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ISDA PRESS REPORT - OCTOBER 24, 2001
CREDIT DERIVATIVES * Documentation Into The Future - FOW * The Direction for Derivatives - FOW Documentation Into The Future FOW - October 2001 By Alessandro Cocco and Joe Kohler Credit derivatives are instruments used for buying or selling the risk that an obligor defaults on one or more specific obligations. In this article, we will examine the foundation stone that underpins the vast majority of credit derivative documentation, the 1999 ISDA Credit Derivatives Definitions, pointing out some of the documentation's key features and where they have already been refined. The definitions are a set of contractual provisions that can be incorporated by reference into confirmations relating to credit derivatives that take the form of single name default swaps. This allows parties to a transaction to use a short form of confirmation containing only the economic and deal-specific terms relating to that transaction. The objective of this structure is to provide market participants with a tool for producing documentation that is sufficiently sophisticated to deal with the majority of issues arising from such transactions, simple enough to facilitate rapid processing, and cost effective. The definitions achieve this by codifying market practices, but more importantly, the prospect of their generation helped to focus minds on establishing some of these practices in the first place. As with all ISDA documentation, the definitions allow for numerous elections to be made by the parties, and the parties are also free to make whatever amendments or additions they agree by inclusion in the confirmation of appropriate language. The definitions also provide for a number of fallbacks to apply in case the parties do not specify otherwise. Market participants recognise the particularly important role of documentation in the credit derivatives market. As a consequence of the Russian and Asian financial crises, it became clear that in the case of credit derivatives, more than for other derivative transactions, the payment of large sums of money may depend on the interpretation of the wording of a specific clause. The 1999 ISDA Credit Derivatives Definitions Scope The definitions apply to credit default swaps relating to obligations for the payment of money by a reference entity.With appropriate modifications, the definitions can also be used to document credit derivative transactions that refer to baskets of reference entities, or to form the basis of documents relating to funded products. In a transaction, the party buying credit risk protection, or buyer, undertakes to pay the seller of protection a predetermined amount. In return the seller undertakes to make a payment in favour of the buyer in case the defined credit events occur. Credit events serve as indicators of the deterioration of the creditworthiness of the reference entity. One of the main characteristics of a credit derivative is that the buyer does not have to suffer a loss as a result of a credit event in order to qualify for the payment from the seller. For example, A buys from B the right to receive from B a payment of $10m in case company X is subject to bankruptcy proceedings or does not repay loan Y If company X undergoes bankruptcy proceedings or loan Y is not repaid, a credit event occurs. The occurrence of one of these events, in circumstances involving the satisfaction of any other condition to payment that the parties may have specified in the transaction, would give A the right to receive from B the agreed payment, irrespective of whether A had any credit exposure to company X or loan Y. This feature is of crucial importance to the determination of the regulatory environment applicable to credit derivatives. In the UK if entering into credit derivatives transactions constituted the carrying on of insurance business, there would be a requirement for authorisation under the Insurance Companies Act 1982. The fact that a buyer of a credit derivative does not have to hold the obligations in question in order to obtain a payment from the seller means that the credit derivative does not fall within the scope of this legislation. This analysis was set out in full in a legal opinion obtained by ISDA in 1997. Reference entity It is essential that the reference entity is identified with sufficient precision. For example, to what extent are successors or affiliates of an entity to be included? This point is particularly important when dealing with a sovereign.What, if any, governmental agencies or authorities should be included within this definition? The demerger of National Power last year led to further debate surrounding the definition of successor. National Power shifted a large number of obligations to a new company called Innogy. Following the demerger, Innogy became a stronger credit than National Power had been beforehand, and National Power, in its new guise, became weaker. As a consequence, buyers and sellers of credit protection in relation to National Power had opposing views, from a commercial perspective at least, as to which was the successor. ISDA is now looking into further refinements to the concept of successor. Credit events The buyer and seller may buy and sell credit risk defined by reference to different types of credit events. It is appropriate that both select carefully the type of event on which they wish to trade. The definitions offer a menu that comprises (1) failure to pay, (2) acceleration or default, (3) repudiation/moratorium, (4) restructuring (in each case in respect of one of the obligations identified in the confirmation) and (5) the bankruptcy of the reference entity. In the case of all but the last of these the parties can choose to implement a type of materiality threshold by agreeing a payment requirement or default requirement that has to be crossed before the credit event is deemed to have occurred. The parties may consider the definitions' menu to be in need of amendment or supplement in order to deal with the specific credit risk they wish to trade. For example, the bankruptcy credit event focuses on events that corporate obligors could experience and would require tailoring if the Reference Entity were to take some other legal form. The definition of restructuring was one of the most controversial provisions in the drafting process that led to the definitions. In the forerunner of the definitions, ISDA's 1998 long form of confirmation, restructuring was defined by reference to events that had the effect of making the terms of the relevant obligation materially less favourable from an economic, credit or risk perspective. This definition was generally considered to be too subjective, and had given rise to a number of disputes. The new definition now refers to more objective criteria, such as a -reduction in the amount of principal or premium. A degree of subjectivity is, however, retained in that events that would otherwise fall within the definition of restructuring do not constitute a restructuring if they do not result directly or indirectly from deterioration in the creditworthiness or financial condition of the reference entity. However, the market's disquiet regarding restructuring was not quelled by these changes, and this recently gave rise to ISDA publishing a Restructuring Supplement. The supplement restricts the types of obligation to which restructuring can apply. It clarifies issues that the definitions were not clear on and places certain additional parameters on the ways in which a transaction can settle following a restructuring credit event. Obligations Apart from the bankruptcy of the reference entity, the question of whether a credit event has occurred is determined by reference to obligations identified in the confirmation. The definitions introduce a matrix system based on the choice of one obligation category, and, if appropriate, one or more obligation characteristics. The aim of this structure is to introduce flexibility into the documentation process. The obligation categories are: payment, borrowed money, reference obligations only, bond, loan, or bond or loan. It is possible to give a very wide definition of obligations by selecting payment (any obligation for the payment or repayment of money). On the other hand it is possible to specify that credit events are only relevant if they occur with reference to only one obligation, the reference obligation. Choosing one or more obligation characteristics has the effect of restricting the field of obligations in relation to which a credit event may occur, because an event will be relevant only if it occurs in relation to obligations of the chosen category, and which have the chosen characteristics. Examples of obligation characteristics are: specified currency, not domestic currency, not domestic law Conditions to payment The fact that a credit event has occurred is not sufficient to trigger the payment of credit protection. Before that can occur, certain conditions to payment must be satisfied. The definitions set out three conditions involving the service of notice. A credit event notice must be served in any transaction before the credit protection will become payable. The parties may choose that a notice of publicly available information must be served to cite news sources that confirm the occurrence of a credit event. Finally, if the transaction is to settle physically, a notice of intended physical settlement must be served by the buyer. Term of a transaction A credit event notice must refer to a credit event that occurs during the term of the transaction. The term begins on the effective date and ends on the scheduled termination date, both of which are agreed by the parties in the confirmation. However, where the credit event is a failure to pay, the credit event must be continuing at the end of any applicable grace period or three days, whichever is the longer. This requirement is intended to avoid a credit event being triggered by a technical default, but it means that a default could have occurred on or before the scheduled termination date, even though the grace period is still pending at that time. The definitions provide that the parties have two options in these circumstances. They may either postpone the end of the term of the transaction beyond the scheduled termination date to the end of the grace period, at which point, if the failure to pay is continuing, a credit event notice may be served. Alternatively, they may agree that the grace period must have expired before the scheduled termination date or no credit event notice may be served. The latter is the fallback provision, which applies unless the parties agree otherwise. Physical and cash settlement The parties agree at the outset whether cash settlement or physical settlement applies to the relevant credit derivative transaction. These are different means of realising the protection bought by the buyer where a credit event actually occurs. If cash settlement applies, the payment to be made by the seller to the buyer may be an amount fixed in advance or, more usually, an amount to reflect the drop in value of the reference obligation as determined by way of a dealers' poll. In the case of a physical settlement, the buyer will deliver to the seller certain types of obligations - deliverable obligations - against payment of a fixed amount, usually the face value of those obligations. The buyer realises its protection because it delivers to the seller assets that are worth less than their face value, but obtains payment of full face value from the seller. Physical settlement is widely used in the market, because it avoids having to determine the exact market value of the relevant obligation, and in circumstances where a credit event has occurred it may be difficult to assess the drop in value of the reference obligation for the purpose of cash settlement. On the other hand, some buyers may prefer cash settlement because if the buyer has selected physical settlement and is unable to obtain suitable deliverable obligations to deliver due to, for instance, a squeeze of liquidity in the market, the buyer may lose some or all of the protection it had under the credit derivative. Deliverable obligations Deliverable obligations are defined, as is the case for obligations, by choosing one deliverable obligation category and any relevant deliverable obligation characteristic. Although they are defined in the same way, obligations and deliverable obligations play different roles. Whereas obligations are what the parties refer to in order to assess whether a credit event has occurred (other than in the case of bankruptcy), deliverable obligations come into play only as a settlement tool and if the parties have specified that physical settlement applies. The two do not need to be the same. Future developments ISDA is working on producing dispute resolution guidelines. It is also preparing a user's guide to the definitions. A goal in the future is to expand the definitions to govern more types of credit derivatives. Assembling market consensus support for such developments has proved tricky. As a result, ISDA has recently introduced a new approach to the compilation of standard documents involving the inauguration of a small working party to make recommendations to the rest of the market. This working party, nicknamed the G6, is formed of institutions representing constituencies on both sides of the Atlantic and different parts of the market. The agenda it has set itself includes review of other parts of the definitions including the bankruptcy, repudiation/moratorium, acceleration and default credit events, language for zero coupon bonds and convertible bonds, and a clarification of the successor definition, with a view to producing further supplements or guidance as to what constitutes market standard on various issues. Developments expected to be implemented in the coming months will show whether the C 6 approach is more efficient than the previous collegiate approach.The credit derivatives market will continue to mature and expand. These developments will mean that refining the definitions is a continuing process that will inspire fierce debate. The Direction for Derivatives FOW - October 2001 There are several ongoing have hindered the development of credit derivatives. Lack of a single body to oversee disputes, and concerns about risk exposure transparency have all added to a reluctance by some financial services organisations to use them. As a result, the development of underlying technology supporting credit derivatives has progressed more slowly than in other banking industry areas. But this looks likely to change. One of the major reasons for this is that the use of credit derivatives is --beginning to climb. According to the Bank of England, the notional principal outstanding exceeds $1 trillion globally. And the British Bankers' Association says the credit derivatives market has grown from an estimated $40 billion outstanding notional value in 1996 to an estimated $740bn at the end of 2000. This increase is being driven by various developments in the banking industry, not least the push for transparency. Other key factors include the need for banks to: * Diversify their risk portfolio, which is particularly important in a recession or slowdown to limit exposure to individual market sectors * Achieve straight through-processing (STP) to improve efficiency and cost savings * Demonstrate to regulators that they meet capital adequacy requirements * Ensure an integrated, single view of investment and risk As our current economic situation worsens, exposure to credit risk grows and the use of financial instruments such as credit derivatives is increasing This has coincided with growing pressure in recent years for financial institutions to automate and integrate all their applications and processes to meet regulatory requirements, minimise risk and keep pace with technological innovation. Recent market developments Although not widely used, the advent of online credit derivatives trading exchanges such as Creditex.com, CreditTrade.com and CreditDimensions.com is a significant indication that the market is growing. The exchanges are backed by major players. Creditex, founded in April 1999, for example, has equity investment and support from Deutsche Bank, JP Morgan Chase and Bank of America among others, while CreditDimensions' eclectic mix includes Algorithmics, Bureau van Dijk Electronic Publishing and Standard and Poor's. Prebon Yamane and Internet Capital Group are among -the supporters of CreditTrade.com, And a new entrant, Eprimus.com, is expected to join the fray later this year, intending to act as a creator and investor by selling credit protection in the form of default swaps on more than 1,500 investment-grade names. These online exchanges also highlight the need for integrated systems, particularly as banks are notorious for the number and diversity of platforms and applications used. Integration interlude In the past, financial organisations have relied on spreadsheets to record -credit derivatives transactions. And for most this is still the case. Yet as STP and risk management become even higher on the agenda, so too does the push for technologies that can effectively automate and manage transactions. Banks must ensure that all processes are fully integrated and that back and middle offices can keep pace with front offices. However, given the plethora of proprietary trading platforms used by banks, offerings must be easily designed, built and integrated into core systems to be a worthwhile investment. Electronic initiation, execution and settlement is essential. It is therefore crucial that any credit derivatives solution is: * Open * Scalable * Stable * Flexible * Easy to integrate * Future-proof Software today So what's on the market so far? Some vendors are pushing end-to-end solutions while others are focusing on packaged, component-based solutions, which can be 'bolted on' to core systems. And other vendors say their solutions can be bought as a standalone module or as part of a suite. Leading players so far include Front Capital, Murex, Summit, SunGard and Savvysoft. The US companies appear to be benefiting from first mover advantage in the UK marketplace at this stage. Current suppliers tend to be global organisations with an HQ in New York. One exception is Front Capital Systems, which has an office in London as well as in New York, Stockholm, Frankfurt, Zurich and Johannesburg. Many of the vendors are pushing front-to-back-office solutions covering cash and derivatives trading as well as foreign exchange, energy and commodities, equities and interest rates. Front Arena, from Front Capital Systems, for example, combines fixed income, asset swap and interest rate derivative capabilities with credit derivative functionality. With high yielding securities and credit derivatives in the same system, monitoring all positions simultaneously becomes easier. Some vendors, such as Murex, offer a suite of integrated front and back office systems sharing the same middle and back office platform. The solution offers integrated, front-to-back office software solutions for cash and derivatives trading and processing in fx, energy and commodities, equities and interest rates. This includes listed, over-the- counter (OTC) and exotics derivatives on securities and fx. Summit's credit derivatives module can be run as a standalone application or as part of a product suite and supported instruments include credit swaps, credit- linked bonds, risky bonds (theoretical valuation) and forward bonds purchase (binding and non-binding). Features include default probabilities and recovery rates. Vendors including SunGard and Savvysoft have created component-based offerings. SunGard's Credit Derivatives Components module provides a 'building-block' asset, allowing any possible credit derivative product to be structured and managed in a portfolio. The module aims to offer staff the ability to structure, price, analyse, trade and risk manage a variety of credit derivative instruments. It supports several credit derivative instruments, including credit default swaps, credit spread options and total rate of return swaps. The functionality includes the ability to: * Touch - Pay/receive par amount at the time a credit event occurs * End - Pay/receive par amount at the end of the contract's life if a credit event occurs * Annuity - Pay/receive a fee from the time a credit event occurs until the maturity of the contract * Fee Pay/receive a fee from the start of the contract until the first of either a credit event occurring or contract maturity And risk management is not forgotten. The solution emphasises the importance of analytical integrity and the ability to support enterprise-wide risk management. It includes risk measures for credit derivatives commensurate with other interest-rate sensitive instruments such as bonds, caps and swaps. This means that risk can therefore be aggregated across asset classes and/or on a portfolio or enterprise-wide level. There is also an option to produce specific credit derivatives reports. Savvysoft's TOPS suite of products comprises nearly 70 OTC and exchange-traded derivatives models. Savvysoft's newest product, TOPS Credit, is geared to handling many types of credit derivatives, including total rate of return swaps, credit default swaps, credit linked notes, credit spread options and others. Like Summit, Savvysoft takes default probabilities into account. In addition to letting the user specify the probability of an issuer default, TOPS Credit can also base its calculations on the probability of counterparty default and the correlation between these two probabilities. The probabilities include functions of time, interest rate levels and stock price levels to give users control over credit derivatives valuations Huge opportunity The credit risk transfer market has the potential to increase the overall robustness of the global financial system over time. But to do this, it is essential that financial institutions can rely on a stable, scalable, flexible solution that can be easily managed and integrated into core systems. The growing popularity of credit derivatives will offer IT vendors an opportunity to extend their reach within financial institutions. But we are currently at the early stages. The credit derivatives instrument is still in development and the market is wide open for technology vendors particularly UK based suppliers to enter. This is an emerging market and we have a long way to go before we know who will be the leader in this space and how it will develop. **End of ISDA Press Report for October 24, 2001** THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY. THIS PRESS REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION), AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT. Scott Marra Administrator for Policy and Media Relations International Swaps and Derivatives Association 600 Fifth Avenue Rockefeller Center - 27th floor New York, NY 10020 Phone: (212) 332-2578 Fax: (212) 332-1212 Email: smarra@isda.org
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