Traders of credit default swaps (CDS) are being asked to sign up to amended rules underpinning their contracts from September 16, as part of a plan to stamp out manufactured defaults – or narrowly tailored credit events (NTCEs) – which threaten to undermine the product's credibility.
The industry-wide protocol, run by the International Swaps and Derivatives Association, will automatically switch adhering parties' legacy contracts onto the updated standard on January 13, 2020, when the terms will become standard for new contracts. The protocol will remain open until October 14, an Isda spokesperson confirmed.
Some participants have reservations over whether the relatively narrow fix is enough to stamp out ever-more inventive ways in which savvy traders have gamed the market. Even so, take-up is expected to be high, since global regulators ramped up the attack on so-called 'opportunistic CDS strategies' following a wave of shady financing deals built around derivatives outcomes.
The changes have generally been relatively well received by the market, as a lot of people use the product in a neutral way rather than an opportunistic way. Many were worried that these situations could have a negative impact on their trades and CDS market liquidity more generally. But now it's time to test those changes," says Fabien Carruzzo, a partner at law firm Kramer Levin.
"While a lot of people think it's a good idea, they haven't yet given much thought to direct implications on their portfolios"
This means a more detailed consideration of any potential value transfer stemming from changes, which ultimately raise the bar for credit protection to pay out.
"While a lot of people think it's a good idea, they haven't yet given much thought to direct implications on their portfolios. People are going to have to look at their trades and start thinking about what these changes mean in practice," Carruzzo adds.
The switch has already attracted early support from some of the largest credit trading houses, including Bank of America Merrill Lynch, Citigroup and JP Morgan.
Valuation shift
As a yardstick, more than 340 firms signed up to Isda's last CDS protocol launched in February, which switched protection on senior German bank debt to the senior non-preferred level. This change mirrored a reclassification in cash markets to more closely align the country's approach to bail-in rules with other European Union jurisdictions.
While the German protocol was viewed as little more than a relabelling exercise for CDS players, amendments intended to stamp out NTCEs could translate into a clear valuation shift on directional portfolios.
CDS buyers, for example, could see value erosion from amendments that reduce the likelihood of contracts paying out. This is because greater discretion is afforded to the credit determinations committee – the group of 15 sell-side and buy-side firms tasked with ruling whether an issuer is in default and ultimately whether CDSs pay out. Under amended wording, first proposed by Isda in March, a failure-to-pay credit event – once a clear-cut test – would only be called and lead to CDS protection being paid out if it is accompanied by an observable deterioration in creditworthiness.
"For market participants who are buying CDS, maybe the switch is going to have a negative impact, but the question is whether they would get stuck in a smaller liquidity pool by not amending their contracts. If that's the case, it could be harder for them to get out of their contract, or novate their trades," says Carruzzo.
A causation test, whose definition is left purposefully vague, is intended to ward off some of the most egregious manufactured default situations, for which US homebuilder Hovnanian remains the posterchild.
In 2017, the firm reached a financing agreement with Blackstone's GSO unit that would see the builder default on a small amount of debt, triggering payouts on CDSs – of which GSO was a holder. This followed a blueprint set by earlier trigger-to-finance deals from iHeart Communications earlier the same year and Spanish gaming company Codere in 2013. But the Hovnanian debacle plunged to new depths in the murky CDS world when a second restructuring proposal included the issue of deeply discounted debt, intended to maximise the payout on CDSs.
Originally published by Risk.net.
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