ISDA has released the ISDA 2019 NTCE Protocol (the Protocol) to address issues in the credit derivatives market relating to deliberate defaults by a Reference Entity* with the intention to trigger payouts under credit derivatives.

Background

The credibility of the credit derivatives market has been impacted in recent years by concerns over deliberate defaults with the intention of triggering credit derivatives payouts (so-called “narrowly tailored credit events”). This was exemplified by the U.S. homebuilder Hovnanian, which proposed to default on a payment months in advance that would trigger credit derivatives while at the same time issuing high volumes of deeply discounted bonds that would have maximised the resulting payout on those credit derivatives. The public nature of many defaults or near-defaults has led some commentators to question the viability of credit derivatives on single corporate entities as a financial product.

To address these issues, on 15 July 2019 ISDA published changes to the 2014 ISDA Credit Derivatives Definitions in the form of the 2019 Narrowly Tailored Credit Event Supplement (the NTCE Supplement).

Users of credit derivatives now have the opportunity to apply the changes made by the NTCE Supplement to their existing credit derivatives by adhering to the Protocol, which opened for general adherence on 16 September 2019.

The Protocol

The Protocol is expected to take effect from 13 January 2020. From the same 13 January implementation date, the standard terms on which new credit derivatives are traded will incorporate the NTCE Supplement’s terms, meaning that any party that wants to trade on the old terms would (implausibly) need to reach bilateral agreement to do so.

The NTCE Supplement applies two key new terms:

  1. Failure to Pay Credit Deterioration Requirement. A Failure to Pay will not result in a Credit Event if the failure to pay “does not directly or indirectly either result from, or result in, a deterioration in the creditworthiness or financial condition of the Reference Entity”. This new requirement is accompanied by interpretive guidance with non-exhaustive examples of factors that indicate whether or not the credit deterioration requirement has been satisfied.
  2. Amendment to the definition of Outstanding Principal Balance. The definition of Outstanding Principal Balance has been amended so that if a bond or loan has been issued at material discount (as was the case in Hovnanian) then for the purposes of determining the payout under a credit derivative the discounted issue level is the reference point, rather than the par value claim that the bond or loan holder may have on the Reference Entity. For example, if a $100 bond was issued at a price of 50% of par, a Credit Event occurred immediately after issue and post-default the bond traded at $45, then the payout on a credit derivative would be based on the 10% difference between the current price of $45 and the issue level of $50, rather than treating the $45 price as a 55% loss compared to par.

The requirement for a deterioration in creditworthiness or financial condition has been contentious, as it involves an element of discretion. Whether a Failure to Pay has occurred cannot be known until a determination is made, which at first instance would be made by the relevant Regional Determinations Committee comprised of market participants. However, the parties most advantaged by the current objective test have been those seeking to manipulate credit derivatives. The uncertainty created by the new provision should significantly discourage future manipulation efforts relating to narrowly tailored credit events. The unusual approach of giving guidance on how to apply the provision reinforces the uncertainty that a potential manipulator faces – rather than a single bright-line test that a manipulator could try to satisfy to trigger a Credit Event, the relevant Regional Determinations Committee has the freedom to determine that a deterioration in creditworthiness or financial condition has not occurred based on a range of factors.

Several of the most significant banks trading credit derivatives have adhered to the Protocol prior to its general opening. Other credit derivative market participants are likely to be strongly encouraged by their bank trading counterparties to adhere now.

A firm that on a net basis has bought significantly more credit protection than it has sold might consider that in adhering to the Protocol it will lose the opportunity to benefit from payments on its existing credit derivatives caused by possible future manufactured credit events of the type that the NTCE Supplement acts against. However, if the Protocol succeeds in dampening manipulation then events designed to trigger only the contracts based on the old language are likely to be rare, particularly since the type of manipulation that the NTCE Supplement acts against most often involves the manipulator acquiring significant positions in credit derivatives that would be triggered by the manipulation. Such contracts will not be on offer following the implementation date of the Protocol.

The Protocol is currently scheduled to be open for adherence until 14 October 2019. The relatively long period from the closing of the Protocol to the expected 13 January 2020 implementation date is to allow credit derivatives clearing houses to get regulatory approval to make the same amendments to cleared derivatives, and there is a mechanism in the Protocol to allow ISDA to delay the implementation date if those approvals are not gained in good time.

Finally, it should be noted that while the NTCE Supplement deals with the most significant concern around the manipulation of credit derivatives, other concerns remain – such as the potential for credit derivatives to be made valueless through “orphaning”. Orphaning occurs where the Reference Entity referred to in the credit derivative redeems all bonds and loans and refinances by issuing new debt through a new entity, making the original Reference Entity unlikely to ever default. ISDA has yet to announce proposals for further fixes to prevent manipulation, but further efforts to discourage abuse would surely be welcomed by the large majority of users of credit derivatives.

Process for adherence

To adhere to the Protocol, firms should submit an Adherence Letter to ISDA and pay a one-time fee of US$500 at or before submission of the Adherence Letter. The text of the Protocol and information on adherence is available on the relevant section of ISDA’s website.

*The “Reference Entity” is the issuer of the debt that underlies a credit derivative, and is the entity on which a Credit Event is determined.