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CDS Small Bang:
Understanding the Global
Contract & European
July 20th, 2009
CDS Small Bang: Understanding the Global Contract & European Convention Changes
Introduction: Why Have a CDS Small Bang?
Expected Global Contract Changes
Expanding the Role of the Determinations Committees to Auctions for Restructuring Events
Auctions for Restructuring Events
Matching Deliverables to Maturity Buckets
Matching Transactions to Maturity Buckets and The Rounding Down Convention
To Auction or Not to Auction and the “300/5” Criteria
Comparing Mod Mod R and Mod R
Old R Auctions
“Use It or Lose It”
European CDS Convention Changes
Trading with a Full Coupon
Restructuring Clause Convention
Markit CDS Converter and ISDA CDS Standard Model
Treatment of Markit iTraxx and CDX EM Index Trades
Migration of Old Contracts to New Contracts/Conventions
Global Contract Changes
Small Bang Protocol
2009 Restructuring Supplement to the 2003 ISDA Credit Derivatives Definitions
DC Committee Rules
European Convention Changes
Appendix: History and Definitions of Restructuring
Copyright © 2009, Markit Group Limited. All rights reserved. www.markit.com CDS Small Bang: Understanding the Global Contract & European Convention Changes Executive Summary The CDS Small Bang is a natural extension of the CDS Big Bang. The Big Bang entailed global contract changes as well as convention changes in North American contracts. The CDS Big Bang protocol gave investors the option of adhering to the protocol to have the global contract changes apply to their existing positions. By launch, over 2,000 accounts had elected to adhere to the protocol—an overwhelming vote of confidence in the industry’s efforts to facilitate the creation of more standardized contracts. Our prior report “Understanding the CDS Big Bang: Global Contract Changes and North American Convention Changes” discussed these changes in detail and can be found at www.markit.com/cds. We expect the CDS Small Bang to be similarly successful for Europe.
Why is the CDS Market Changing?
The industry is extending contract standardization to other aspects of the CDS markets. The CDS Small Bang entails contract changes related to Restructuring, alongside separate convention changes to the European corporate CDS market and Western European Sovereign CDS trades. For clarity, the contract changes will also apply to the handling of any outstanding CDS trades globally that have some form of restructuring specified. The motivations for the convention changes in European contracts are similar to the ones in the North American conventions—facilitate central clearing, gain efficiencies in trade and operational processing, and reducing the gross notional amount outstanding in the market.
The convention changes were implemented in Europe on June 20th, 2009 (June 22nd was the first trading day). Contract changes are scheduled in advance of July 31, 2009 – the commitment date made by dealers to the European Commission to begin central clearing in Europe.
Global Contract Changes On April 8th, the Big Bang Protocol went into effect, hardwiring the auction mechanism, creating Determinations Committees with the responsibility to declare whether a credit or succession event has occurred. It also introduced the concept of rolling effective dates with “lookback” periods defining credit event and succession event protection.
Simultaneously with the global contract changes, North American corporate single names started trading with fixed coupons and a full first accrual period.
While CDS Big Bang authorized the Determinations Committees (DC) to decide whether or not a Restructuring Event took place, the DC rules under the CDS Big Bang specifically prohibited them from authorizing auctions to settle trades for Restructuring Events due to the complications cited in this report. The CDS Small Bang addresses the need to incorporate the auction settlement mechanism for Restructuring Events.
Under the current restructuring definitions there is significant optionality in determining a settlement price due to eligibility of deliverable obligations based on whether the buyer or seller triggers the contract, the maturity date, and whether restructured or other obligations are being delivered. In order to determine an appropriate cash settlement price for all contracts under a reference entity in a Restructuring Credit Event, an auction might be required for every outstanding CDS maturity date. This is not practicable for both operational reasons and the considerable cost associated with conducting a large number of auctions. The major benefit and thrust of the CDS Small Bang is to ensure that the auction settlement mechanism used for “bankruptcy” and “failure to pay” events can be applied to “restructuring” events.
Thus CDS Small Bang contract changes specifically address Restructuring in the following ways. First, Determinations Committees will be able to decide whether or not to hold auctions for specific Maturity Buckets. Maturity Buckets will be established to limit the number of auctions while still maintaining the optionality for buyers or sellers to trigger and preserve the spirit of the Restructuring Maturity Limitation Date and Modified Restructuring Maturity Limitation Date provisions in the ISDA Credit Derivatives Definitions. Second, in order to maintain the concept of a statute of limitations on credit events as designed in the CDS Big Bang, as well as to prevent investors from “shopping” the auction results, a “Use It or Lose It” date will be implemented. This stipulates that investors must trigger the trade prior to auction or lose the Restructuring Event.
Copyright © 2009, Markit Group Limited. All rights reserved. www.markit.com CDS Small Bang: Understanding the Global Contract & European Convention Changes European Convention Changes Quoting Conventions and Coupons Since June 20th, standard European corporates trade with fixed coupons of 25, 100, 500 and 1000, similar to North American corporates albeit with additional coupons. Most trades should gravitate to the 100 or 500 coupons with corporate investment grade credits likely to trade with a 100 strike and high yield credits with a 500 strike. Western European sovereigns are quoted with a 25 or 100 strike.
The additional coupons allow for greater minimization of the upfront fees that will be exchanged. Two additional coupons, 300 and 750, have been implemented to allow more flexibility in recouponing legacy trades. We have seen these coupons being quoted in runs as well, the 300 strike significantly more so than the 750 strike.
Restructuring For clarity, the European corporate contract will continue to trade with Modified Modified Restructuring as the standard convention.
Full First Coupon Similar to the SNAC contract, there will be no more short stub or long stub dependent on the trade date. The protection buyer will pay the seller the full period accrual even if the trade is entered mid-period. The cash settlement amount due at settlement date includes a rebate payment from the seller for the accumulated accrued coupon.
How Will This Change Existing CDS Positions?
Legacy CDS positions under the existing contract and trading conventions in all likelihood will become relatively illiquid.
Consequently, investors may elect to “roll” into new standardized contracts, work on a bilateral basis with their counterparties to modify their positions, or utilize a portfolio recouponing service to rebook their existing positions into new positions reflecting the new coupon strikes (while maintaining the risk profile and payments of their existing net positions). Adhering to the CDS Small Bang Protocol would allow for the Determinations Committee, cash auction, and effective date provisions to be applied retroactively to existing positions—this minimizes basis risk between legacy and new positions. Also this will allow those who did not adhere to the Big Bang protocol another opportunity to adhere their trades to that protocol as well. Regulators have encouraged the industry to closely consider the CDS Small Bang Protocol.
Copyright © 2009, Markit Group Limited. All rights reserved. www.markit.com CDS Small Bang: Understanding the Global Contract & European Convention Changes Introduction: Why Have a CDS Small Bang?
On March 11, 2009 major European dealers made a commitment to European regulators to begin clearing index and single name CDS trades through a European central clearing party by July 31, 2009. While the contract and convention changes are not explicitly required for central clearing of CDS trades (any more than the changes were required under CDS Big Bang), the changes to promote greater standardization of contracts improves the ability of central clearing parties to conduct daily hedging operations and reduce systematic counterparty risk. In our CDS Big Bang report we also discussed the benefits of contract standardization to trade compression and trade processing.
CDS Big Bang, while a dramatic first step for the CDS markets, did not cover everything. The convention changes only applied to North America. The contract changes did not resolve the complications around restructuring. As restructuring, which is more prevalent in Europe and raised additional issues, it made sense to implement restructuring related changes separately from CDS Big Bang.
Clearly from the above diagram, there is more standardization to do in other global regions and product areas of credit derivatives. Neither the CDS Big Bang nor Small Bang applied to U.S. Municipal CDS, Loan CDS, or CDS on ABS. The industry is actively reviewing the need for modifications to these other products on an ongoing basis.
Auction hardwiring was incorporated into Loan Only CDS at the time of the product’s design, well ahead of the implementation dates associated with CDS Big Bang. Our intention here is just to simplify the progress report.
Due to the CDS Big Bang, the restructuring convention standard for North America is now No Restructuring. However, the contract changes here could be used to handle Restructuring Events for significant legacy positions struck under Modified Restructuring in North America. Asia has typically traded with Old Restructuring which does not have any maturity limitation restrictions to address but to the extent that there may be significant positions in Mod Mod R or Mod R in Asia, these contract changes would be applicable.
European Corporates and Western European Sovereigns did not change their restructuring conventions which continues to be Mod Mod R and Old R, respectively, but the issue has been addressed explicitly as part of CDS Small Bang.
Copyright © 2009, Markit Group Limited. All rights reserved. www.markit.com CDS Small Bang: Understanding the Global Contract & European Convention Changes Since there is interest in central clearing of CDS trades in Asia, one would expect some changes to CDS trading to take place particularly around trading conventions in the region. Currently being discussed are modifications to Loan Only CDS in North America moving to a true bullet contract, and changes to emerging markets trades. Lastly, a direct consequence of the CDS Small Bang changes is the need to address Markit iTraxx and CDX EM index tranches standardization, which some are already referring to as the “Tiny Bang”.
Copyright © 2009, Markit Group Limited. All rights reserved. www.markit.com CDS Small Bang: Understanding the Global Contract & European Convention Changes Expected Global Contract Changes While removing Restructuring as a standard credit event in North America was straightforward and had broad market support, the need for restructuring protection in Europe is more complicated and compelling. First, in North America the Chapter 11 process allows for many restructuring scenarios to be covered under the definition of bankruptcy. Since Europe does not have a similar Chapter 11 process, protection buyers would not have adequate credit protection if restructuring were excluded. Second, Basel II capital requirements dictate to banks that CDS positions must include a restructuring provision in order to qualify fully for capital relief on hedged positions. Positions hedged using CDS without restructuring protection only provides 40% capital relief, significantly hindering the ability of banks to extend credit.
Maintaining the Modified Modified Restructuring convention for Europe while trying to promote further standardization of CDS contracts raises some unique challenges. The contract changes for CDS Small Bang addresses these challenges.
The need to maintain the restructuring convention of Mod Mod R in Europe is clearly illustrated here with 96% of the curves in Europe trading under the Mod Mod R convention currently.
Note we make the assumption that readers are familiar with the different types of Restructuring clauses used by the market today as well as the evolution of the issues over time. For those that are not or need to refamiliarize themselves with the concepts, the Appendix provides the various restructuring clause definitions and reviews the issues in some detail.