“It would definitely give impetus to the hedging of otherwise un-hedgeable names, because there are so many counterparties who enter into derivatives transactions that do not have outstanding debt deemed deliverable,” said Spiro Santoni, the London-based head of active counterparty risk management at Royal Bank of Scotland.
The working group, assisted by the International Swaps and Derivatives Association (Isda), has been hammering out standard documentation for swap-deliverable CCDSs for almost a year, following publication of the original standard CCDS contracts in early 2007.
Like conventional credit default swaps, CCDSs involve a series of protection premiums paid by the buyer to the seller, until the reference entity undergoes a credit event. If such an event happens, payment at par is transferred from the seller to the buyer of protection, in exchange for an amount of deliverable bonds or loans equal to the contract’s notional size. But while the size of a conventional CDS is fixed, the notional of CCDSs is dynamic and contingent on the value of an underlying derivatives trade – a currency or interest-rate swap for example.
As a result, the value of a CCDS tends to move in line with the counterparty risk exposure incurred through the underlying derivatives trade. Many dealers have consequently embraced it as a better hedge against counterparty credit quality than plain vanilla CDSs.
However, there are some instances – such as where counterparties have no deliverable bonds or loans – in which they cannot be used to hedge exposure to counterparty credit. Another example would be where buyers of protection do not hold sufficient bonds or loans to satisfy their deliverable obligations under CCDSs.
William Mertens, head of credit hybrids at Icap in New York – who has spearheaded the drive towards CCDSs over the past five years – also pointed to a concern that sovereign counterparties might rescind swap or derivatives contracts, but not default on their government debt.
While it is not believed they will replace ordinary CCDSs, swap-deliverable CCDSs are intended to address these scenarios. Under a swap-deliverable CCDS, the underlying derivatives trade would itself become a deliverable obligation – as opposed to the counterparty’s debt.
For the Isda working group, constructing a derivatives contract allowing for the delivery of another derivatives contract has proven nettlesome. “For about the last three months the group has been struggling with the issue of what is the best method of delivery of the claim,” said Mertens. David Geen, Isda’s London-based general counsel, explained one tricky issue was the possibility of a swap contract, once delivered, being legally contested.
If the new standard documentation is published soon, counterparty risk managers suggested it would provide a boon to their work at a difficult time. Counterparty credit has recently been a focal point for many dealers, as exposures have multiplied while solvency fears linger across the financial sector.