Everybody loves a good credit derivatives story. And market participants and the media have had a very good one in recent weeks. It concerns CDS contracts written on Novo Banco, a Portuguese bank.

The Novo Banco story begins with Banco Espírito Santo (BES). The central bank of Portugal, in its capacity as a resolution authority, transferred various assets and liabilities from BES (which was in difficulty) to Novo Banco (a so-called good bank) in August 2014, under the Portuguese bank resolution regime. Sixteen months later, the central bank took the decision to re-transfer five senior bonds back from Novo Banco to BES, reportedly because the European Central Bank’s stress test had uncovered a capital shortfall at Novo Banco. To say this is unusual is an understatement.

Let’s now turn to the credit derivatives market. Credit derivatives contract terms set out the conditions for a credit event to occur, typically using the ISDA Credit Derivatives Definitions. Decisions about whether an event meets those conditions are made by the ISDA Credit Derivatives Determinations Committees (DCs). These committees, which each comprise 10 sell-side and five buy-side firms, make their determinations by gathering publicly available information and comparing it against the definitions to see if the relevant conditions are met (you can read more about the process here and here). A supermajority (12 out of 15 votes) is required to reach a determination. In the case of Novo Banco, the European DC was asked to resolve whether the transfer of bonds from Novo Banco back to BES constituted a governmental intervention credit event.

One of the cornerstones of the Credit Derivatives Definitions is that they are as precise as possible from a legal perspective to enhance predictability and objectivity. This protects both buyer and seller. But like any contract, unanticipated events occasionally emerge that aren’t neatly covered by the definitions. In the case of Novo Banco, the majority of DC members voted that the bond transfer did not constitute a credit event, but the majority fell one short of the supermajority threshold. As a result, the issue was (as per the DC rules) referred to an external panel of experts.

The panel unanimously agreed with the majority of the DC. The decision hinged on whether the transfer constituted a mandatory cancellation, conversion or exchange, or whether the transfer had an analogous effect to those defined events. Ultimately, they determined the transfer was neither a cancellation, conversion nor exchange, and was sufficiently different to those events to be not analogous to them. Taking a broader, catch-all interpretation of ‘analogous’ would mean this clause would “dominate the whole of the definition, which is inconsistent with the careful and detailed drafting”, the external panel decided.

So there it is. While most CDS credit event determinations in practice are clear cut, it’s clearly challenging (and perhaps impossible) to consider and explicitly address all possible future scenarios and contingencies that might occur in the credit markets. That’s why it is important to have a robust process (which includes industry definitions drafting committees, as well as the DCs and the external review panels) through which issues and uncertainties can be addressed and clarified. This enables market participants to gain the clarity they need and deserve, even in exceptional situations such as the one involving Novo Banco.