On March 12, 2009, International Swaps and Derivatives Association, Inc. (ISDA), published the Credit Derivatives Determinations Committee and Auction Settlement Supplement (the “Supplement”) and Protocol (the “Big Bang Protocol”). The Supplement will introduce four broad changes into the Credit Default Swap (“CDS”) market that will be applied to new CDS trades and can be applied to existing CDS contracts via adherence to the Big Bang Protocol. Each of these changes is outlined in the discussion below.
The purpose of the Supplement is to further standardize CDS contracts in anticipation of centralized clearing and to create greater transparency in the CDS market. The Supplement includes the following modifications:
- Adopts the auction model as the default settlement mechanism based on the documentation used in connection with previous credit derivative auction protocols;
- Establishes Credit Derivatives Determinations Committees (“Determinations Committees”) for the purpose of making determinations with respect to credit events and succession events, for overseeing the auction process (and any modification required for a specific credit event) and for addressing other issues presented by the CDS market;
- Establishes a credit event backstop date and a successor event backstop date; and
- Modifies currency exchange rates and related provisions for physical settlement and the auction settlement process to eliminate the perceived inequity relating to foreign exchange provisions with respect to the use and amendment of a Notice of Physical Settlement during the settlement of CDS trades.
The Supplement will be in effect as of April 8, 2009. ISDA expects the majority of new trades after that date to include the Supplement and for the Big Bang Protocol to hardwire the changes into documentation for existing trades. The adherence period for the Big Bang Protocol is expected to close on April 7, 2009.
ISDA has also announced a new Standard North American Corporate CDS contract, nicknamed “SNAC.” SNAC is a single-name CDS contract with a fixed coupon of 100 or 500 basis points, depending on whether the Reference Entity is considered investment grade (for which the fixed coupon is 100 basis points) or high yield (for which the coupon is 500 basis points). SNAC contracts will also trade without Restructuring as an applicable credit event. Note that adhering to the Big Bang Protocol will not convert existing CDS contracts to SNAC. The Big Bang Protocol and the new SNAC contract are separate ISDA initiatives that will take effect on the same date.
CDS Auction Settlement
The majority of outstanding single name CDS contracts provide for physical settlement following a credit event. Under physical settlement, the buyer of protection delivers to the seller of protection one or more debt instruments of the relevant reference entity. However, as demonstrated by prior CDS settlements following a credit event, the notional value of CDS contracts written on a particular reference entity is often substantially in excess of the face value of the references entity’s outstanding debt. This imbalance could prevent the orderly settlement of CDS contracts, thereby causing severe market and CDS valuation disruptions during the settlement process. As an alternative to physical settlement, and to alleviate market disruptions, ISDA has developed an auction mechanism to facilitate the settlement of CDS contracts. Since 2006, CDS market participants have participated in many CDS auctions via a protocol process. These CDS auction protocols amend the settlement method pertaining to existing CDS contracts from physical settlement to cash settlement, with the cash settlement price determined at a settlement auction involving dealers and other market participants.
The Supplement adds auction settlement as the default settlement method for CDS contracts and adopts standardized auction procedures. These standardized auction procedures are designed to remain consistent from one CDS settlement auction to the next. The adoption of the auction settlement will provide consistency among CDS settlement auctions and will eliminate the need for (i) ISDA to publish auction protocols for each credit event and (ii) protection buyers and sellers to adhere to multiple ad hoc CDS settlement protocols. If no auction is conducted for a particular credit event, CDS contracts will settle under a fallback settlement method (i.e., physical settlement, unless Cash Settlement is specified in the CDS confirmation).
Determinations Committees and External Review Panels
Currently, various determinations required under CDS contracts are made by the named calculation agent (typically the dealer in a dealer/end-user CDS transaction). These determinations include, among others, whether or not a credit event or succession event has occurred. The Supplement provides for these determinations to be made by the newly formed Determinations Committees. In addition to making determinations regarding credit and succession events, the Determinations Committees will establish (i) the timing of CDS settlement auctions; (ii) whether the procedures for any specific CDS settlement auction need to be amended; and (iii) the list of deliverable obligations for the settlement auction. There will be five regional Determinations Committees,1 each of which will decide issues involving reference entities traded under transaction types for the relevant region. The regional Determinations Committees will consist of two-thirds dealer representatives and one-third end-user representatives.2 Any market participant may request that the relevant Determinations Committee make a determination, but the Determinations Committee may decline to make a determination on any question posed.
If a consensus cannot be reached by the relevant Determinations Committee, then an External Review Panel (comprising individuals nominated by ISDA members) will decide the issue. Determinations made by the Determinations Committees—or, when applicable, the External Review Panels—will be binding upon all market participants and will override any calculation agent determination, but will not supersede any bilateral agreement between counterparties.
Establishment of Credit Event and Succession Event Backstop Dates
Under current CDS contracts, a credit event or succession event under a specific CDS transaction can be declared only if the event occurs between a transaction’s effective date and its termination date. To increase the fungibility of contracts, the Supplement provides that, to declare a credit event, the credit event must have occurred no more than 60 calendar days prior to the date that notice of the credit event is made to a Determinations Committee. Similarly, a succession event must have occurred no more than 90 calendar days prior to the date that notice of the succession event is made to a Determinations Committee. The new credit event and succession event backstop dates (i) implement a time limitation on when such events can be declared and (ii) allow a credit or succession event occurring prior to the effective date of a CDS transaction to be a triggering event for such CDS transaction. These backstop dates place an additional burden on protection sellers to ensure that no credit event or succession event occurred in the relevant time frame prior to selling such protection. Conversely, protection sellers will benefit because a credit or succession event cannot be declared beyond a relatively short period of time.
Until June 20, 2009, the credit event and succession event backstop dates for all CDS contracts will be the effective date of such contracts. As of June 20, however, the 60- and 90-day backstops dates will apply.
Revised Foreign Exchange Provisions
Under the current ISDA Credit Derivatives definitions, the foreign exchange rate applicable to the physical settlement of a given CDS contract is set as of the date upon which a Notice of Physical Settlement is originally delivered. If, however, a Notice of Physical Settlement is amended prior to the physical settlement date (as the current definitions allow), the foreign exchange rate is reset to the amendment date. Buyers of protection can therefore amend a Notice of Physical Settlement solely to take advantage of a currency fluctuation (even if the deliverable obligations set forth in the underlying Notice of Physical Settlement have not changed). As a result of this loophole, sellers of protection face currency risk and may not be able to effectively hedge their currency exposure.
The Supplement shifts the foreign currency risk from the seller of protection to the buyer of protection (the counterparty that has the option of amending the Notice of Physical Settlement) by locking in the foreign exchange rate set forth in the original Notice of Physical Settlement as both the initial foreign exchange rate and the foreign exchange rate for any amended Notice of Physical Settlement.
Should a CDS Participant Adhere to the Big Bang Protocol?
The Supplement will become a part of the standard 2003 ISDA Credit Derivatives Definitions as of April 8, 2009. Additionally, the credit event and succession event backstop dates for all CDS contracts will be the effective date of the CDS contract until June 20, 2009, at which point, the 60- and 90-day backstop dates, as applicable, will apply. Due to the volume of market standard documentation, all market standard documentation will be deemed amended prospectively to include the Supplement until January 1, 2011 (when it is expected that the amendment of each document will be completed). Additionally, it is important to note the following:
- Contracts entered into on or after April 8, 2009, will be subject to the 2003 ISDA Credit Derivatives Definitions, as supplemented by the Supplement.
- CDS counterparties who wish to have the Supplement govern all their existing CDS contracts must adhere to the Big Bang Protocol no later than April 7, 2009.
- All novated transactions with a trade date on or after April 8, 2009, and on or prior to January 1, 2011, will be deemed covered by the Big Bang Protocol.
- CDS counterparties may also bilaterally amend their ISDA Master Agreements, individual Confirmations or CDS Master Confirmation Agreements to incorporate any or all of the provisions of the Supplement.
The Big Bang Protocol will apply to CDS contracts on indices, which constitute the majority of the CDS market, and on most CDS contracts involving single-name and sovereign issuers. The Big Bang Protocol will not apply to loan only, municipal, ABS, MBS, CDO and certain bespoke portfolio CDO transactions, but CDS counterparties may amend one or more of their transactions on a bilateral basis to customize those contracts as the counterparties deem appropriate. Additionally, Fixed Recovery transactions , Reference Obligation Only transactions, Preferred CDS or other contracts negotiated as such by the parties will be subject to the Supplement with the exception of Auction Settlement.
The changes described above will address certain commitments made to regulators including standardization for purposes of centralized clearing and transparency. Interestingly, the changes will not address many of the CDS contracts at issue in the matter of American International Group because these contracts were written on tranches of loans or mortgage-backed securities.3 An end-user participant’s decision as to whether to adhere to the Big Bang Protocol will depend to a large extent on the nature of the participant’s book of outstanding CDS contracts and its evaluation of the risk of being shut out of future auctions. For a CDS participant with existing trades, failure to adhere to the Big Bang Protocol and adopt the Supplement may result in reduced liquidity, physical settlement requirements and possibly unfavorable calculation agent determinations. While it remains to be seen how end users, as a group, choose to adopt these changes for pre-existing transactions, the dealer community has expressed that it will require counterparties to incorporate the Supplement into all future transactions. Thus it is important for all end users to consider how the Supplement will affect their participation in the CDS market and react to dealers taking this position.
The foregoing is a broad, preliminary overview of the Supplement, the Big Bang Protocol and the SNAC initiative. Additional information is available on the ISDA website. See: www.isda.org. We are continuing our review of these major market initiatives and will be monitoring market reaction. Please, do not hesitate to contact us if you have questions or other views on any of these matters.