As the credit default swap (“CDS”) market continues to adapt to a changing regulatory landscape and the evolving role of government intervention in capital markets, CDS market participants will soon experience the most signiﬁcant ISDA-led product shift since the implementation of the 2009 auction settlement and determinations committee rules.
A major evolutionary step, the 2014 ISDA Credit Derivatives Deﬁnitions (the “2014 Deﬁnitions”) represent the industry’s resolve to improve the ﬂexibility of the product and address many of the challenges the CDS product has confronted over the past decade.
The 2014 Deﬁnitions comprehensively update the 2003 ISDA Credit Derivatives Deﬁnitions (the “2003 Deﬁnitions”), and effectuate a re-launch of CDS as a fungible and effective risk transfer product that is primed for the world of central clearing and for future credit market innovations and challenges.
The revisions are detailed and technical, and will likely produce different economic outcomes for CDS transactions in certain situations (compared to outcomes under the 2003 Deﬁnitions). Market participants will need to study the impact of the new 2014 Deﬁnitions on their current positions and their future trading decisions.
Parties with CDS contracts outstanding under the 2003 Deﬁnitions now have the opportunity to update certain of those transactions through the use of a well- established ISDA protocol process which will remain open for adherence until September 12, 2014 and be implemented on September 22, 2014.
The 2014 Deﬁnitions include a signiﬁcant number of changes, both substantive and procedural – this brief memorandum discusses a select number of key changes and expected improvements.
NEW CREDIT EVENT: GOVERNMENTAL INTERVENTION
The 2014 Deﬁnitions add a new “Governmental Intervention” credit event which is expected to apply (at least initially) to CDS transactions that reference ﬁnancial entities in certain regions outside of North America. Under the 2003 Deﬁnitions, it was unclear whether a “Restructuring” credit event would be triggered by a government action to expropriate or write down a Reference Entity’s debt obligations in certain situations, as illustrated by the debate over the impact on CDS of the expropriation of certain bonds of SNS Bank NV by the Dutch government in connection with a “bail-in”.1 The new “Governmental Intervention” credit event populates that gap in the Restructuring credit event and provides protection buyers with clear protection against a bail-in, write-down or other action by a governmental authority with respect to a ﬁnancial Reference Entity’s debt obligations.
Governmental Intervention is triggered by the action or announcement of a governmental authority pursuant to a restructuring and resolution law or regulation that results in certain binding changes to a Reference Entity’s debt obligations, including (i) a reduction or postponement of interest or principal, (ii) a subordination of the debt obligation, (iii) expropriation, transfer or other event which mandatorily changes the beneﬁcial holders, or (iv) mandatory cancellation, conversion, or exchange of the debt obligation.
Governmental Intervention covers much of the same ground as the Restructuring credit event, but contains a number of key differences intended to address the practical reality of future bail-ins in European jurisdictions. For instance, Governmental Intervention, unlike a Restructuring, can be triggered even if the terms of the underlying debt obligations expressly permit a bail-in or write-down: the override acknowledges a trend in recent European legislation requiring such express terms in debt documentation.
PRESERVATION OF DELIVERABLE OBLIGATIONS: ASSET PACKAGE DELIVERY
The CDS market has experienced a number of actual or potential “orphan” events over the past decade – situations where a Reference Entity is left with no Deliverable Obligations – particularly after a debt exchange or governmental expropriation of debt and protection buyers are deprived of the economic beneﬁt of the CDS contract. The 2014 Deﬁnitions include new “Asset Package Delivery” provisions allowing protection buyers to deliver the assets resulting from such an exchange or similar event.
Following a Governmental Intervention or Restructuring with respect to a ﬁnancial Reference Entity, protection buyers may deliver the “Asset Package” (which may include debt, equity, cash, rights or other assets) that is received by the holders of a “Prior Deliverable Obligation”, and following a Restructuring with respect to a sovereign Reference Entity, protection buyers may deliver the “Asset Package” that is received by holders of a “Package Observable Bond”. A “Prior Deliverable Obligation” is (a) in the case of a Governmental Intervention, an obligation that would have fulﬁlled the requirements of a Deliverable Obligation immediately prior to the Governmental Intervention but was the subject of the Governmental Intervention, and (b) in the case of a Restructuring, the Reference Obligation that was the subject of the Restructuring. A “Package Observable Bond” is a pre-determined widely-held bond of a sovereign Reference Entity which is selected and published by ISDA. Notably, an Asset Package could be determined to be zero if holders of the applicable obligation are offered no assets in connection with the relevant exchange, providing protection buyers with 100% recovery.
STANDARDIZATION OF CONTRACTS: STANDARD REFERENCE OBLIGATIONS
Standardization of CDS contracts has become increasingly important given the migration toward central clearing and the need to facilitate trade matching and portfolio compression. In order to promote fungibility of CDS contracts, ISDA will identify and publish a “Standard Reference Obligation” for each of the more frequently traded Reference Entities, though parties may still elect to trade on a “Non-Standard Reference Obligation” speciﬁed in the relevant conﬁrmation. Accordingly, unless the parties opt out, new CDS transactions on many Reference Entities will point to a “Standard Reference Obligation” with the relevant seniority level speciﬁed on the “SRO List” published by ISDA. If no Standard Reference Obligation is published for a particular Reference Entity, the Reference Obligation speciﬁed in the relevant conﬁrmation will apply until a valid Standard Reference Obligation is published on the SRO List.
AMENDMENTS TO THE SUCCESSOR PROVISIONS
The 2014 Deﬁnitions include several revisions to the “Successor” provisions intended to address general uncertainty that was created by the terms of the 2003 Deﬁnitions in connection with certain recent corporate events.
First, the concept of a “Succession Event” has been eliminated. Under the 2003 Deﬁnitions, in order for a Successor Reference Entity to be identiﬁed, a “Succession Event” must have occurred. The deﬁnition of “Succession Event” focused on signiﬁcant corporate events, such as mergers and transfers of assets or liabilities, in connection with which the Successor Reference Entity “succeeds to” the relevant debt obligations of the Reference Entity. The Succession Event requirement led to debate and uncertainty, and in some cases produced unexpected results under CDS transactions. The 2014 Deﬁnitions take a major step in the direction of clarity by eliminating the need to identify a qualifying corporate event.
In a related modiﬁcation, the 2014 Deﬁnitions introduce the concept of a “Steps Plan”, which is a plan contemplating a series of assumptions or exchanges of debt obligations. Under the 2003 Deﬁnitions, corporate restructurings involving multiple related debt transfers occurring over a period of time did not clearly qualify as a single “Succession Event,” as evidenced by the debate over the CDS impact of multiple debt and asset transfers at Energy Future Holdings Corporation. Various proposals were made to address this issue, including a “connected transactions” concept. The 2014 Deﬁnitions clarify that related transfers that are part of a “Steps Plan” are aggregated in order to determine whether there is a Successor, and the effective date of the last transfer (after which a determination of the Successor will not be affected by subsequent events in the Steps Plan) is considered the “Succession Date”.
A new “Universal Successor” provision allows the identiﬁcation of a Successor even if the succession request is not raised within the standard 90-day look- back period. If a Reference Entity transfers all of its debt obligations to another entity and then ceases to exist but the succession does not become known to the CDS market within 90 days (which occurred in the case of Unitymedia GmbH), the 90-day look-back rule under the 2003 Deﬁnitions would preclude the identiﬁcation of a Successor, and would result in “orphaned” CDS contracts. The 2014 Deﬁnitions dis-apply the 90-day look -back rule in this circumstance. This change, however, does not apply to sovereign Reference Entities and only applies to transfers on or after January 1, 2014.
In addition, the concept of “Best Available Information” – the type of information used to make a Successor determination – has been simpliﬁed and replaced with the concept of “Eligible Information”. The new term means any information which is publicly available or which can be made publicly available without violating any conﬁdentiality restrictions.
OTHER CHANGES TO THE DEFINITIONS
Many other improvements have been made in the 2014 Deﬁnitions. For instance, if the “Financial Reference Entity Terms” apply, Governmental Intervention will only be triggered by an event occurring with respect to obligations of the relevant, or higher, seniority of the CDS, and Successor Reference Entities will be identiﬁed based only on the movement of obligations of the relevant seniority. In addition, concerns regarding the impact of currency re-denomination have been addressed, and the qualifying guarantee provisions have been incrementally expanded. These and other (even seemingly innocuous) changes in the 2014 Deﬁnitions could potentially alter the economics of CDS contracts compared to the 2003 Deﬁnitions.
The 2014 Deﬁnitions will apply to CDS transactions after September 22, 2014, although parties to a transaction still have the option to apply the 2003 Deﬁnitions by agreement. The ISDA 2014 Credit Derivatives Deﬁnitions Protocol published on August 21, 2014 (the “2014 Protocol”), which remains open for adherence until September 12, 2014, allows market participants to apply the 2014 Deﬁnitions to most existing CDS transactions that incorporate the 2003 Deﬁnitions. The 2014 Protocol excludes legacy CDS transactions referencing certain enumerated Reference Entities since the application of certain provisions of the 2014 Deﬁnitions to those transactions (including the Financial Reference Entity Terms and Asset Package Delivery provisions) would create an economic disincentive for voluntary adherence. Additionally, the 2014 Protocol will not apply to certain enumerated products, including loan credit default swaps, US municipal swap transactions, CDS on ABS and Reference Obligation only trades.
The 2014 Deﬁnitions are a direct response to credit market developments in recent years, including sovereign debt crises and the nationalization of ﬁnancial institutions. The most signiﬁcant revisions illustrate an attempt to further improve the governing terms of the CDS product to address many of the material changes in practice and policies that have occurred in the past decade, and to align these terms with the expectations of market participants seeking an effective economic risk transfer. As the new standard for CDS, the 2014 Deﬁnitions reﬂect the industry’s commitment to improving and strengthening the CDS product in a new and evolving economic and regulatory environment.