Yesterday, the International Swaps and Derivatives Association, Inc. (ISDA), published a new supplement (the Restructuring Supplement) to the 2003 Credit Derivatives Definitions (the Definitions). The Restructuring Supplement will be incorporated into the confirmations of all new Credit Default Swap (CDS) contracts and into existing CDS contracts via a new ISDA protocol (the Small Bang Protocol)[click here for a copy of the protocol].  

The purpose of the Restructuring Supplement is to apply the Auction Settlement methodology established in the Credit Derivatives Determinations Committee and the Auction Settlement Supplement (implemented by the Big Bang Protocol in April 2009) following a restructuring credit event. At the same time, the Restructuring Supplement seeks to replicate, to the extent possible, the maturity limitation requirements for Deliverable Obligations as set forth in the Definitions.

Review of Big Bang Protocol

The Big Bang Protocol went into effect on April 8, 2009 [click here to link to the previous client alert]. The main provisions of the Big Bang Protocol include the following:

  • Determinations Committees: 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. There are five regional committees, with buy- and sell-side representation, that determine whether a credit or succession event has occurred. Previously this determination was made through a bilateral process between the two counterparties involved, which often resulted in disagreements. In addition to making these determinations, the committees also have the power to decide whether a credit event auction will take place and under what parameters. Finally, the Determinations Committees publish the list of deliverable bond obligations (Deliverable Obligations).  
  • Hardwiring of Auctions: Adopts the auction model as the default settlement mechanism for CDS contracts based on the documentation used in connection with previous credit derivative auction protocols. Credit event auctions are now hardwired into the standard ISDA CDS contract, making the settlement process more efficient.  
  • Look-back Period: Establishes a credit event backstop date and a successor event backstop date. Previously, the effective date of a CDS contract was a fixed date. The Big Bang Protocol, however, established a 60-day rolling period from the current date for credit events and 90 days from the current date for succession events.

Details of the Small Bang Protocol

One of the major issues left unaddressed by the Big Bang Protocol was the restructuring credit event. The U.S. Bankruptcy Code (and specifically Chapter 11 of such code) enables corporations to file for bankruptcy protection and then restructure their debts. Because bankruptcy filings so often precede a restructuring in the United States, the U.S. CDS market is less concerned about including restructuring as a credit event.  

In Europe, however, each jurisdiction has its own bankruptcy regime that offers unique procedures and protections. In addition, under the Basel II Capital Accord requirements applicable in Europe, banks receive additional capital relief if they hedge exposure with CDS including restructuring as a credit event. For both of these reasons, most European CDS still include restructuring as a credit event.

The current challenge faced by the CDS market is how to include restructuring credit events into the existing auction settlement mechanism. “Mod-Mod” restructuring, which is the CDS market standard in Europe, places a maturity cap on Deliverable Obligations depending on the maturity of the CDS contract. This means that it is not possible to hold a single auction for a restructuring credit event. The Small Bang Protocol addresses this problem by holding several auctions, with a list of Deliverable Obligations for each “maturity bucket.” The Determinations Committee will decide the terms of the auction and the specific Deliverable Obligations.

The basic provisions of the Small Bang Protocol are as follows:

  • Hardwiring of Auctions: Adopts the auction model as the default settlement mechanism for restructuring credit events.
  • Maturity Buckets: Defines maturity buckets for Deliverable Obligations following a restructuring credit event. CDS contracts may be grouped into as many as eight possible buckets depending on maturity, with buckets having the maturity end dates listed below. An additional bucket may be created to settle contracts that terminate before 2.5 years.
    • 2.5 years
    • 5 years
    • 7.5 years
    • 10 years
    • 12.5 years
    • 15 years
    • 20 years
    • 30 years
  • Deliverable Obligations: The Determinations Committee will decide which bonds or loans will be deliverable into which maturity buckets. ISDA will publish the lists of buckets and their Deliverable Obligations, and buyers or sellers of protection will then have five business days to decide whether to trigger their CDS contracts.  
  • Auctions Mandated: For each maturity bucket, if 500 CDS contracts are triggered and five or more dealers are parties to these contracts, an auction will be mandated. The Determinations Committee also can decide that an auction will be held for a bucket that does not meet these criteria.  
  • Trigger by Buyer1: If a CDS is triggered by the buyer of protection, it will go into one of the buckets in accordance with its specified maturity. If no auction is held for a particular bucket, then the protection buyer holding CDS in such bucket will have the option within three business days to roll down into the next shorter-maturity bucket.
  • Trigger by Seller: If a CDS is triggered by the seller of protection, it will go into the 30-year bucket.  
  • “Use It or Lose It”: CDS contracts that are not triggered for a given auction will continue as before until there is another credit event or the contracts terminate. Trades that are not triggered before an auction cannot be triggered afterwards in reliance upon the same credit event.  
  • Mod-R and Old-R: The Small Bang auction process will apply to CDS contracts that include the "Mod" restructuring credit event. The Big Bang auction process will apply to CDS contracts that include the "Old" restructuring credit event.

Should a CDS Participant Adhere to the Small Bang Protocol?

It is important to note that market participants who adhere to the Small Bang Protocol will be deemed to have adhered to the Big Bang Protocol for all existing and new trades. An end-user participant’s decision as to whether to adhere to both the Big Bang and Small Bang Protocols 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 Small Bang Protocol may result in reduced liquidity, physical settlement requirements, and possibly unfavorable calculation agent determinations. The dealer community has expressed that it will require counterparties to incorporate the Restructuring Supplement into all future transactions that include restructuring as a credit event. Thus it is important for all end users to consider how the Restructuring Supplement will affect their participation in the CDS market and react to dealers taking this position.

Standard European Corporate CDS

ISDA has also announced a new Standard European CDS contract, which began trading as of June 22, 2009. The new single name European CDS contracts incorporate fixed coupons of 25 basis points (bp), 100bp, 500bp or 1000bp along with an upfront fee. Additional coupons of 300bp and 750bp will also be available for the re-couponing of existing trades. The additional coupon levels reflect the fact that restructuring remains a credit event in European CDS contracts.

The foregoing is a broad, preliminary overview of the Small Bang Protocol. Additional information is available on the ISDA Web site. See: We continue to review these major market initiatives and will be monitoring related market reaction. Please do not hesitate to contact us if you have questions or other views on any of these matters.