ISDA will publish a new set of Credit Default Definitions in September this year. These set- out defined terms that are used in most CDS Confirmations, and form a critical basis for an increasingly-standardised CDS market.
A pre-publication draft of the new Definitions is available to ISDA members, and market feedback (and certainly our view) is that the new Definitions will entail the most significant change to the CDS market since the publication of the 2009 ‘Big Bang’ Protocol (which established the Credit Derivatives Determination Committee, and incorporated auction settlement as a means for settling CDS transactions).
The proposed changes to the existing Definitions are extensive, and it is not possible to cover them all. Here is a brief summary of seven of the most interesting changes to note:
- Governmental Intervention – one of the biggest criticisms of the existing regime has been uncertainty as to whether the Restructuring Credit Event is broad enough to capture government bail-ins. The new Definitions introduce a “Governmental Intervention Credit Event”, which may be triggered by the announcement or taking of action by a Governmental Authority by means of a restructuring or resolution law or regulation, which causes one of a prescribed list of changes to the terms of the relevant obligation. These prescribed changes are generally broader than those which potentially trigger a Restructuring Credit Event, and significantly there is no requirement for such changes to be brought about by a deterioration in the creditworthiness of the relevant Reference Entity.
- Asset Package Delivery – under the new Definitions, the concept of “Deliverable Obligations” has been extended in order to include obligations which would have been deliverable had an auction taken place prior to the occurrence of an “Asset Package Credit Event” (i.e. a Governmental Intervention Credit Event or Restructuring which meets certain criteria). Events such as debt exchange or expropriation (which potentially constitute “Asset Package Credit Events” under the new Definitions) may otherwise have prevented the relevant obligations from being deliverable in auction. Going forward, such obligations may be deliverable as an “Asset Package”, and would be determined by reference to the proceeds of the relevant Governmental Intervention or Restructuring. If more than one Asset Package is offered, the “Largest Asset Package” (i.e. the package of assets for which the greatest amount of principal has been exchanged or converted) would be delivered.
- Successor Provisions – the draft Definitions introduce a “universal successor” concept, under which a Successor Reference Entity may be identified even where the succession event has occurred prior to expiration of a 90-day look back window, provided that (i) the Successor Reference Entity has assumed all of the debt and (ii) the original Reference Entity has ceased to exist, or is in the process of being dissolved. This should help to prevent certain CDS transactions from becoming orphaned where the market has not reacted to a transfer event within the 90-day period. In addition, the current definition of “Succession Event”, which sets out circumstances that may lead to the determination of a Successor Reference Entity, will be replaced with the concept of a “Steps Plan” which looks at a broader series of transfers in order to determine a Successor.
- Qualifying Guarantee – a perceived problem of the current CDS regime has been the failure of certain guarantees to satisfy the criteria of a “Qualifying Guarantee”, resulting in certain guarantees failing to trigger a Credit Event where they might otherwise have been expected to do so by the market, as well as certain guarantees not being deemed as deliverable for the purposes of settlement. Under the new Definitions, the concept of “Qualifying Guarantee” has been broadened in a number of ways, so that guarantees which (A) only guarantee principal and interest, and not all amounts under the relevant obligation, (B) include certain release provisions, for example upon transfer of the guarantee or (C) incorporate a fixed cap, may now be Qualifying Guarantees (together with certain other new additions).
- Single Standard Reference Obligation – it is proposed that ISDA will publish a list, known as the “SRO List”, of Reference Entities that are frequently traded on the CDS market, and the SRO List will specify a Standard Reference Obligation (and seniority tier) for each of these Reference Entities. This means that such Reference Obligations may no longer need to be specified in CDS documentation relating to a listed Reference Entity (unless the parties elect to disapply the Standard Reference Obligation).This should increase the fungibility of CDS transactions with the same Reference Entity.
- Financial Reference Entity Terms – this proposed feature can be applied within the CDS confirmation, and potentially permits a distinction between senior and subordinated Reference Obligations for the purpose of determining whether a Restructuring or Governmental Intervention Credit Event has occurred. It would also potentially enable a CDS to track the applicable seniority level in the event of succession.
- Redenomination – the new Definitions propose to amend the Restructuring Credit Event so that such event would not be triggered solely by reason of redenomination from euro to another currency (i.e. there would need to be some form of adverse economic impact in order to trigger the Credit Event).
At the time of writing, it is expected that all transactions confirmed from September 2014 will incorporate the new Definitions. For existing transactions, ISDA have yet to provide details of their Implementation Protocol. (When the 2003 Definitions were released it was clear that the 1999 Definitions would continue to apply unless otherwise agreed between the relevant trade counterparties, and we would expect the same approach to be adopted this time around. Where such agreement exists, adherence to the Implementation Protocol (once open) should enable parties to adopt the new Definitions with relative simplicity).
CDS users may wish to consider (i) whether language exists within relevant CDS Confirmations that automatically adopts new Credit Default Definitions published by ISDA, (ii) whether any CDS transactions (or credit-linked notes) incorporating the 2003 Definitions are hedged by CDS transactions incorporating the new Definitions, or vice-versa (potentially creating basis risk) and (iii) potential cost of CDS transactions where fungibility may be reduced due to a bifurcated market. Notwithstanding the possible pitfalls of implementation, the new Definitions are clearly an improvement and correct a number of issues under the existing CDS regime, and the market appears to be welcoming them as such.