CDS 'big bang' could see 18% increase in tear-ups, Markit says

Markit's London-based director of credit products, David Austin, said the changes would "simplify the process of trading".

From tomorrow, the auction settlement process for CDSs worldwide will be hardwired into the contract; the determinations committees set up by the International Swaps and Derivatives Association (Isda) will have the final say on whether or not a credit event has occurred; and the protection granted by a CDS will start 60 days before the current day for a credit event, and 90 days before a succession event, rather than starting the day after the CDS trade is completed.

The latter change is intended to allow offsetting trades to provide perfect hedges. For example, picture a CDS dealer who sold protection on an underlying on January 5 and bought protection on the same underlying a week later, on January 12. Credit events are not always immediately obvious, and if, later on - say February 10 - it was discovered that a credit event had occurred on January 10, the dealer would not have been hedged. Under the new rules, the dealer would be hedged because the contract provides protection for the 60 days before the credit event took place.

In North America, the 'big bang' will also see single-name CDS trades with a fixed coupon of either 100 basis points or 500bp, together with an upfront payment to cover the difference between the fixed coupon and the current price. Austin expects investors in high-yield and distressed names to gravitate towards the 500bp CDS.

The measures are broadly aimed at improving standardisation - as well as simplifying the trading process and reducing the risk of trade breaks. Austin said they will also allow for more trade compression, in which offsetting trades are cancelled out and torn up. Markit estimates the reforms will allow 18% more trades to be compressed, reducing the notional outstanding in the credit derivatives market.

Markit, with the US trading platform Creditex, managed to tear up $1.35 trillion in trades last year in this way -standardised index trades were easier to handle than single name CDSs, the companies said. The total notional outstanding of the credit derivatives market was $54.6 trillion in June 2008, the most recent date for which figures are available, according to Isda.

See also: Isda launches hardwiring supplement for CDS settlement auctions
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Isda documentation to cover CDS settlement auctions
Isda to publish auction settlement supplement, launches close-out protocol
Standard US CDS contract sparks hedging worries