Preparing for the new 2014 credit derivative definitions

ISDA’s 2014 credit derivatives definitions will enter into force on 22 September 2014. Nigel Dickinson, partner in the capital markets team at Norton Rose Fulbright LLP considers the main changes and what lawyers can do to best prepare for the changes.

Original news

Press Release: ISDA Publishes ISDA 2014 credit derivatives definitions

A new standard reference obligation allowing for the adoption of a standardised reference obligation across credit default swap (CDS) contracts is among the new terms introduced in revised credit derivatives definitions published by the International Swaps and Derivatives Association (ISDA). The new definitions will be implemented on the September 2014 CDS roll date, but will only apply if parties reference them in their trade documentation for new trades or agree to amend the documentation for existing transactions through the use of a protocol.

What are the main changes from the old definitions?

The 2014 definitions introduce a number of new concepts, including:

• a new credit event for CDS transactions on financial reference entities, triggered by a government-initiated bail-in

• a provision for delivery of the proceeds of bailed-in debt or a restructured reference obligation, and more delineation between senior and subordinated CDS transactions on financial reference entities

• the ability to settle a credit event in a CDS transaction on a sovereign reference entity by delivery of assets into which sovereign debt is converted, and

• the adoption of a standardised reference obligation across all market-standard CDS contracts on the same reference entity and seniority level

Further details are available on ISDA’s website. ISDA has also published a protocol relating to the 2014 definitions, which will allow parties to incorporate the terms of the 2014 definitions into their existing CDS transactions (and for a certain period of time, new CDS transactions) by adhering to such protocol (the protocol).

How have the changes been received by the market?

Trading on the 2014 definitions is scheduled to begin on 22 September 2014 (the next iTraxx roll date) and from then onwards the credit derivatives market will move to trading on the 2014 definitions as the new market standard. Participants will be able to upgrade their existing CDS on the old definitions to the 2014 definitions in advance of 22 September 2014 by adhering to the protocol, subject to carve-outs for CDS referencing European financials, global sovereigns and certain corporates trading on guarantees which would fail as qualifying guarante under the old definitions but which would qualify under the softer qualifying guarantee definition in the 2014 definitions.

The 2014 definitions should restore faith in CDS as an accurate hedging product for credit exposure to European banks as the 2014 definitions were specifically drafted, among other things, to address problems seen when the old definitions were tested publicly in the crisis and found (by banks, end users and commentators) not to work as expected. For example, there was uncertainty as to whether CDS buyers’ credit protection would be triggered and even if it was triggered recovery often wasn’t equal to that expected. In particular, the Greek crisis highlighted the need to better preserve in CDS contracts a sovereign credit protection buyer’s bargain where they may not have a good deliverable bond (to deliver to the credit protection seller) where a government unilaterally changes the terms of domestic law debt (hence the new ‘governmental intervention credit event’ referred to in above).

How long is it expected that the market will be bifurcated?

Estimates vary but quite soon post-September, it will be difficult to trade and hedge on the old definitions because the market will move onto the 2014 definitions. Liquidity for trades using the old definitions is expected to dry up quickly because:

• old definitions trades will have wider pricing as they’ll be non-standard

• even if a trade on the old definitions is clearable by a central counterparty (CCP), CCPs are not necessarily going to clear old definitions trades indefinitely and if CDS trades cannot be cleared then they will be subject to the European Market Infrastructure Regulation (EU) 648/2012 (EMIR) risk mitigation obligations

• volumes of old definitions trades will drop off after September, when there’s a credit event then ISDA may decide there aren’t enough trades to hold an auction (see below), and

• even if a CDS can be traded on the old definitions, unless an offsetting trade is available for risk-weighted asset purposes the capital charge will likely impair the trade economics

What impact will the 2014 definitions have on issuers and arrangers of credit-linked notes?

Credit-linked note programmes (used to issue credit-linked notes on standard terms, which are based closely on the old definitions) will need to be updated to reflect the 2014 definitions, so that new issues of notes under the programme reflect the new market standard (and also so that the arranger can hedge its risk in the CDS market with a market standard CDS contract).

The majority of existing credit-linked notes (issued with terms based on the old definitions) will have been issued with ‘future-proofing’ built-in, enabling the issuer of the notes to unilaterally amend the terms of the notes to track developments in the CDS market. Sophisticated issuers have been doing this as a matter of routine since 2007 (when ISDA started to be involved in running auctions for credit events).

It is very likely that the CDS hedge transactions (using the old definitions) for existing credit-linked notes will be automatically converted into transactions that use the 2014 definitions by virtue of the relevant banks adhering to the protocol. Therefore unless the notes contain the relevant ‘future-proofing’ described above, the note issuer may have basis risk between the terms of its credit-linked notes and its CDS hedge transactions.

Will auction settlement terms post-September 2014 apply to all CDS transactions on a particular reference entity?

Not necessarily. Whether or not ISDA holds an auction following the occurrence of a credit event (to determine the value of the debt of the defaulting reference entity) is determined by reference to trading volumes of transactions on the relevant terms. It is not yet clear whether auction settlement terms post-September 2014 will apply to:

• all CDS transactions on that reference entity

• new transactions using the 2014 definitions and old transactions covered by the protocol, or

• just new transactions using the 2014 definitions

Where a party is not going to upgrade a CDS on the old definitions to the 2014 definitions, the parties should consider the possibility that the ‘fallback settlement method’ may apply following the occurrence of a credit event (which would usually be physical settlement of the CDS).

Interviewed by Jon Robins.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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