Introduction

As an aftershock to the Big Bang Supplement that adopted the auction mechanism globally to settle most types of CDS contracts, the International Swaps and Derivatives Association (“ISDA”) has published a new supplement to the 2003 Credit Derivatives Definitions referred to as the “Small Bang” (the “Small Bang Supplement”). The purpose of the Small Bang Supplement is to resolve current difficulties in applying the auction methodology to settle CDS contracts following the occurrence of a restructuring credit event with respect to the underlying reference entity.

The Small Bang Supplement will be incorporated into confirmations for most new CDS contracts and a Small Bang Protocol (the “Small Bang Protocol”) will enable parties adhering to the protocol to apply the terms of the Small Bang Supplement to their existing CDS contracts (legacy trades) with other adhering parties.

This Alert describes (i) the rationale for implementing the Small Bang Supplement, (ii) the new framework for restructuring credit events and its practical implications and (iii) the effects of adhering to the Small Bang Protocol.

Big Bang Supplement

On April 8, 2009, the Big Bang Supplement went into effect and implemented large-scale changes to the CDS landscape. As a result, most CDS contracts now (i) utilize an auction methodology for settlement purposes, (ii) are subject to established contractual statutes of limitation to exercise contractual rights with respect to credit and succession events (rolling look-back periods) and (iii) have Determinations Committees make binding determinations in connection with credit and succession events, including whether or not to hold an auction to settle CDS contracts following the occurrence of a credit event.

Rationale for the Small Bang Supplement

Under the Big Bang Supplement, Determination Committees could decide whether or not a restructuring event had occurred. However, they were prohibited from authorizing auctions to settle CDS contracts for restructuring credit events because of the current difficulties in administering auctions for a restructuring event, as discussed below.This was not seen as an impediment for the North American CDS market where a restructuring typically takes place after the reference entity files for bankruptcy and a bankruptcy credit event has already been triggered to settle the CDS contract. By contrast, European entities traditionally restructure debts without an analogous bankruptcy filing as seen in the U.S. and, accordingly, a restructuring credit event is necessary to provide protection buyers with adequate credit protection.

The difficulty arose from the fact that the auction methodology requires a single list of deliverable obligations for the auction. The final price established through the auction (which will dictate payment obligations by protection sellers) will ultimately depend on those deliverable obligations. This can be easily achieved in connection with a failure to pay or a bankruptcy credit event as there is typically one set of deliverable obligations for each reference entity and tier of debt. By contrast, when settlement is triggered by a Modified restructuring (“Mod R”) or a Modified Modified restructuring (“Mod Mod R,” the standard in Europe), a maturity cap is placed on deliverable obligations based on the remaining tenor of outstanding trades. One could see a different list of deliverable obligations for each tenor of outstanding trades, potentially leading to a multitude of auctions.

The Small Bang Supplement addresses this issue by assigning CDS contracts to so-called “Maturity Buckets,” thereby limiting the number of auctions that may have to be held, and establishing the deliverable obligations for each Maturity Bucket for purposes of the auction.

New Framework under the Small Bang Supplement

Maturity Buckets

Auction settlement will become the default settlement method for restructuring credit events. Multiple auctions will be held for each restructuring credit event. CDS contracts will be allocated to Maturity Buckets by reference to the scheduled termination date of the CDS contracts to be settled, subject to a rounding down convention (see below). Up to eight Maturity Buckets with an additional pre-2.5 yearMaturity Bucket forModified Restructuring can be used.1 The applicable Determination Committee will assign deliverable obligations to each Maturity Bucket for which an auction is held.

Rounding Down Convention

If a CDS contract is assigned to aMaturity Bucket that contains no deliverable obligations with a final maturity date occurring on or prior to the scheduled termination date of such contract, then the CDS contract will be reallocated to an earlier Maturity Bucket which contains deliverable obligations with a final maturity date prior to the scheduled termination date of the contract.

To Auction or Not to Auction

The applicable Determination Committee will decide whether or not to hold an auction for a Maturity Bucket depending on the number of CDS contracts that are triggered (based on DTCC data). An auction mandatorily will be held for each Maturity Bucket with 300 or more transactions and if 5 or more dealer members of the Determination Committee are parties to such contracts.

Settlement Trigger by Parties—Use it or Lose it

Even though Determination Committees decide whether to hold an auction for an applicable Maturity Bucket, the protection buyer and the protection seller still retain the freedom to decide whether or not to trigger settlement following a restructuring (a credit event notice must be delivered by a certain deadline).2 If the protection seller triggers, the CDS contract will be assigned to the 30-year Maturity Bucket, regardless of the underlying CDS contract’s scheduled termination date. If the protection buyer triggers, the CDS contract will be assigned to its appropriate Maturity Bucket. If no party triggers, the CDS contract may not be settled based on the restructuring credit event and the parties will have to rely on a subsequent credit event to settle their CDS contract.

Movement Option

If a CDS contract is assigned to a Maturity Bucket for which no auction is to be held, the protection seller can move the contract to the 30-year Maturity Bucket (if an auction is held for that Maturity Bucket) or the protection buyer can move the contract to the next earlier Maturity Bucket for which an auction is held. The determination is made by the party that moves first.

Old Restructuring

For CDS contracts referencing Old restructuring (“Old R”), the concept of Maturity Buckets will not apply because there is no applicable deliverable obligations maturity limitation and accordingly, only one auction (per tier of debt) will be held.

To Adhere or Not to Adhere  

The Small Bang Supplement incorporates the Big Bang Supplement and, therefore, by adhering to the Small Bang Protocol, the changes effected through the Big Bang Supplement will also apply to existing trades. Thus, the Small Bang Protocol provides another opportunity to sign up for the Big Bang Supplement if the Big Bang Supplement adherence deadline was missed earlier this year. By failing to adhere to the Small Bang Protocol, a party will not have access to the auction settlement mechanism which, in turn, may reduce the liquidity of such party’s CDS contracts.

The deadline to adhere to the Small Bang Protocol is July 24th, with an effective date of July 27th.