News Analysis
CDS developments gather momentum
Two developments - one under ISDA's control and the other seemingly out of it - are dominating the CDS market. The first is a new type of CDS due to be included in credit derivatives indices next year, while the other is the ongoing CDS uncertainty concerning the possible restructuring of a Noble loan.
The first issue concerns trading definitions for a new type of senior non-preferred CDS. The contracts would help investors to hedge senior non-preferred bonds, used by European banks to transfer risk from the taxpayer to institutional investors.
"The revision is intended to address certain hedging issues for the buy-side; i.e., to help investors to hedge senior non-preferred bonds and similar instruments," says Assia Damianova, special counsel at Cadwalader, Wickersham & Taft.
She continues: "Since the crisis, regulators have been keen to ensure a fairer distribution of losses among creditors, because one of the big lessons from 2008 has been that insolvency really does not work for significant banks, but if such bank is saved, many issues have arisen around which types of creditors should be impacted by the haircuts of the bank's liabilities."
ISDA is preparing trading definitions for the new type of CDS with the aim of including the instruments in credit derivatives indices from next year. While a date has not been confirmed, the European iTraxx CDS March 2018 roll is considered likely.
Regulators have dictated which funds and eligible liabilities a bank should keep, as well as how debt should be subordinated. Different jurisdictions have taken different approaches to the structuring of the required new bank bonds, so the issues concerning the CDS tracking these bonds vary by jurisdiction.
Jurisdictions which take the holding company approach, such as the UK, should only require simple changes. Germany subordinates all senior debt to other unsecured liabilities and therefore would require no index changes. Other jurisdictions could be more complicated.
"For example, in the UK CDS is at a holding company level and the changes to reflect that should not require too much work, but for jurisdictions such as France and Spain, where banks issue a new type of debt, the so-called Tier 3 bonds that suffer losses after the subordinated bonds, the ISDA definitions may require more changes," says Damianova.
She continues: "Trades on financials in those jurisdictions may need their own CDS terms, which will require ISDA to amend documentation so that those terms can be selected. Without such amendments to their documentation, buy-side participants who are concerned if they have a good hedge of Tier 3 bonds may consider getting bespoke terms - that is an expensive process and is opposite to the direction of greater standardisation in which CDS contracts have been moving."
While ISDA is busily making necessary changes, pension funds and asset managers also have to be alert. When putting on trades, Damianova notes that managers will need to be mindful that senior non-preferred bonds can be effectively subordinated, so they will need to ensure they are not paying for senior protection.
ISDA has also been kept busy by the Noble case, albeit mainly busy telling the market that it is unable to act. Holders of Noble Group's CDS have expressed dismay at the failure of ISDA's relevant Determinations Committee to rule on whether the CDS have been triggered by a restructuring credit event in June.
While ISDA acts as secretary to the various Determinations Committees and administers their work, ISDA itself does not have a vote or make the decisions, as it has been at pains to point out to the market. As ISDA also points out, the failure of the Asia Ex-Japan Determinations Committee to come to a conclusion is because that committee felt that it did not have sufficient information, because it was not able to get hold of the underlying loan documentation and details of the guarantee.
"ISDA is administering the auction process but for the outcome to be correct then the input must be precise. I am sympathetic to the Determinations Committee's plight because the Determinations Committee can only make a decision after analysing the specific provisions of the instrument in question, but loans agreements tend to be private instruments and if there is not enough information available on which to base a decision then the hands of the Determinations Committee are tied," says Damianova.
The failure of the Determinations Committee - so far - to come to a conclusion is not the end of the road, however. While this situation is unusual and undesirable, the option to settle the contract bilaterally does remain.
"From a legal perspective, the bilateral settlement requests that followed have now raised some interesting interpretation issues. For example, whether the (bilaterally served) credit event notices are valid if the relevant protection buyer cannot provide the underlying documentation and whether credit event notices can be validly served after the expiry of a certain 14-day 'Post Dismissal Additional Period'," notes Damianova.
The Asia Ex-Japan Determinations Committee is due to meet again tomorrow, 13 September, to further discuss the Noble case.
12/09/2017 14:32:33
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