On March 12, 2009, the International Swaps and Derivatives Association, Inc. ("ISDA") published the 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement Supplement (the "Auction Supplement") to the 2003 ISDA Credit Derivatives Definitions (the "CDS Definitions") together with a new protocol (known as the Big Bang Protocol (the "Protocol")) specifying standard auction settlement procedures and related terms applicable to credit default swap transactions ("CDS").
The fundamental components of the Auction Supplement include the establishment of:
- standard auction settlement procedures to eliminate the need for future bespoke auction protocols;
- a Credit Event and Succession Event look-back period to enhance the fungibility of similar CDS trades with respect to the impact of Credit and Succession Events; and
- Credit Derivatives Determinations Committees (each, a "DC") comprised of dealer and buyside representatives to make binding determinations with respect to certain conditions and events.
The Protocol is open for adherence until 5:00 p.m. New York time on April 7, 2009. As a failure to adhere means that existing trades will not be subject to future settlement auctions and related terms, market participants are encouraged to give serious consideration to adhere to the Protocol. As of the publication of this memorandum, according to ISDA's website, approximately 150 parties have adhered to the Protocol.
This memorandum summarizes the Auction Supplement and the mechanics of the Protocol, and highlights certain issues for market participants as they consider adherence to the Protocol.
The Auction Supplement's Framework and Covered Transactions
The Auction Supplement is comprised of the 2009 ISDA Determinations Committees Rules (the "DC Rules") and Form of Credit Derivatives Auction Settlement Terms (the "Auction Terms"). Parties can elect to incorporate the Auction Supplement in new CDS trades by referencing the Auction Supplement in the trade confirmation. For parties adhering to the Protocol, the Auction Supplement will also apply to:
- covered CDS trades (defined below) outstanding as of April 8, 2009;
- new covered trades entered into between April 8, 2008 and January 11, 2011; and
- novated trades which would have been covered pursuant to (i) or (ii) above if the original parties had adhered to the Protocol.
The Protocol's coverage is split between transaction types subject to both the DC Rules and the Auction Terms ("Protocol Covered Transactions") and transaction types subject to the DC Rules but not the Auction Terms ("Covered Non-Auction Transactions"). The Protocol Covered Transactions are trade types typically covered by past auction protocols including: (i) certain index trades (e.g., CDX and iTraxx tranched and untranched); (ii) certain swaptions (single name and portfolio); and (iii) certain non-swaption trades (single name, Nth to default, recovery lock, and bespoke portfolio transactions). Covered Non- Auction Transactions include reference-obligation only, fixed recovery, preferred CDS and party-specific non-auction trades.
Trade types specifically excluded from the Protocol include: (i) loan-only CDS; (ii) U.S.-muni CDS; (iii) CDS on ABS, CDO or MBS; (iv) certain index trades (e.g., back-to-back CDS linked to named high-yield indexes between specified dealers); and (v) transactions that the parties have agreed to exclude from the Protocol as specified in the relevant confirmation.
The Auction Supplement will be incorporated into DTCC operating procedures and will therefore apply automatically to trades with a Trade Date or novation Trade Date on or after April 8, 2009. Parties to Covered Transactions desiring not to apply the Auction Supplement will need to so specify in a paper confirmation. Bilateral market standard Master Confirmation Agreements between adhering parties will also be automatically amended to incorporate the Auction Supplement.
Auction Settlement Procedures
ISDA's publication of the Auction Supplement and Protocol is intended to provide a more standardized approach to the settlement procedures across CDS auctions. For this reason, ISDA does not anticipate that there will be future bespoke ISDA CDS auction protocols. The Auction Supplement's prescribed Auction Terms retain much of the auction methodology applied in ISDA's recent protocols. Without the prospect of future bespoke CDS auctions, parties who do not agree to include Auction Settlement in future confirmations, or who fail to adhere to the Protocol, will need to settle their trades in accordance with the terms of the relevant confirmation (absent an agreement to an alternative approach).
Each Determinations Committee (described below, each a "DC") will govern, oversee, and implement the standard Auction Terms. Upon determination by the DC, each of the following settlement terms will be published by ISDA: (i) auction date; (ii) initial bidding information publication time; (iii) inside market quotation amount; (iv) maximum inside market bid-offer spread; and (v) minimum number of valid inside market submissions. Amendments to the auction methodology specified in the Auction Supplement may only be adopted by a supermajority vote of the DC after notice and a public comment period.
Changes to previous auction procedures adopted within the Auction Terms include the establishment of a method to determine the applicable currency exchange rate to address foreign currency risk and procedures related to loan settlements involving physical settlement requests submitted in the relevant auction.
Credit Event and Succession Event Look-back Provisions
The Auction Supplement creates the concept of a "look-back period" applicable to Credit Events (60 days) and Succession Events (90 days). An event will only have relevance for a specific transaction if it occurs during the look-back period prior to: (i) the date on which the DC is notified of a request for determination or (ii) the date on which a party to the transaction is notified of (a) both a Credit Event Notice and Notice of Publicly Available Information is effective (with respect to Credit Events) or (b) a Succession Event Notice is effective (with respect to Succession Events).
A Credit Event or Succession Event found to have occurred prior to the relevant look-back period will have no impact on the relevant trade even if such event occurred within the term of such trade. As the look-back period may commence prior to the Effective Date of a trade, the look-back period effectively extends the term within which an applicable event may occur.
Under the Protocol, with respect to previously existing Protocol Covered Transactions, the concept of the look-back period will not be effective until June 20, 2009. In effect, up until June 20, 2009, the terms of any existing trade will govern with respect to the impact of any Credit Event or Succession Event absent an agreement to an alternative approach.
The Credit Derivatives Determinations Committees
By establishing the DC, the Auction Supplement creates a binding and streamlined method to address issues affecting CDS in the relevant market. Within each of 5 regions (Americas, Asia ex-Japan, Japan, Australia-New Zealand and Europe), each DC will be comprised of 8 global dealers, 2 regional dealers, 5 buy-side members, 2 non-voting dealers (as alternates), and 1 non-voting buy-side member (as an alternate), with ISDA staff serving as the DC secretary.
To become a member of a DC, a dealer must: (i) serve as a participating bidder in the auctions relating to the Protocol; (ii) adhere to the Protocol; and (iii) maintain certain CDS notional trade volumes based on DTCC data. A buy-side member must have: (i) at least $1 billion under management; (ii) single-name CDS transactions in excess of $1 billion in notional amount; and (iii) the approval of 1/3 of the thencurrent buy-side committee. For inclusion on a DC, the buy-side committee will randomly select the buyside members to serve for staggered one-year terms. The buy-side committee will also ensure that the buy-side DC representatives are comprised of at least one alternative asset manager and one traditional asset manager.
Any ISDA member may request that a DC be convened to address specific questions relative to a covered CDS transaction or the CDS market generally. The Protocol sets forth clear timelines and guidelines under which the DC must respond to the ISDA member and/or address and resolve the question. Before agreeing to deliberate an issue, at least one member of the DC must accept the ISDA member's question for review. The DC's resolution of the matter is binding on all transactions which incorporate the Auction Supplement; however, resolutions by the DC will not retroactively affect a previous bilateral determination by a transaction's calculation agent or otherwise.
A DC will address and resolve questions pertaining to: (i) Credit Events; (ii) Deliverable Obligations; (iii) Succession Events; (iv) Substitute Reference Obligations; (v) Auctions; and (vi) issues relevant to the CDS market generally. To the extent that the DC votes on questions relating to items (i) through (iv) in the preceding sentence and an 80% supermajority vote is not obtained, the issues will automatically go to an external review panel nominated and confirmed by DC members. Upon the resolution of an issue by the DC, or by the external review panel, if applicable, ISDA will publish the results promptly on its website.
Note that the settlement terms specified in a confirmation will govern in the event the DC declines to hold an auction (absent an agreement to an alternative approach). For example, the DC will not hold auctions for Restructuring Credit Events, nor may it hold an auction if it determines the reference entity is too illiquid or if there is no Deliverable Obligation.
Protocol Adherence Procedures
To adhere to the Protocol, market participants must submit an adherence letter, in the form attached as Exhibit 1 to the Protocol (http://www.isda.org/bigbangprot/bbprot_formadherenceletter.html), to ISDA via email at hardwiring@isda.org on or before 5:00 p.m. New York time on April 7, 2009. The adhering party's email to ISDA must include each of the following: (i) a signed copy of the adherence letter stating the name and information of the contact person at the adhering party and (ii) a conformed copy of the adherence letter (hard copies are not required nor is there a fee for adherence). Protocol adherence will not be effective until both the signed and conformed versions of the adherence letters are submitted by email in accordance with foregoing procedures.
For investment managers seeking to adhere on behalf of clients, a number of additional issues arise. A manager needs to confirm whether a client has granted it authority to adhere to the Protocol on the client's behalf. If all clients have granted such authority, the manager may sign the Protocol on behalf of the funds and accounts listed in the relevant master agreement with another adhering party. If only some clients have granted such authority, the manager needs to consider the implications of attaching a list of funds or clients to the Adherence Letter as a copy of the letter will be disclosed on the ISDA website. If assistance is needed in completing the Adherence Letter, please contact one of the attorneys listed below.
Issues for Consideration
As market participants assess the merit of adhering to the Protocol as well as incorporating the Auction Supplement into trade confirmations going forward, they should give consideration to various issues, including, among others: "
- How will the Protocol and Auction Supplement impact current initiatives supported by the Department of the Treasury, the Federal Reserve Board, the SEC, the CFTC and the New York State Banking Department, among others, to encourage the development of CDS central counterparties/clearinghouses? To what extent will such central clearinghouses be facilitated by the streamlined settlement procedures and increased fungibility of similar CDS trades? "
- If a party, such as an asset manager, elects not to adhere to the Protocol, what issues relating to basis risk, operational risk, and liquidity risk arise from possible mismatches between existing trade terms and those amended through the Protocol to leverage determinations by the DC and the settlement approach achieved through the auction process? What operational efficiencies can be achieved through the global amendment of covered trade terms in accordance with the Auction Supplement? "
- Does the buy-side representation on the DC provide sufficient protection for buy-side interests with respect to the CDS market – and OTC derivatives market generally?
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.