ISDA auction hardwiring for credit derivatives following a restructuring
22 July 2009
On 14 July 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, Auction Settlement and Restructuring Supplement to the 2003 ISDA Credit Derivatives Definitions (the July 2009 Supplement)
- 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restructuring CDS Protocol (the Small Bang Protocol)
On 12 March 2009, ISDA published the 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement Supplement to the 2003 ISDA Credit Derivatives Definitions (the March 2009 Supplement) which, amongst other things, hardwired Auction Settlement as the Settlement Method into certain Credit Derivative Transactions and established the Credit Derivatives Determinations Committees (each, a DC).
For the reasons set out below, the March 2009 Supplement did not address the technical difficulties involved in applying Auction Settlement as the Settlement Method following a Restructuring Credit Event. The amendments to the 2003 Definitions made by the July 2009 Supplement, combined with accompanying revisions to the Credit Derivatives Determinations Committees Rules, now make it possible to hold an auction to settle Credit Derivative Transactions following a Restructuring.
Restructuring under the 2003 Definitions (prior to the July 2009 Supplement)
In cases where settlement of a Credit Derivative Transaction is triggered by Buyer, and Mod R (being market standard for Credit Derivative Transactions referencing North American corporate entities to which Restructuring is applicable) or Mod Mod R (being market standard for Credit Derivative Transactions referencing European corporate entities) is applicable, any obligation which Buyer wishes to Deliver to Seller must not only constitute a Deliverable Obligation but must also satisfy additional requirements as to transferability (for Mod R, being a Fully Transferable Obligation and for Mod Mod R, being a Conditionally Transferable Obligation) and as to its final maturity date.
Pursuant to Mod R, Buyer may only Deliver a Deliverable Obligation which has a final maturity date not later than the applicable Restructuring Maturity Limitation Date. This date is the earlier of:
- 30 months following the Restructuring Date; and
- the latest final maturity date of any Restructured Bond or Loan, provided, however, that the Restructuring Maturity Limitation Date shall not be earlier than the Scheduled Termination Date or later than 30 months following the Scheduled Termination Date and if it would otherwise be so, it shall be deemed to be the Scheduled Termination Date or 30 months following the Scheduled Termination Date, as the case may be.
Pursuant to Mod Mod R, Buyer may only Deliver a Deliverable Obligation which has a final maturity date not later than the applicable Modified Restructuring Maturity Limitation Date. This date is the later of:
- (a) the Scheduled Termination Date;and
- 60 months following the Restructuring Date in the case of a Restructured Bond or Loan, or 30 months in the case of all other Deliverable Obligations.
The Auction methodology as set out in the March 2009 Supplement (and in each of the CDS Cash Settlement Protocols that preceded the March 2009 Supplement) operates in such a manner that a single Auction will be held in respect of a single list of Deliverable Obligations. This methodology does not work following a Restructuring where what would be deliverable depends on whether settlement of the relevant Credit Derivative Transaction is triggered by Buyer or by Seller and, further, on the Scheduled Termination Date of such Credit Derivative Transaction (due to the limitation dates described above). The July 2009 Supplement overcomes the technical obstacles that have hitherto prevented use of the Auction methodology following a Restructuring.
The Auction Solution under the July 2009 Supplement
- Broadly speaking, eight separate buckets (each, a Maturity Bucket) have been established for Credit Derivative Transactions for which Mod or Mod Mod R is applicable. The first seven such Maturity Buckets will each encompass a maturity period that ends, respectively, 2.5 years, 5 years, 7.5 years, 10 years, 12.5 years, 15 years, or 20 years following the Restructuring Date; and the eighth Maturity Bucket will encompass a maturity period ending after 20 years following the Restructuring Date (each such ending date, a Maturity Bucket End Date).
Note that in order to properly reflect the provisions of Mod R, there may be an additional pre-2.5 year Maturity Bucket, and to properly reflect the provisions of Mod Mod R, Restructured Bonds or Loans with a final maturity date of 5 years following the Restructuring Date will be deliverable for purposes of settling Credit Derivative Transactions assigned to the 2.5 year Maturity Bucket.
- If Buyer triggers settlement, Deliverable Obligations which are Fully Transferable or Conditionally Transferable, as the case may be, and which have a final maturity date on or prior to the relevant Maturity Bucket End Date will be deliverable for purposes of settling Credit Derivative Transactions assigned to such Maturity Bucket and for those Maturity Buckets with later Maturity Bucket End Dates, if any.
- The Rounding Down Convention will apply to a Credit Derivative Transaction in circumstances where there are no Deliverable Obligations with a final maturity date occurring on or prior to the Scheduled Termination Date and following the Maturity Bucket End Date of the Maturity Bucket with the next earliest Maturity Bucket End Date; and if there are no Deliverable Obligations with a final maturity date occurring on or prior to such Maturity Bucket, it will be assigned to the Maturity Bucket with the next earliest Maturity Bucket End Date and so on.
- If Seller triggers settlement, the Credit Derivative Transaction will be assigned to the Maximum Maturity Seller-triggered Maturity Bucket. Neither Restructuring Maturity Limitation Date or Modified Restructuring Maturity Limitation Date restriction, as applicable, nor the Fully Transferable or the Conditionally Transferable restriction, as applicable, will apply to Deliverable Obligations deliverable to settle such Credit Derivative Transaction.
- The relevant DC will determine whether an Auction will be held with respect to any Maturity Bucket, amongst other things, by reference to the number of contracts triggered. An Auction will always be held for a Maturity Bucket if, according to DTCC data, 300 or more triggers occur in respect of one Maturity Bucket and 5 or more Dealers are party to such Credit Derivative Transactions (the 300/5 Criteria). If the 300/5 Criteria are not satisfied with respect to a Maturity Bucket, the relevant DC may decide to hold an Auction for such Maturity Bucket nonetheless. The relevant DC will generate lists of Deliverable Obligations for each Maturity Bucket whenever it determines that one or more Auctions may be held.
- The Movement Option is available where no Auction will be held for the relevant Maturity Bucket. The Movement Option may be exercised by either
- Buyer, regardless of who has triggered settlement, who has the option to move such Credit Derivative Transaction down to the Maturity Bucket with the next earliest Maturity Bucket End Date for which an Auction will be held and/or
- Seller, if Buyer has triggered settlement, who has the option to move the Credit Derivative Transaction to the Maximum Maturity Seller-triggered Maturity Bucket. The party that exercises the Movement Option by effective notice on or prior to the Movement Option Cut-off Date (close of business on the 3rd Business Day after the publication of the number of triggered Credit Derivative Transactions) will determine whether, and in what direction, movement will occur. If both parties deliver notice before the Movement Option Cut-off Date, Buyer's exercise of the Movement Option will prevail, regardless of which party was first in time to exercise.
- If the Movement Option is not exercised, the Fallback Settlement Method applies. In that case, the only Deliverable Obligations that will be deliverable to settle the Credit Derivative Transaction are those that have a final maturity date on or prior to:
- the Maturity Bucket End Date of the Maturity Bucket to which such Credit Derivative Transaction is assigned, in circumstances where Buyer has triggered settlement, or
- the Maximum Maturity, in circumstances where Seller has triggered settlement.
"Small Bang" Protocol
A wide range of Credit Derivative Transactions that are in existence as of 27 July 2009, and which incorporate the 2003 Definitions, are to be amended such that the provisions of the July 2009 Supplement will be deemed to apply.
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 its adherents enter into and 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
The Small Bang Protocol 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 27 July 2009, and such adherents document such Credit Derivative Transaction using market standard documentation (such as the template confirmations that ISDA and other industry bodies have placed at the disposal of market participants in recent years), such market standard documentation will be deemed to have been amended prospectively to implement the changes to the 2003 Definitions contemplated by the July 2009 Supplement. It is important to note that a party that adheres to the July 2009 Supplement automatically becomes an 'Adhering Party' for the purposes of the Big Bang Protocol.
The Protocol is open for adherence from 14 July 2009 to 24 July 2009 via an adherence letter available on the ISDA website. The adherence letter should be submitted to ISDA email@example.com