ISDA reforms target battered confidence in sovereign and financial CDS

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The International Swaps and Derivatives Association (ISDA) is attempting to bring the credit default swap (CDS) market into the modern era of government intervention in credit markets with its most profound consultation paper in a decade as bank bail-in risks rise.

The proposed rules, which impact single-name CDS contracts, are intended to address the controversy surrounding government rescues, bail-ins and pre-emptive bond restructurings that have become part of the transatlantic debt capital markets in the past few years.

The primary proposal concerns package delivery for sovereign CDS, whereby investors would be able to submit compensation claims on a wider range of deliverable securities than the traditional bonds and loans.

Driven by investor reaction to the Greek €100 billion sovereign restructuring in 2012 – when the Greek government exploited a domestic law, a collective action clause, to execute a debt exchange ahead of the CDS auction – the new rule would allow CDS holders to take delivery of whatever financial instruments are included in an exchange package.

In the epoch of the western sovereign debt crisis, a product that was designed to capture emerging market (EM) sovereign default risk is now in need of a make-over.

“The European CDS market developed in the absence of an actual sovereign credit event,” says one London-based CDS investor. “EMs typically reference international law bonds, which are generally more difficult for issuers to restructure.

“Western European governments, however, predominately issue under domestic law, giving them much more scope to change the terms of the bonds as we saw happening in Greece. Bond investors hadn’t really expected that to happen, and CDS holders were even less prepared for what happened in the debt exchange.”

Although Greek sovereign CDS holders were spared disproportionate losses by the fact the new bonds were trading at similar levels as the old, retired debt at the time of the auction, market participants are now looking for structural improvements to ensure protection against the risk of de-facto government interference.

“Sovereigns are taking a more active role in the credit markets, and people want protection against the unforeseen aspects of those kind of actions,” says an industry source in London.

CDS on subordinated bank debt has also taken a battering in the wake of recent government actions, specifically respective moves by the Irish and Dutch governments to eliminate SNS and Anglo Irish Bank subordinated debt from the market ahead of nationalization.

These bail-in events, where private investors are required to contribute funds to a bank rescue, are not recognized by traditional CDS contracts as credit events, although they effectively remove the underlying reference from the market and eliminate bond holder value.

Under the new proposals, government bail-ins will be included in the credit event definition, and whatever the proceeds of the bail-in are will be deliverable into the CDS auction.

However, whether the reforms will revive those parts of the CDS market that have taken a beating since the crisis remains to be seen. Indeed, while index products have outperformed single-name contracts in volume terms during the past few years, dealers say that single-name CDS volumes in 2013 were similar to 2012.

According to data compiled by the CDS trade repository at the Depository Trust & Clearing Corporation in New York, single-name CDS outstandings of the top 100 reference organizations stood at $935 billion as of May 31, 2013, compared against $1.1 trillion 12 months ago.

European subordinated financials – where market volume in the Markit iTraxx Europe Subordinated Financials Index Series 17 CDX product has fallen to $1.7 billion net notional from $6.9 billion a year ago – could benefit from increased confidence that new government bail-in strategies are included in the small print.

“Government intervention has been a big issue for subordinated financial products, and the changes deliver a clear benefit to those contracts,” says one credit market participant. “I expect to see increased volume over time in that asset class.”

Notwithstanding the outlook for subordinated financials, while investors remain focused on systemic, macro risks, it’s unlikely the new ISDA standards will drive single-name volumes up to levels comparable with index products, which totalled $1.4 trillion net notional outstanding at the end of May 2013.

“Reduced single-name volumes are driven by the fact that investors are generally more interested in gaining risk exposure to the broader market, rather than idiosyncratic single-name risks,” says the source. “With investors looking to gain access to credit on a macro level, index products are more popular and more liquid.”

Market participants are now responding to the initial proposals, with final standards expected at the end of the summer.

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