on that reference entity, terms of deliverable obligations upon settlement of CDS, whether a succession event has occurred with respect to a reference entity, and the identity of any successor entity. All parties who agree to the March 2009 Supplement will be bound by the decisions of the relevant Determinations Committee unless they agree otherwise bilaterally. The Determinations Committees will be composed of sell side and buy side representatives, with the composition being weighted towards the sell side. A lengthy set of rules governs the selection of the Committees, the qualifications of their members, which issues they will review, how they reach their determinations, what steps will be taken if a Committee does not reach a decision, and how to address conflicts.
  • Auction Settlement. Parties can select auction settlement as the method for settling a CDS, in lieu of cash or physical settlement. If the relevant Determinations Committee decides that an auction will be held for a reference entity, settlement of all CDS contracts referencing that entity for which auction settlement has been selected are subject to the results of the auction process. The auction process is largely the same as the numerous CDS auction settlements over the last three and a half years. Parties can continue to select cash settlement or physical settlement if they prefer. Those methods will also be the fallback settlement methods if the Determinations Committee decides that an auction will not be held.
  • Backstop dates for credit events and succession events. At any point in time, a credit event occurring during (but not prior to) the last 60 days can trigger a CDS settlement if the conditions for settlement have been satisfied. The practical effect of the credit event backstop date is that all outstanding CDS on a particular reference entity are triggered by the same credit event, regardless of the effective date of the CDS. This brings uniformity to the treatment of CDS on the same reference entity. Similarly, succession events occurring during (but not prior to) the last 90 days can trigger a replacement of the reference entity with a successor, regardless of the effective date of the transaction. This too brings uniformity to treatment of CDS on the same reference entity.
  • Market standard fee payments. Market practice will move to trading CDS transactions with standard fixed payments of 100 basis points or 500 basis points. If parties want to incorporate different fixed payment rates, an adjustment must be made through an up front payment on the CDS.
  • Foreign currency conversion. Changes have been made to the treatment of foreign currency conversion so as to shift certain foreign currency risk to the party best able to manage the risk. Buyers of protection under a physically settled CDS contract who specify deliverable obligations in a currency which differs from the settlement currency will be responsible for covering exchange rate fluctuations if the party changes the currency of the deliverable obligation to the seller’s disadvantage.

The parties to a CDS transaction can agree, on a bilateral basis, to vary the application of particular provisions of the March 2009 Supplement.

According to a press release issued by ISDA today, these changes represent “a major milestone in the ongoing refinement of practices and processes for the efficient, liquid and transparent conduct of the CDS business.”