# Laying down the ground rules

## CDS guide: documentation

One critical element that limited the expansion of the CDS market in its early days was the absence of any broadly accepted and standardised documentation clearly defining the precise terms and conditions of contracts. Instead, even after the publication of a 19-page ‘form of confirmation’ by the International Swaps and Derivatives Association (Isda) in 1998, these tended to be negotiated between buyers and sellers of protection on what amounted to an ad hoc basis, which inevitably opened the way for disputes between the two parties when credit events occurred. As the BIS puts it, “risk shedders appear sometimes to have been able to exploit the terms of credit derivative agreements at the expense of risk takers, insofar as payments under CDS contracts are not conditional on actual losses.”

The Russian default of 1998 brought some of the disagreements between buyers and sellers of protection into the public eye. As the Bank of England explained in its Financial Stability Review, published in June 2001, one dispute arising from the Russian default concerned a short delay in payments due on the City of Moscow’s debt. “Some market participants had entered into CDSs that did not include any specific provision for grace periods to allow for technical delays in making payment by the reference entity,” this explained. “The English courts ruled that the delayed payment was a credit event under the terms of these contracts and the protection seller should settle.”

An essential breakthrough for the development of the CDS market came in 1999, when, in response to disagreements prompted by the Russian crisis, Isda published its new ‘master agreement’ designed to standardise credit derivatives contracts, formalising the guidelines on standard documentation originally published at the beginning of the previous year. One year in the making, and applicable to contracts on sovereign and non-sovereign names alike, these guidelines, according to Isda, were “developed by a working group of Isda member institutions, including most of the world’s leading participants in privately negotiated derivatives activity”.

Delegates at the Isda conference in Vancouver in March 1999 were given a sneak preview of these new definitions, which were formally unveiled in July the same year. As Isda commented in 1999, the new definitions enshrined within the master agreement were “viewed as critical to the growth in demand for these types of transactions”.

While these guidelines represented an important step forward for the CDS market, they did not constitute a watertight and definitive solution applicable to all developments impacting on the market. One example of a situation not decisively addressed by the Isda guidelines came in November 2000 with the demerging of the UK power company, National Power, into two successor entities, Innogy (which focused purely on the UK market) and International Power, which concentrated on business development in all other markets.

According to a Fitch analysis, this demerger resulted in a question as to the identity of the reference entity in connection with a number of credit default swaps – given that the Isda definition of a successor company referred to the entity that assumes “all or substantially all of the obligations”.

In a market as young, fast-expanding and open to innovation as the CDS market, it is inevitable that determining documentation standards should be a dynamic rather than a static process, and the debate over the status of a successor company provided one good example of Isda’s flexibility in re-drafting its guidelines to bring more clarity and transparency to the derivatives market.

In this instance, Isda released a supplement on successor events in November 2001, advising that it was replacing the “all or substantially all” language in its definitions with a numerical threshold. This would determine that if an entity succeeds to 75% or more of the bonds or loans of the original reference entity, “then the sole successor would be that entity”. The same supplement outlined alternative approaches in the event that the 75% threshold is not met.

While this supplement clearly removes uncertainties regarding the specific issue of successor obligors, Isda will probably be called upon to publish many more such amendments as additional unanticipated ‘special situations’ emerge in the fast-evolving CDS market. A report published by Fitch in October 2002 neatly sums up the problem that Isda has inevitably needed to grapple with in the drafting of watertight documentation standards that are universally acceptable. “In attempting to standardise documentation for credit default swaps, Isda faces the unenviable task of trying to manage conflicts of interest between protection sellers who want the narrowest possible definition of a credit event and the narrowest possible interpretation of deliverable obligation characteristics and protection buyers who need the opposite,” this explains.

Trigger events

It is important to recognise that the contractual terms of credit default swaps provide no protection against ‘events’ such as disappointing earnings, rating downgrades and other market-related developments that may lead to spread widening and potential losses for bondholders. Nor, therefore, do credit default swaps provide much of a defence for investors who have simply made a poor investment decision.

In broad terms, the events that will trigger a payment by sellers of protection in the CDS market include the following:

Bankruptcy: this refers to a corporation’s insolvency or its inability to pay its debts, and is therefore the most immediately visible event that would trigger payment on a credit default spread.

Failure to pay: if after expiration of the applicable grace period, the reference entity fails to make payment with respect to principal or interest on one or more of its obligations. Failure to pay sets a minimum dollar threshold.

Repudiation/moratorium: if the reference entity or government authority indicates that one or more of its obligations is no longer valid, or if the entity or government stops payment on such obligations. This provision now applies only to sovereign reference entities.

Obligation acceleration: when an obligation has become due and payable earlier than it would otherwise have been due because of a borrower’s default or similar condition. Like failure to pay, obligation acceleration is subject to a minimum dollar threshold payment amount.

Restructuring: this has proved to be the most thorny of the credit events originally outlined by Isda, and refers to a change in the terms of a borrower’s debt obligations that are deemed to be adverse for creditors. The sticking point here has often been defining what is or isn’t necessarily ‘adverse’ for bondholders or lenders, which has led to a lively and protracted debate (see below).

Credit event procedures

In the event of one of the above developments occurring, a so-called ‘credit event notice’ will be delivered by the protection buyer, protection seller, or both, indicating that a trigger event has taken place and providing two sources of publicly available information describing the occurrence of the credit event.

The debate over restructuring

Credit derivatives market terminology would suggest that credit default swaps are contracts that, by definition, provide buyers of protection with a form of insurance against default – that is to say, against the failure of a borrower in the loan or bond market to meet its interest obligations. Although that definition would appear to be clear enough, there have already been a number of well-documented cases where technical loopholes have been exploited by signatories to CDS contracts, in turn forcing a reassessment of accepted definitions among participants in the market.

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The week on Risk.net, November 10-16, 2017