Storm Warnings

As the eastern US hunkers down in the face of a potential historic snowfall, a storm of a different sort hit the derivatives markets yesterday, courtesy of The Wall Street Journal.

The article claims there has been little change in the “murky” credit derivatives market since the financial crisis, and contains an unchallenged quote from one source that the market is “self-regulated” with “little adult supervision”.

Dodd-Frank, anyone?

Among other things, the law requires all over-the-counter derivatives to be reported to trade repositories. That means regulators can see who owns what. A high proportion of the credit derivatives market is now cleared through central counterparties and the more standardised instruments are subject to electronic trading requirements, which include pre- and post-trade transparency obligations. The reality is that the credit derivatives market is subject to more regulation than ever.

Over the years, ISDA has contributed to the development of standardised credit default swaps (CDS) contracts and a transparent process to determine whether or not credit events have occurred. This standardisation has helped facilitate greater levels of central clearing, and enabled firms to better manage risk.

Here are a few other facts that have been buried in the WSJ article.

1) In 2014, ISDA updated its Credit Derivatives Definitions. (The previous set of Definitions had been published in 2003.) The Definitions define the terms used in the documentation of credit default swap (CDS) transactions.

2) The 2014 Definitions introduced a variety of changes to the legal language governing credit derivatives trades – for instance, they established terms for new developments like bank bail-in or the possibility of a euro exit and made several upgrades to the 2003 Definitions. They did not, however, change the fundamental rules defining whether a company’s failure to pay what it owes, or a filing for bankruptcy protection, would trigger the settlement of CDS contracts.

3) To help market participants navigate the change, ISDA established a Credit Derivatives Definitions Protocol. Firms that adhered to the Protocol agreed to use the new Definitions for all eligible outstanding contracts with other adhering parties. Adherence was strictly voluntary, and adhering parties also had the right to revoke their adherence at any time up to the very end of the adherence process.

It’s fair to say most market participants would want as many of their counterparties as possible using the same standards. If not, the differences in the legal language would mean 2014 contracts would have to be managed separately to contracts referencing the same entity under the 2003 Definitions.

4) As part of the process to develop the Protocol, ISDA recognised that not all outstanding trades could be switched automatically to the 2014 Definitions via the Protocol. That included those that were considered to be too complex or where there was a near-term possibility of a credit event. As part of the Protocol, ISDA published a list of excluded reference entities after a consultation process with its membership and publication of the draft Protocol.

Two entities in the Caesars Group were added to the excluded list late in the process, but the additions were widely publicised, and those market participants that had already adhered to the Protocol had the option to revoke adherence if they didn’t agree with the change.

On top of the Caesars entities, the ISDA Credit Steering Committee – a group comprising buy- and sell-side representatives – agreed to exclude 194 other entities in total from the Protocol.

5) Exclusion from the Protocol doesn’t mean these reference entities could not trade under the 2014 Definitions. It just means contracts referenced to those reference entities wouldn’t automatically switch to the new Definitions as part of the Protocol. Individual sets of counterparties could choose bilaterally whether to move them to the 2014 Definitions or keep them trading under the 2003 language. Either way, as noted above, it wouldn’t affect whether those contracts trigger in the event of a default of the reference entity.

The process to bring standardisation and transparency to the credit markets is important. ISDA is committed to a transparent and fair process that is beyond reproach. Toward that end, ISDA will continue to review and update as necessary the policies and procedures to drive the highest standards of conduct.

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