Last week, we published a proposal to amend the ISDA Credit Derivatives Definitions to address narrowly tailored credit events, often referred to as manufactured defaults. No matter what you call them, we think this behavior is not healthy for the credit default swaps (CDS) market. By removing the incentive for these types of events to occur, this proposal is an important step to help rebuild confidence in the effective functioning of this market.
The proposed amendment follows a statement from the ISDA board last year that these types of events could impact the efficiency, reliability and fairness of the CDS market – a view echoed by regulators in both the US and UK.
Such manufactured events involve arrangements with corporations that result in a credit event for the purposes of CDS, but are designed to minimize the impact on the corporation. The ISDA proposal, which was agreed by a working group of buy- and sell-side market participants, aims to take away the incentive for these arrangements by requiring a failure to pay credit event to result from or in a deterioration in creditworthiness. The next step is to put this proposal out to the broader market for feedback, and then for market participants to adopt it.
As the process moves forward, it’s important to keep a couple of things in mind. First, the proposal specifically focuses on narrowly tailored credit events – an issue highlighted by regulators, the industry and the ISDA board.
Second, the definitions set standard terms that parties agree when entering into a CDS contract. However, the contract is just one part of the overall legal and regulatory framework.
Regulation like the Dodd-Frank Act in the US and the European Market Infrastructure Regulation in the European Union means regulators have transparency over the trades and positions held by market participants as a result of rules requiring all over-the-counter derivatives transactions to be reported to trade repositories.
In addition, credit derivatives market participants – like all market participants – are subject to relevant anti-manipulation and anti-fraud laws. We believe these tools should be used when necessary to address inappropriate market behavior.
Now, some may argue this change isn’t enough. However, in the words of Mark Twain, “Actions speak louder than words, but not nearly as often”. We think this proposal to amend the industry standard definitions will address narrowly tailored credit events, and we look forward to receiving feedback from the broader industry.
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