The International Swaps and Derivatives Association, Inc. (“ISDA”) has proposed the Credit Derivatives Determinations Committee and Auction Settlement Supplement to the 2003 ISDA Credit Derivatives Definitions (the “Supplement”; and the 2003 ISDA Credit Derivatives Definitions, the “2003 Definitions”) for all future trades which will fundamentally affect the credit default swap market. ISDA will also publish a protocol (the “Big Bang Protocol”) which will allow parties to apply the proposed changes to all current credit default swap trades. ISDA has stated that adherence to the Big Bang Protocol is essential to the overall effectiveness of the new operational and legal framework and urges all dealers and buyers to adopt the Protocol.
The proposed Supplement is an effort to further standardize and encourage the fungibility of trades, create transparency and legal certainty in the credit default swap market as well as promote a stable market with less basis risk. The Supplement modifies the current operational and legal structure of credit default swaps by (i) establishing the Credit Derivatives Determinations Committees for the purpose of making determinations of credit events, succession events, overseeing the auction process and other matters, (ii) standardizing determinations on credit events and succession events, (iii) adopting an auction settlement method based on the documentation used in connection with previous credit derivative auction protocols, (iv) modifying currency exchange rates and related provisions for physical settlement and the auction settlement process and (v) modifying the physical settlement process for loans and establishing a cash settlement fallback option.
Establishment of the Credit Derivatives Determinations Committees
In a move towards a more standardized and transparent legal infrastructure, the Supplement establishes a Credit Derivatives Determinations Committee for each major region (each, a “Committee”), and grants each Committee the authority to decide issues pertaining to credit events, auctions, deliverable obligations, succession events and mergers of reference entities. Appropriate determinations by the Committee will include but are not limited to: (1) whether a credit event or succession event has occurred, (2) whether or not to hold an auction, (3) what obligations constitute deliverable obligations and whether supplemental and/or substitute reference obligations should be included and (4) any other contractual interpretation of relevance to the credit derivatives market. The Committee may, however, decline to make a determination on any question posed. While Committee decisions are final, certain Committee determinations will be subject to an external review process in cases where an 80 percent supermajority vote is not achieved. Committee determinations, however, will not supersede the provisions of bilateral agreements between counterparties. Moreover, in order to foster the transparency of Committee determinations, ISDA will make public every Committee decision on their website.
A Committee will be established for each major region: (1) the Americas, (2) Asia and (3) Europe, the Middle East and Africa, and will be comprised of eight global dealer members, two regional dealer members from the respective region and five buy-side members. ISDA will serve as secretary of each Committee. The Committee members will be made up of interested dealer and buy-side members who have the largest trading volumes or exposure, respectively, and who have amended their existing trades by adhering to the Big Bang Protocol.
Standardization of Credit Event and Succession Event Determinations
As a response to regulatory requirements and market demands, the Supplement modifies the period for which credit events and succession events may occur to encourage fungibility of trades. When determining whether a credit event or succession event has occurred, the Committee will be allowed a look-back period of 60 days, in the case of credit events, and 90 days in the case of succession events from the date notice of such event is received by the Committee. This is a departure from the current 2003 Definitions, which provides for the determination of a credit event or succession event as of the effective date through the termination of the trade. Of particular note, the Committee will still apply a look-back period of either 60 or 90 days, respectively, as of the date of determination, regardless of whether part or all of the look-back period falls before the trade date. This means that parties will be responsible for possible credit or succession events occurring up to 60 and 90 days before the trade date, respectively.
Adoption of an Auction Settlement Mechanism
The need to hardwire an auction settlement method into the 2003 Definitions has become increasingly apparent, in particular with the recent surge of credit default swap auction protocols as a result of the current financial turmoil. Using ISDA’s recent credit default swap auction protocols as models, the Supplement incorporates the auction settlement method into the 2003 Definitions. While the Supplement for the most part adopts the auction settlement methodology as applied in the recent protocols, certain modifications of the rights of the parties upon settlement include changes to the foreign exchange provisions and the settlement process for loans (each described in detail below). These will work to streamline the settlement process and correct some shortcomings in the settlement process applicable to previous credit events. Additionally, the newly constituted Committees will oversee and govern the auction process with the goal of providing a more transparent and standardized legal framework for the auction settlement process. Specific auction settlement terms and the particular deliverable obligations will be determined by the Committee for each auction it decides to hold. To establish consistency, amendments to the auction methodology in the Supplement can only occur by a supermajority vote by the Committee after a public comment period.
Fixing Currency Rates for Settlement
Currently under the 2003 Definitions, the currency rate for physical settlements is pegged to the date on which the Notice of Physical Settlement (“NOPS”) becomes effective. Additionally, if a buyer of protection amends a NOPS, the date for currency conversion is the date of the amendment. Hidden consequences of the way these provisions work became more apparent in recent credit events—drawing much criticism. Under the existing provisions of the 2003 Definitions, protection buyers may amend their NOPS solely to take advantage of currency fluctuations and once a NOPS is amended, the date for the currency rate conversions for all deliverable obligations specified in the NOPS will be changed. Sellers of protection are unable to effectively hedge their exposure to this foreign exchange risk. Dealers are also unable to price this risk into the transactions. Additionally, the lack of a uniform currency exchange methodology may result in mismatches in the size of positions. The right to wait until the very last moment to modify a NOPS may also prevent one party (a seller of protection) to an intermediated transaction from modifying a NOPS it previously delivered to a third party who sold it protection to account for the last minute modification. Finally, as the currency exchange rate is established after an auction, the parties to the auction will not know beforehand the size of the interest to submit under a physical settlement request when they wish to deliver a non-auction currency-denominated bond. As a result, in an effort to address these issues in the physical settlement process, the Supplement: (1) sets the currency rate on the business day or two business days prior to the auction date, (2) reduces foreign exchange risk by requiring the NOPS to be delivered on the business day following the auction date and (3) shifts the risk of currency rate fluctuations to the buyer where such buyer exercises its option to amend its NOPS by basing the currency rate for new deliverable obligations by reference to the spot rate of the incoming and the outgoing deliverable obligations.
Acceleration and Compression of Loan Settlement
In cases where physical settlement is elected and a loan must be delivered to multiple intermediate parties before delivery to the final protection seller, the Supplement proposes to streamline the auction settlement process. This is achieved by giving the initial protection buyer that must deliver the loan the option to skip delivery of the loan to the intermediate parties and deliver the loan to the ultimate protection seller, or if delivery is not possible to the ultimate protection seller, then to the last possible intermediate party capable of receiving delivery (subject to certain necessary consents). The respective intermediate parties which have not physically settled will cash settle their respective trades. Finally, the Supplement will also add a cash-settlement fallback mechanism where there is a failure to physically settle.
Proposed Market Practice Changes
ISDA has also been discussing the elimination of restructuring as a credit event with respect to the standard terms on high-grade North American Corporate reference entities. Additionally, credit default swap market participants are discussing setting the fixed coupon to either 100 or 500 bps. Finally, the market is looking to standardize payment dates and accrual periods by setting all fixed rate payer payment dates to March 20, June 20, September 20 and December 20 and designating the accrual period for fixed amounts as the standard payment date on or immediately prior to the effective date. This is a departure from the current ISDA framework which allows parties to specify in the related confirmation the accrual periods and payment dates for fixed amounts.
Next Steps for Our Clients
The terms of the Supplement and the Big Bang Protocol are in their final comment period and will be finalized by early March. The Supplement is due to take effect on March 20, 2009 for all prospective credit default swap trades. Qualifying parties who wish to amend their existing trades should adopt the Big Bang Protocol. Parties wishing to do so will also have the added flexibility of opting out of the auction settlement terms if they so choose. Trades which have been excluded from eligibility for adherence to the protocol include loan-only trades, US municipal trades, credit default swaps on asset-backed securities, mortgage-backed securities or collateralized debt obligations and bespoke portfolio transactions, referencing credit-linked notes, trust certificates or similar securities. The final text of the Big Bang Protocol will be published and available for the parties on ISDA’s website (www.isda.org). The intention is for the supplement to be published on March 12, 2009 and for the adherence period for the Big Bang Protocol to open on March 12, 2009 and close on April 7, 2009. For those adhering to the Big Bang Protocol, the new Credit Derivatives Determinations Committee and auction settlement changes will be effective upon close of the adherence period, however, the credit event and succession event look-back provisions will not be effective until June 20, 2009, unless otherwise pushed back due to timing changes in the launch.