'Big bang' protocol provides wake-up call for CDS market over credit event settlement

A new scheme for adjudicating on credit event auctions, consisting of a centralised committee, will replace the old system of ad hoc decision-making

The credit derivatives industry is set to introduce profound changes to the way it works in the coming few weeks, as bilateral decision-making on credit events is replaced by a centralised system of adjudication. By signing a so-called "big bang" protocol, adherents will agree to settle existing trades through centrally administered auctions for any future credit event.

Cash settlement auctions are a well-established feature of the credit derivatives market, but using them has until now been voluntary. Ad hoc protocols have accompanied each auction, to allow traders to opt out of the physical settlement otherwise required by documentation. The "big bang" protocol will be open to signatures until April 7, following its publication on March 12. In addition, an auction settlement supplement is set to be incorporated into Isda's 2003 credit derivatives definitions. Credit derivatives determinations committees, which will decide on questions such as whether a credit event has occurred or whether a reference obligation is deliverable, form the central plank of the new system.

Even more changes are afoot. In a momentous period for the market, restructuring is to be dropped as a credit event for new trades in the US, from March 20. On the same date, which is when credit derivatives contracts roll over, US single-name default swaps will begin trading with fixed spreads, as is the case already with index trades.

All of these changes are designed to increase the efficiency of the market. However, so-called hardwiring of credit event auctions is the most fundamental change.

"The auction process has been used on 30 or so occasions since 2005, two-thirds of those within the last six months. It is well tested," says Thomas Benison, managing director in credit derivatives trading at JPMorgan in New York. "The market has recognised the benefits of having the process hard-coded. It entails giving up the bilateral right to make determinations, but means all trades in the market have the same answer."

The "big bang" protocol is expected to have broad adherence. However, as recently as late last year, there appears to have been a level of scepticism over whether hardwiring could be accomplished in the fullest sense of the word. "There's a difference between hardwiring the process of going for cash-settled auctions rather than physical settlement, and hardwiring how the market agrees on whether credit events have occurred," says one market participant. "Deciding on credit events for oneself is a basic right."

Signing on the dotted line

However, there has been huge pressure from regulators to have the reforms pushed through. Moreover, months of legal drafting and hard negotiating have gone towards achieving market consensus. "People are basically on board," says a New York-based credit derivatives lawyer. "The expectation is that the vast majority of market participants will sign up to the protocol." Adds a buy-side operations manager: "There's no reason to doubt that the protocol will be embraced. The events of last year and the ensuing confusion over the intricacies of dealing with credit events mean that anything that can be done to 'institutionalise' this process can only be good news."

The kind of changes the operations manager hopes to see include greater transparency and a reduction in the potential for human error and documentation error.

Hard-coding doesn't magically do away with the potential for disputes in relation to credit events. But the central tenet of the project is that guaranteed full participation in auctions will increase orderly settlement. Regulators who wish to see greater operational certainty in the credit derivatives market have insisted on hard-coding based on that argument.

Under the planned new system, decision-making will first go to regional determinations committees, depending on the location of the reference entity. Based on drafting details, the Americas, Europe and Asia will each have committees formed from dealers and buy-side firms, which will make binding decisions based on an 80% majority. If the necessary majority is not reached, the decision passes to a review panel consisting of external lawyers (see box).

Agreeing the composition of the committees, and the sorts of thresholds that constitute a binding vote, have been among the more intensely debated areas. For example, according to one source, an earlier permutation would have allowed sell-side dealers to reach majority decisions based purely on their votes. Buyside firms were subsequently dealt a stronger hand. "It isn't possible to reach an 80% majority only by having the sell-side represented," says a credit derivatives lawyer, who declined to be named. "Majority decisions can't be passed unless there are two votes from the buy-side."

The best way to achieve the highest degree of independence for external review panels also resulted in a variety of proposals. For instance, in the US, one proposal was to use a panel of judges from the Delaware Court of Chancery, a major forum for settling US commercial disputes. That was rejected in favour of using derivatives specialists at external law firms. It was argued that the Delaware approach was too difficult to adapt as legislation would have to be crafted.

JPMorgan's Benison says that the new system has strong integrity. "The ability to opt out of auction-based settlement will be gone so the dispute resolution framework must be appropriately robust," he says. "We have a strong process, one that was developed with input from all corners of the market."

Two out of three ain't bad

Hardwiring will apply to two out of three triggers for credit events: bankruptcy and failure to pay, but not restructuring. Using auctions to settle the latter is impractical, as restructuring is a 'soft' credit event. Some but not all debt is triggered, meaning separate auctions would be needed for individual deliverables, potentially running into large numbers. With bankruptcy and failure to pay, all debt becomes due, so a single auction can determine a price for all deliverable obligations. The fact that restructuring falls outside the new hardwired system is an inconvenience. However, dropping restructuring events in the US for new trades helps reduce the problem.

The other big change - the switch to trading single names in the US using fixed running coupons and variable upfront payments - dovetails with the broad thrust to minimise operational risk in the credit derivatives market. In particular, it will expand the scope for clearing through central counterparties.

Netting down positions (collapsing offsetting trades) is a key advantage of central clearing. But ease of netting depends on having fixed coupons. CDS index contracts already trade on the basis of fixed coupons and have been the first target for central clearing initiatives. Clearers can now extend their sights to single names.

"It is all part of moving to greater fungibility," says Benison, "and it sets the market up better for central clearing." The credit derivatives market is on the verge of a new era. Many elements will be unfamiliar and the crucial test of the machinery will be over the coming few months.

Credit event arbitration: how it works

Determinations committees and external review panels form the linchpin of hardwired credit event auctions. Based on drafting details in early February - and thus subject to any last-minute revisions - the regional determinations committees will each consist of eight global dealers, two regional dealers and five buy-side members all with the power to vote. Two non-voting dealers and one non-voting buy-side member will also have seats, with Isda acting as determinations committee secretary.

The committees will be reconstituted on a yearly basis. Based on the draft proposals, buy-side firms must have at least $1 billion in assets under management to qualify, and also at least $1 billion of notional single-name exposure. A committee must include at least one hedge fund manager and one traditional asset manager. Any Isda member may request that a determinations committee is convened. At least one member of the committee must agree to deliberate the issue.

If an 80% majority isn't achieved on binding votes, the question passes to a panel of three external reviewers, chosen from a pool. If 61% to 79% of the committee have voted together, that can be overturned only if all three reviewers are in agreement. Where the margin is 50% to 60%, two out of the three external reviewers can overturn the vote.