ISDA Auction Hardwiring
18 March 2009
On 12 March 2009, the International Swaps and Derivatives Association, Inc. ("ISDA") published the following new documentation that effects a number of key changes for certain credit derivatives products, particularly credit default swaps, but also credit-linked products such as new credit-linked notes and synthetic CDOs:
- 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement Supplement to the 2003 ISDA Credit Derivatives Definitions (the "Supplement ")
- 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement CDS Protocol (the "Protocol ")
The Supplement introduces three new concepts to the 2003 ISDA Credit Derivatives Definitions (the "2003 Definitions "):
- Credit Derivatives Determinations Committees (the "Determinations Committee(s) ")
- a new settlement method for credit derivative transactions, known as auction settlement
- new provisions for taking into account the occurrence of credit events and succession events by operation of look-back dates that require action by a party to a credit derivative transaction within 60 or 90 calendar days, respectively, of the occurrence of the relevant event in order for such event to affect such credit derivative transaction
Credit Derivatives Determinations Committees
The Supplement establishes 5 regional Determinations Committees that will be tasked with making determinations of general importance to the credit derivatives market, including:
- whether a credit event has occurred
- whether to hold an auction to settle a credit event
- the obligations to be valued in any auction held to settle a credit event
- whether a succession event has occurred
- the identity of any successor
A Determinations Committee will be formed for each of the following 5 regions:
- Europe, Middle East and Africa
- Australia and New Zealand
- Asia excluding Japan
Each Determinations Committee will consist of:
- 8 global dealer voting members
- 2 regional dealer voting members for the relevant region
- 5 global non-dealer voting members
- certain non-voting consultative dealer and non-dealer members
Each member generally serves a one-year term, with non-dealer members serving on a staggered one-year basis. Dealer members are chosen based on trading volume, whereas non-dealer members are chosen at random from a pool of non-dealer institutions that have the required amount of assets under management and derivative exposure.
The Determinations Committee for the relevant region will be convened each time a question is submitted to ISDA, as secretary of each Determinations Committee, as long as one member of the relevant Determinations Committee believes that such question merits deliberation.
Each Determinations Committee must reach at least 80 per cent consensus in order to pass the most important decisions. Should any such question attain less than an 80 per cent supermajority vote, it will be referred to a panel of external reviewers chosen randomly from a pool composed of individuals nominated by ISDA members and approved by a majority of the members of the relevant Determinations Committee.
Effect of Determinations Committee Decisions
Each decision of a Determinations Committee will be binding, to the extent relevant, on parties to a credit derivative transaction that incorporates the Supplement (including by operation of the Protocol) unless such parties bilaterally agree at the relevant time to disapply the relevant Determinations Committee's decision, provided that a determination by a Determinations Committee, or a calculation agent, of the identity of a successor, a substitute reference obligation or certain other matters, such as the determination that a credit event has occurred that has resulted in a settlement, may not be reversed by a subsequent determination of a Determinations Committee. Each Determinations Committee has the power to refuse to decide a question or to dismiss a question, in which case the parties must reach their own conclusions on the relevant question (or the calculation agent will make the relevant determination) in the same way as they do under the 2003 Definition.
Joining the Determinations Committees
To participate on the initial Determinations Committees:
- dealer institutions must submit a dealer participation letter to ISDA by March 25, 2009
- non-dealer institutions must submit a non-dealer committee participation letter to ISDA by March 20, 2009
Templates of these letters are available at www.isda.org . Submission of these letters does not guarantee a position on a Determinations Committee. Successful applicants will be notified that they have been selected to serve on the initial Determinations Committee(s) by April 7, 2009, at which point they must also agree to be bound by the rules of the relevant Determinations Committee by executing an agreement between ISDA and the other committee members.
The process of holding auctions to determine a settlement price in respect of a credit derivative transaction following the occurrence of a credit event has functioned smoothly since its inception in 2005 as the primary settlement method for credit events on widely traded reference entities. As a result, ISDA has facilitated, at the request of regulators in the U.S. and Europe, the "hardwiring" of auction settlement as a new settlement method into the documentation for corporate and sovereign credit derivative transactions. It is expected that auction settlement will swiftly become the market standard settlement method in the over-the-counter credit derivatives markets and that auction settlement will also be adopted in other credit-linked products.
The ability to elect auction settlement as the settlement method at the time a credit derivative transaction is entered into obviates the need for parties to adhere to an auction settlement protocol each time a credit event occurs. Instead, ISDA has published, as Annex B to the Supplement, a form of auction settlement terms that are based on the settlement methodology applied in recent auction settlement protocols, and that will be used as the basis for the auction settlement terms that are published each time the relevant Determinations Committee determines to hold an auction with respect to a credit event. For each auction, the Determinations Committee will determine certain auction-specific terms, as well as deliverable obligation terms and a list of deliverable obligations to be valued in the auction. A credit derivative transaction that has auction settlement as its primary settlement method will automatically be settled by reference to the settlement price determined under any such auction, although certain types of credit derivative transactions are excluded from the auction settlement process, including:
- reference obligation only transactions
- fixed recovery transactions
- transactions for which the provisions for identifying deliverable obligations are different from the market standard provisions for credit derivative transactions referencing the relevant entity
- transactions for which auction settlement is specified as the settlement method but that the parties have subsequently agreed to exclude from the auction process
Credit Event and Succession Event Backstop Dates
Under the 2003 Definitions, a credit event that occurs on or after the effective date of such credit derivative transaction may trigger settlement. While this trading convention has long provided flexibility to buyers of protection, the practice prevents two credit derivative transactions that are identical, but for their effective date, from being fungible, since the transaction with the earlier effective date may have experienced credit events or succession events that would not impact the credit derivative transaction with the later effective date.
To remove this potential for lack of fungibility between credit derivative transactions with otherwise identical terms, the Supplement provides that any credit event that occurred more than 60 calendar days prior to the date on which a request is submitted to ISDA for the relevant Determinations Committee to consider whether a credit event has occurred will not be able to trigger settlement of a credit derivative transaction, unless the parties thereto have already exchanged notices with respect to such event.
For succession events the look-back period is 90 calendar days and functions similarly.
These changes mean that parties face a time limit on their ability to act on a credit event or succession event under their contracts. The changes also mean, however, that it is possible that, unlike under the 2003 Definitions, a credit derivative transaction could be affected by a credit event or succession event that took place before the trade date or the effective date of such credit derivative transaction.
"Big Bang" Protocol
A wide range of credit derivative transactions that are in existence as of April 7, 2009 are to be amended such that the provisions of the Supplement, imported into the 2003 Definitions, will be deemed to apply to such credit derivative transactions. Amendment to such a broad range and large number of existing credit derivative transactions is to be achieved by operation of the market-wide Protocol. The Protocol seeks to amend the most common types of credit derivative transactions that reference corporate and sovereign entities, not including :
- loan-only credit derivative transactions
- credit derivative transactions referencing U.S. municipalities
- credit derivative transactions referencing asset-backed securities and similar securities
- credit derivative transactions that parties separately agree to exclude from the scope of the Protocol
Unlike previous ISDA protocols, the Protocol also seeks to amend, prospectively, certain types of credit derivative transaction that are typically documented using market standard documentation. To the extent that two adherents to the Protocol enter into a credit derivative transaction on or after April 8, 2009, and such adherents document such credit derivative transaction without separately incorporating the supplement, such market standard documentation will be deemed to have been amended to implement the changes to the 2003 Definitions contemplated by the Supplement and to hardwire auction settlement as the primary settlement method.
The Protocol is open for adherence through April 7, 2009 via an adherence letter available on the ISDA website. The adherence letter should be submitted to ISDA at email@example.com
The Protocol implements the application of certain provisions of the Supplement on a staggered basis as follows:
- Determinations Committees
- Applicable to each covered credit derivative transaction in existence on April 7, 2009 (each, a "Legacy Transaction") from April 8, 2009
- Applicable to each covered credit derivative transaction entered into on or after April 8, 2009 (each, a "New Transaction") from the date the relevant credit derivative transaction is entered into
- Auction Settlement
- Applicable to each Legacy Transaction from April 8, 2009
- Applicable to each New Transaction from the date the relevant New Transaction is entered into
- 60/90 Day Look-back Dates
- Applicable to all New Transactions (other than New Transactions that reference credit indices such as CDX and iTraxx®) from the date the relevant New Transaction is entered into
- Applicable to each Legacy Transaction from June 20, 2009
- Applicable to each New Transaction that references a credit index such as CDX and iTraxx® from the later of June 20, 2009 and the date the relevant New Transaction is entered into
Note that, because most of the changes to credit derivative transactions effected by the Supplement and Protocol will take effect for new credit derivative transactions (other than those referencing a credit index) beginning on April 8, 2009, market participants who enter into credit-linked transactions or issue credit-linked notes for which they intend to hedge their exposure in the credit derivatives market on or after April 8, 2009 will need to take account of the impact of these new provisions and should consider incorporating these provisions into their transactions.
If you have any questions about the information contained in this article, feel free to contact one of the individuals listed above or your usual Allen & Overy advisor.