September 22, 2014 (the “Implementation Date”) will mark a new chapter in the credit derivatives market with the implementation of the new 2014 ISDA Credit Derivatives Definitions (the “New Definitions”). The New Definitions constitute a major reform of the terms governing credit derivatives products and address numerous issues identified this past decade with regard to credit and succession events and in the context of the Eurozone crisis. Most new credit derivatives trades entered into after the Implementation Date will follow the New Definitions, which are expected to ultimately fully replace the 2003 ISDA Credit Derivatives Definitions (the “Old Definitions”) in the market. Market participants will also have the opportunity to adopt the New Definitions for their portfolio of existing trades.
This alert provides an overview of the most significant amendments made to the Old Definitions and describes how the market will migrate to the New Definitions.
Government Intervention Credit Event
The New Definitions introduce a new Credit Event, Government Intervention, with respect to non-U.S. financial Reference Entities. The necessity for this new Credit Event became obvious in early 2013 when the Dutch government nationalized SNS Bank and expropriated all of its subordinated bonds. This action created significant market uncertainty since government bail-in was not expressly covered by the Restructuring Credit Event under the Old Definitions. Government Intervention is therefore a useful complement to Restructuring and provides certainty to market participants when governments take certain bail-in actions in respect of financial institutions, especially since new European legislation has facilitated those types of intervention.
Pursuant to the New Definitions, a Governmental Intervention Credit Event is triggered when a government’s action or announcement results in binding changes to certain Obligations of a Reference Entity including a reduction or postponement of principal or interest or further subordination of the Obligation, an expropriation, transfer or other event which mandatorily changes the beneficial holder of the Obligation, or a mandatory cancellation, conversion or exchange of the Reference Entity’s Obligations.
While Government Intervention and Restructuring overlap to some extent, there are noteworthy differences between the two Credit Events. Importantly, a Government Intervention Credit Event can be triggered regardless of whether there has been a deterioration in the creditworthiness of the Reference Entity and even if the government intervention event is expressly contemplated by the terms of the Obligation.
Subordinated/Senior CDS Split
The New Definitions insulate senior from subordinated CDS contracts written on financial Reference Entities for certain credit event and succession event purposes. One of the main objectives is to avoid a situation where senior CDS contracts are triggered by a credit event affecting only subordinated debt. As a result, a Government Intervention or Restructuring Credit Event solely affecting subordinated debt will not trigger CDS contracts written on senior debt and only CDS written on subordinated debt will be triggered. The New Definitions do not provide complete insulation for all Credit Events though, as Credit Events other than a Government Intervention or Restructuring with respect to subordinated debt will continue to trigger senior CDS contracts as well.
Also, for purposes of determining successor Reference Entities, the allocation of subordinated CDS will be made by reference to the relevant percentage of subordinated debt assumed by one or more successor(s) while the senior CDS will follow senior debt.
Asset Package Delivery Events
To address concerns prompted by the potential lack of any Deliverable Obligations, e.g., in the event of an expropriation of all debt (or all subordinated debt) outstanding or a restructuring implemented by way of a debt exchange (with the new bonds not satisfying the deliverability criteria), the New Definitions introduce the concept of Asset Package Delivery. Asset Package Delivery will allow market participants to deliver assets resulting from the corresponding Deliverable Obligations that have been converted in connection with a Government Intervention or Restructuring Credit Event and those assets will also be used to determine the Final Price in an Auction. In instances where bonds are fully expropriated and no assets are delivered in exchange, the value of the asset package will be deemed to be zero.
These new Asset Package Delivery provisions will apply to Sovereign CDS following a Restructuring Credit Event and financial Reference Entity CDS following a Restructuring or a Government Intervention Credit Event. For a Restructuring Credit Event in respect of a Sovereign, the deliverable asset package will be based on a Package Observable Bond (a benchmark reference obligation of the Sovereign specified by ISDA) that meets the deliverability criteria immediately prior to the Credit Event. In that respect, the New Definitions are designed to avoid moral hazard issues where noteholders would be incentivized to agree to certain restructurings that they would otherwise not accept in the absence of CDS by only permitting certain types of asset packages to be delivered. For a Governmental Intervention Credit Event in respect of a financial Reference Entity, Deliverable Obligations subject to the Governmental Intervention will be taken into account.
Standard Reference Obligations
The new concept of Standard Reference Obligations will apply to liquid Reference Entities and will enable parties to trade without specifying a Reference Obligation in their contract. Specifically, the New Definitions provide that for any CDS contract, the Reference Obligation will be the obligation specified as the Standard Reference Obligation for the relevant Reference Entity on a list to be published by ISDA. Each Standard Reference Obligation will be for a specified Seniority Level. The introduction of Standard Reference Obligation, amongst other things, reduces the risk of trade breaks because parties will no longer need to match the Reference Obligation when using matching or affirmation platforms and, more importantly, removes potential basis risk between transactions that have the same Reference Entity but different Reference Obligations.
Standard Reference Obligations will not mandatorily apply to all CDS and market participants will be able to dis-apply the Standard Reference Obligations in a confirmation for a particular CDS and instead specify an alternative Non-Standard Reference Obligation.
In order to determine a Successor to a Reference Entity under the Old Definitions based on the percentage of Relevant Obligations assumed by the Successor, the identification of a corporate event (a Succession Event) related to the transfer of obligations was a prerequisite. However, the Succession Event requirement gave rise to a substantial amount of uncertainty in the market. Also, complications arose where an entity transferred its debt in stages and as a result did not meet the specified percentages for a Successor to be identified. To address these issues, the New Definitions have been simplified by removing the requirement of a Succession Event. Also, under the new concept of Steps Plan, all individual transfers of debt that take place as part of a specific, pre-determined transfer plan are aggregated for purposes of calculating applicable debt transfer percentage thresholds.
The New Definitions also introduce the concept of Universal Successor. A Universal Successor is a non-Sovereign Reference Entity that assumes all of the obligations (including at least one Relevant Obligation) of an original Reference Entity that has either ceased to exist or is in the process of being dissolved. Furthermore, whereas under the Old Definitions a Successor can only be determined if the ISDA Determinations Committee or the CDS counterparty are notified within 90 days of the Succession Event, Universal Successor applies a single fixed backstop date of January 1, 2014.
Amongst other things, the New Definitions revise and expand the definition of Qualifying Guarantee, introduce a definition of Outstanding Principal Balance (including a provision detailing how such amount is calculated), address redenomination issues in the context of a Restructuring and add the provisions from the 2009 Auction Settlement supplements (the “Big Bang and Small Bang Supplements”).
ISDA will soon publish a protocol (the “Protocol”) enabling market participants to elect to apply the New Definitions to most existing CDS transactions (“legacy transactions”), except for contracts on certain excluded reference entities and for certain credit derivatives products. The Protocol is expected to
cover all legacy transactions between Protocol adhering parties and, for approximately one year after the Implementation Date, new transactions between such parties that would have been Protocol covered transactions had they been entered into prior to the Implementation Date. However, new
transactions resulting from a novation, where the transferor was not a Protocol adhering party will not be within the scope of the Protocol (even if the transferee is an adhering Party).
The Protocol will cover a broad range of legacy transactions currently documented using the Old Definitions. Specifically, the types of transactions covered by the Protocol include Covered Index Transactions (including CDX and iTraxx Tranched and Untranched), Covered Swaption Transactions (single name and portfolio) and Covered Non-Swaption Transactions (e.g., Single name, Fixed Recovery, Recovery Lock, Nth to default and Bespoke Portfolio Transactions).
The Protocol, however, will not apply to transactions on certain sovereign, financial or corporate entities that are specifically listed as being excluded from the Protocol’s coverage. For those entities, the New Definitions will only apply to new transactions entered into on or after the Implementation Date. Certain types of credit derivative transactions that are also excluded from the Protocol include Loan Only transactions, U.S. Municipal type transactions, CDS on asset backed securities and transactions that parties bilaterally agree to exclude. Those transactions should continue to trade on the basis of their current documentation.
Market participants will be able to adhere to the Protocol until a pre-agreed upon date (set by ISDA and which will be prior to the Implementation Date), which will allow firms to reconcile their populations of adhered trades. Depending on market conditions, ISDA may consider re-opening adherence to the Protocol, but market participants may not want to unnecessarily delay adherence on that basis.
The New Definitions implement a multitude of changes modifying the nature and behavior of the product. Many alterations have been perceived as favorable to buyers of protection and it remains to be seen how the New Definitions will impact the growth of the credit derivatives market. In the meantime, market participants should fully understand how CDS contracts governed by the New Definitions will behave under various circumstances in order to accurately price and trade these products. With respect to legacy transactions, market participants also need to determine if they want to migrate CDS trades in their portfolio under the New Definitions based on perceived value differential and liquidity considerations.