ISDA’S BIG BANG PROTOCOL CONTINUES DRIVE TOWARD STANDARDIZATION – AND REGULATION?

The drive toward standardization in the credit derivatives markets continues. In addition to recent efforts to move OTC credit derivatives trades onto centralized clearing platforms, moves are afoot in the market to standardize the way credit default swaps (“CDS”) are traded. These trends perhaps soften the arguments – and may in fact define the framework – for a possibly impending overlay of new regulation in the sector. Both compliance professionals and other officers responsible for CDS trades in their organizations should become familiar with these changes, as they will affect your organization’s use of credit default swaps and the impact future credit events and other events in the industry will have on your existing and future trades.

On March 12, 2009, the International Swaps and Derivatives Association (“ISDA”) launched its 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement Supplement and Protocol, known as the “Big Bang” Protocol (the “Protocol”). ISDA characterized the Protocol as the final stage of the process known as ‘hardwiring’, or the incorporation of auction settlement terms into standard CDS documentation. The Protocol became effective on April 8, 2009. The protocol generally covers corporate CDS, and does not apply to loan only transactions, CDS on municipal bonds, or CDS on asset-backed securities, mortgage-backed securities or collateralized debt obligations.

The text of the changes is contained in ISDA’s March 2009 Supplement. Parties to credit default swaps, both future and existing, may include the March 2009 Supplement in their CDS documentation. The parties can also agree to modify the application of the March 2009 Supplement’s provisions – although many market participants have expressed the view that they expect the Protocol to become the new market standard. 

The Protocol has implemented a number of significant changes, including the following.

The Use of Auction Settlement

Parties to a CDS contract can now select “auction settlement” as the method for settling a credit default swap, rather than cash settlement or physical settlement. If the Determinations Committee (discussed below) determines to hold an auction for a reference entity covered by that CDS contract, the settlement will be governed by the results of that auction. The auction process will be similar to the ad hoc credit derivatives settlement protocols that have been held on an ad hoc basis in the past by ISDA. In a CDS auction, CDS dealers submit bids and offers to the administrator of the auction, and those bids and offers are used to calculate the final price for the reference obligation. Once the final price is determined, counterparties adhering to the Protocol will settle their trades using cash settlement (rather than physical settlement) at the final price determined in the auction. Should the auction fail to determine a final price, CDS trades

Copyright Christopher Lewis 2009

participating in the auction would settle with their originally named settlement method (i.e., cash settlement according to the terms of the particular CDS trade, or physical settlement).

It should be noted that under the Protocol, cash settlement or physical settlement, rather than auction settlement, can still be elected by the parties, although many market participants have expressed the view that auction settlement under the Protocol will become the new market standard.

The Appointment of a Determinations Committee

On March 31, 2009, ISDA announced the initial members of the Determinations Committee, the names of which can be found at www.isda.org. Going forward, there will be one Determinations Committee for each of the Americas, EMEA (Europe, the Middle East, and Africa), Australia and New Zealand, Asia (excluding Japan), and Japan. Each Determinations Committee will seat eight global dealers, two regional dealers from the related region, and five buy-side members. Members of each Determinations Committee will rotate according to the rules set forth in the rules of the Determinations Committee.

The Determinations Committee will decide issues relating to the CDS market, including:

• whether a credit event on any particular reference entity has occurred; • the specific date as of which the credit event will be deemed to have been triggered

(which presumably would be the first date on which an ongoing event occurred);• which obligations constitute deliverable obligations;• whether an auction will be held to settle outstanding credit default swaps naming that

reference entity; and• whether a succession event has occurred with respect to a reference entity and the

identity of any successor entity.

Parties adhering to the Protocol will be bound by the decisions of the Determinations Committee. All determinations by the Determinations Committee of credit events and succession events must be agreed upon by a supermajority of 80% of committee members, or if not so agreed, by an external panel of experts selected by the Determination Committee.

To begin the process of determining whether a credit event in respect of a Reference Entity has occurred, an adhering counterparty will request the related Determination Committee to consider the issue, and at least one member of the applicable Determination Committee must agree.

Backstop Provisions

Additional terms of the Protocol include “backstop” dates for credit events and succession events. This feature of the Protocol implements rolling look-back or retroactive periods for

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credit events and succession events. The backstop date for credit events will be 60 days prior to the date of the related determinations committee is convened to decide whether a credit event on the related reference obligation or entity has occurred. The period is 90 days for a succession event. Thus, if a credit event or succession event occurred more than 60 days or 90 days, respectively, before the related determinations committee was asked to determine its existence, the event will be considered stale and of no effect on existing CDS transactions.

New Market Practice – Standardization of Fees

In developing the Protocol, ISDA had considered including new standardized economic terms (“Standard North American Corporate Terms”) in the Protocol, but instead opted to have these terms will be incorporated into the Standard North American Corporate (“SNAC”) trade type on DTCC and through the ISDA settlement matrix. The Standard North American Corporate Terms include (a) trading CDS transactions with standard fixed payments of 100 basis points or 500 basis points for CDS trades on investment grade and high-yield bonds, respectively, with up-front payments to reflect the pricing of different fixed payment rates, (b) standard quarterly payment dates which match the four quarterly roll dates for the CDX indices, (c) the payment of the full first coupon with no “stub” period, such that accruals of fixed amounts will begin on the “roll” date immediately preceding the effective date of the CDS contract, with the initial payment accounting for any fixed amount accrual prior to the trade date of the CDS contract, and (d) the elimination of restructuring as a credit event for North American corporate CDS trades. Parties will still be able to enter into North American corporate CDS trades on other economic terms; however, they will not be able to use the SNAC trade type to confirm these trades. As such, market participants have expressed the view that they expect the Standard North American Corporate Terms to become the new market standard.

Implementation of the Big Bang Protocol – How is it Going?

On April 13, 2009, Derivatives Week reported that the Protocol had 2,086 adherents. Some have expressed concern about implementation from an IT/Operations perspective, especially at times when many institutions are cutting back on expenses. Notwithstanding these concerns, implementation appears to have so far been successful, with ISDA recently announcing that the Credit Derivatives Determinations Committee for the Americas held its first meeting, determining that a credit event occurred for General Growth Properties, Inc. and Bowater Incorporated. Standardization of CDS contracts is consistent with the recent move of CDS contracts to central clearing exchanges, setting the stage for possible increased regulation. ISDA has also recently reported that the level of electronic confirmations for credit derivatives rose from 62 percent in 2007 to 92 percent in 2008; this trend is consistent with the standardization and automation trend, which will allow both market participants and regulators to better monitor and assess the credit derivatives markets.

Copyright Christopher Lewis 2009