25 Feb 2009, Mark Pengelly, Risk magazine
An International Swaps and Derivatives Association group comprised of buy-side and sell-side market participants has been working on changes to the standard North American CDS contract over recent months. The modifications are part of an effort to shift the market to central clearing and the bulk of them are expected to be implemented by March.
Most prominently, the changes include hardwiring the cash-settlement auction process and a drive towards fixed coupons and up-front payments. They also include the removal of restructuring as a credit event, which worries some credit portfolio managers because of constraints on regulatory capital relief prescribed by Basel II.
The Basel II framework allows only up to 60% of credit exposure to be hedged with CDSs which exclude restructuring. Consequently, the new standard would mean hedgers having to use non-standard and less liquid contracts - or hedging with the standard contract and forgoing as much as 40% of current regulatory capital relief.
"Basel II capital on my book would go up substantially," remarked one New York-based credit portfolio manager at a major bank.
Some dealers favour the removal of the restructuring provision in CDSs, arguing it leads to greater difficulty in valuing and risk managing contracts, impeding liquidity in the market. "Other credit events like bankruptcy and failure to pay are easier to observe and verify. The interpretation of the definition of a restructuring credit event can be subjective," observed Biswarup Chatterjee, head of CDS trading at Citi in New York.
At the moment, most investment-grade North American CDSs include modified restructuring as a credit event. If restructuring is triggered as a credit event, this limits the maturity of deliverable obligations to 30 months after the contract's scheduled termination date. This limitation makes administering a multilateral cash-settlement auction difficult, said Chatterjee. "All contracts may not settle with one obligation, and it may not be possible to have one industry-wide auction. You'd potentially have to settle each contract bilaterally."
Limitations on the maturity of deliverable obligations in a restructuring scenario came after a credit event was triggered on Indiana-based life insurer Conseco during September 2000. Some CDS protection buyers subsequently chose to deliver cheap long-dated bonds to protection sellers, causing consternation among market participants.
However, the limitations have since acted as an incentive not to trigger restructuring credit events. Apart from Conseco, Goodyear in 2003 and clothing retailer Liz Claiborne in 2009 restructured their debt, but neither restructuring led to CDS being triggered.
As a result, banking regulators are accused of placing too much value on restructuring as a credit event in the Basel II framework. "I can't believe the regulators are going to stick to this. Nobody thinks restructuring is as valuable as they do - it hasn't been used in years," says the New York-based credit portfolio manager.
Sources say discussions are under way with regulators in Europe and the US aimed at easing the requirements. While the changes to US single-name CDSs will not directly affect the European market, they are deemed necessary for central clearing - a top priority of European Union officials.
See also: Trichet: Eurozone CCP will help improve oversight
Banks agree to EU CCP for clearing CDS
European CDS regulation 'inevitable' - EC official
JP Morgan CDS pricing model to be made available via Isda
Clearing CDS for lift-off
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