The Credit Derivatives Mailbag

Some recent press articles have raised questions about the process for determining whether a credit event has occurred and therefore whether credit derivatives should trigger. Many of the articles have focused on the ISDA Credit Derivatives Determinations Committees (DCs). So, we thought we’d tackle a few of the most commonly raised issues.

Q: What are the DCs?

A: The DC process was rolled out in 2009 in order to ensure decisions over whether a credit event has occurred can be taken quickly by people with expertise in the credit derivatives market, based on an objective, rules-based review procedure. The process was developed to ensure both speed and certainty. These are important: market participants need to know as quickly as possible whether their trades will be triggered.

The DCs were part of a broader effort to increase standardisation in the credit derivatives market and facilitate central clearing. This included the hard-wiring of an auction settlement system into credit derivatives documentation to reduce operational complexity and increase certainty by creating a uniform, transparent and orderly settlement process. That, in turn, required an objective mechanism for deciding whether credit events had occurred. The entire DC process was developed in coordination with regulators and following market consultation.

Q: How does the DC process work?

A: There are two things that matter in determining a credit event. First, the decision can only be made based on publicly available facts submitted to the DC. Second, these facts need to be referenced to the ISDA Credit Derivatives Definitions – the standard legal terms used in the credit derivatives market – to determine whether a credit event has occurred. This is meant to ensure the process is objective and predictable, and decisions can be made quickly – providing certainty to market participants as to whether they have a hedge or not.

Q: How can you be sure it works?

A: The vast majority of DC questions considered to date have resulted in unanimous decisions. That’s because, in most cases, the application of the available facts to the relevant provisions in the credit derivatives definitions have been straightforward – it’s often as simple as confirming whether a company has paid what it owes on an outstanding bond, or whether it has filed for bankruptcy, with little or no room for ambiguity. A supermajority vote – 80% – is needed for a credit event to be determined, and this has only not been achieved twice over a period spanning nearly six years and well over 1,000 submitted questions.

Q: Why is the process being criticized then?

A: The firms that decide whether a credit event has occurred are the most active participants in the credit derivatives market. Some commentators have argued this results in conflicts of interest.

Q: How does the DC process mitigate these potential conflicts of interest?

A: The DC comprises 15 voting members: 10 from the sell side and five from the buy side (ISDA acts as a non-voting secretary), and a supermajority decision (80%, or 12 of the 15) is needed for a credit event to be determined. That ensures a single firm cannot influence the decision. In addition, the identity of DC member firms is publicly available, as are their individual votes. This transparency is an important point: anyone can see how any single DC member has voted.

Q: Is the credit derivatives market regulated?

A: The credit derivatives market, alongside other derivatives assets classes, is closely regulated following the introduction of the Dodd-Frank Act and other similar legislation elsewhere. Regulators have full transparency on the trades and positions held by all market participants as a result of rules requiring all over-the-counter transactions to be reported to trade repositories.

The standardisation of credit default swap (CDS) contracts and the development of a transparent process to determine whether or not credit events have occurred have also helped facilitate the move to central clearing – another key part of the post-crisis regulatory reforms. According to US swap data repository data, 74.4% of index CDS notional volume was cleared each day on average in 2014, while 62.2% was traded on a regulated swap execution facility.

Until the publication of any determination, DC members are subject to applicable securities laws restricting their ability to trade on material non-public information. Like all market participants, DC members are subject to any relevant anti-manipulation laws. In the US, for example, the Commodity Futures Trading Commission and the Securities and Exchange Commission have the authority to prosecute using their fraud and manipulation statutes.

Q: But don’t the dealers typically get their way?

A: It’s not a matter of buy side versus sell side. There have been some suggestions in the media that dealers are typically sellers of protection, and so they would usually be able to use their greater number on the committees to influence the vote in their favour. That suggestion is based on a faulty assumption: that dealers are always sellers of protection and the buy side is always a buyer, which isn’t the case. Banks have large loan books, which are often hedged through the credit derivatives market via their credit portfolio management desks. Conversely, buy-side firms are as likely to sell protection as they are to buy.

The supermajority requirement also means that even if all 10 dealers vote in favour of a credit event, at least two buy-side members must also vote in favour for that decision to be passed.

The facts also dispute the assumption. As already highlighted, the vast majority of DC questions considered to date have resulted in unanimous decisions. In the two instances where a supermajority vote has not been achieved, the two sides – those that had determined a credit event had occurred and those that thought it hadn’t – contained buy- and sell-side firms.

Q: What happens when the DC isn’t able to reach a decision?

A: If a supermajority is not achieved, then the question is passed to an external review panel comprising a minimum of three and up to five independent experts for consideration (the fourth and fifth members, if any, are essentially back-ups). Until recently, the external review panel had been convened once, back in 2009. The external panel nominations received at that time can be viewed here, the votes by DC members on whether to accept them is here (it was a unanimous decision), and the ultimate decision by the external panel, taken a month later, is available here. In this case, the external panel made a decision contrary to that taken by the majority of DC members during the original vote – the result of which is here.

The DC recently convened a new external review panel to decide a question related to Caesars Entertainment Operating Company. The vote on the composition of the panel can be found here. At time of writing, a decision had not been made.

If – and only if – new information comes to light, then the DC can decide by a majority to take back the question for consideration, but a supermajority vote is still required for a credit event to be determined.

The ISDA Credit Derivatives Determinations Committees were established following extensive consultation with market participants and regulators. The DC process was part of a series of measures to make the credit derivatives market more transparent and standardised – measures that ultimately helped facilitate central clearing and electronic trading in the credit derivatives market. ISDA remains committed to ensuring the process remains robust, and will continue to review policies and procedures and will make updates as necessary.