The Protocol

On 16 September 2019, the International Swaps and Derivatives Association (“ISDA”) launched a protocol to allow market participants to amend their legacy credit derivatives transactions to incorporate the Narrowly Tailored Credit Event Supplement to the 2014 ISDA Credit Derivatives Definitions. ISDA has provided a webinar about the Protocol.

This arises from concerns over deliberate defaults by reference entities with the intention of triggering credit derivatives payouts via narrowly tailored credit events (“NTCEs”) to maximise the resulting payout on credit derivatives. Some commentators have been led to question the viability of credit derivatives on single corporate entities as a financial product.

Amendments to the 2014 ISDA Credit Derivatives Definitions

The Supplement amends the definition of ‘failure to pay’ in the 2014 Definitions and adds a guidance memo on the interpretation of that definition, to the effect that a Failure to Pay will not result in a Credit Event if the failure to pay “does not directly or indirectly either result from, or result in, a deterioration in the creditworthiness or financial condition of the Reference Entity”.

The Supplement also amends the definition of ‘outstanding principal balance’ so that if a bond or loan has been issued at a material discount, then for the purposes of determining the payout under a credit derivative, the discounted issue level is the reference point, rather than the par value claim that the bond or loan holder may have on the Reference Entity.

Scope and Timing

The Protocol is relevant to all market participants that trade over-the-counter non-cleared credit derivatives that incorporate the 2014 ISDA Credit Derivatives Definitions. The Protocol will not apply to transactions documented using the 2003 ISDA Credit Derivatives Definitions. For those firms that have only cleared trades, adherence to the protocol is not required.

The anticipated implementation date of the protocol is 13 January 2020. Central counterparties will also incorporate the supplement into cleared trades on the implementation date. The cut-off date for adherence to this protocol is 5pm EST on Monday 28 October 2019.