The new ISDA Definitions and their likely impact
The International Swaps and Derivatives Association, Inc. (ISDA) has announced that its 2014 ISDA Credit Derivatives Definitions will go live from September 2014, creating a challenge for firms to implement the necessary operational and infrastructure changes.
ISDA highlighted that the revised version of the 2003 ISDA Credit Derivatives Definitions will contain the basic terms used in the documentation of most credit derivatives transactions. Furthermore, the announcement also indicated that the ISDA Credit Steering Committee (CSC) has been working with clearing houses to develop an appropriate implementation schedule. The steering committee was considering an early roll-out date for the 2014 credit derivatives definitions, but it was apparent that a longer time frame would enable market participants and infrastructure providers to make the necessary changes with minimal impact on markets.
ISDA was forced to consider these changes by the Dodd-Frank Act of 2010, and the current emerging crisis with certain sovereign’s securities affecting the credit default swap (CDS) markets and its participants. Market participants would now have to execute CDS transactions on a registered exchange, for clearing by a derivatives clearing organization. The challenge facing most participants is not only to understand the implication of the new ISDA’s amendments for their internal processes and operations, but to coordinate and communicate internally the changes.
The three significant changes in the Credit Derivative Definitions will include:
1. Introduction of a new credit event for new transactions that would be triggered by a government bail-in of a financial reference entity: If the debt is written down or converted into other assets as a result of the bail-in, the changes will provide for the CDS contract to be settled based on such written-down debt or other assets based on the outstanding principal amount before the bail-in. If the debt is written down to zero without any conversion proceeds, the credit default swap (CDS) will settle at a pre-determined fixed cash settlement amount of 100 percent in favour of the Buyer.
2. For new transactions (only on sovereign reference entities), the definition is amended by introducing the ability to settle a credit event by delivery of assets other than “deliverable obligations”. The change would allow the CDS contract to be settled on the basis of an “asset package” into which pre-identified benchmark bonds of the sovereign are converted on a credit event.
3. Introduction of a standard reference obligation for more frequently-traded reference entities: The standard reference obligation would be published and would apply to all contracts that adopt “standard reference obligation”. The new provisions would also standardize the procedures and standards for selecting a replacement reference obligation if the existing obligation is redeemed in full or in material part. This change is anticipated to apply to existing trades, but it is expected that parties will have a window following determination of a standard reference obligation in respect of a reference entity and seniority level to “opt-out” existing single-name CDS trades on a trade-by-trade basis.
The challenge now is how market participants translate the requirements into an operational process, enterprise-wide. The financial institution should already have in place and in writing the processes taken when a credit event is triggered. At the time the credit event is triggered, the financial institution should have in place a guidebook listing the comparable assets that may be considered during the conversion. There should be no surprises for the counterparties when a credit event occurs. ISDA has indicated it will publish a list of comparable securities that could be considered in the “Asset Package” at conversion. In any case involving an event having a significant financial impact to an organization, the internal communication and reporting processes would be very critical in getting it right. Prior to the event being triggered, the financial institution should be developing a market-risk profile and an impact analysis on the pre-identified benchmark bonds of the sovereign. The analysis should consider the interest rate risks, considering the value-at-risk and earnings-at-risk impact on the financial institution’s portfolio when the sovereign’s bonds are designated in the “asset package”. This circumstance and portfolio should be “stressed” tested to determine a worst-case scenario and its financial impact. The analyses should be prioritized based on country risk and the likely event of default. From a credit risk and market risk perspective, a specific “exit strategy” should also be developed for this particular event to ensure that the financial institution would incur minimal negative impact.