Investment Management Alert
July 2009
Author:
Gordon F. Peery
gordon.peery@klgates.com
+1.617.261.3269
K&L Gates is a global law firm with
lawyers in 33 offices located in North
America, Europe, Asia and the Middle
East, and represents numerous GLOBAL
500, FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies,
entrepreneurs, capital market
participants and public sector entities.
For more information, visit
www.klgates.com.
Small Bang Protocol Adherence Period
Closes on July 24, 2009
In its first concerted effort to standardize certain over-the-counter (“OTC”)
derivatives and address problems surrounding the settlement of credit default swaps
(“CDSs”), the International Swaps and Derivatives Association, Inc. (“ISDA”)
published earlier this year the Big Bang Protocol, which became effective on April 8,
2009. That protocol, among other things, enabled adhering parties to automatically
amend CDSs that are triggered by credit events such as bankruptcy, failure to pay
and certain other standard credit events. A summary of the Big Bang Protocol is
available at ISDA Launches the Big Bang Protocol, Determinations Committees and
SNAC CDSs, Investment Management Alert, by Gordon F. Peery, Robert A. Wittie,
Anthony R.G. Nolan and Stacey H. Crawshaw-Lewis, March 13, 2009. Importantly,
the Big Bang Protocol did not bring about the settlement by auction of CDSs upon
the occurrence of a restructuring credit event.
In its next effort to standardize credit derivatives and make CDS settlement more
efficient, ISDA launched the Small Bang Protocol. The Small Bang Protocol
addresses the settlement by auction of CDSs upon a “restructuring,” when a
distressed company restructures debt that is referenced in the CDS. In connection
with this protocol, ISDA published a supplement to the 2003 ISDA Credit
Derivatives Definitions (the “2003 Definitions”)—the 2009 ISDA Credit Derivatives
Determinations Committees, Auction Settlement and Restructuring Supplement (the
“Restructuring Supplement”).
Market participants may adhere to the Small Bang Protocol until 5:00 P.M.
EDT on Friday, July 24, 2009, by using the form of adherence letter that is
accessible via ISDA’s website, www.isda.org. By adhering to the Small Bang
Protocol, parties to CDSs would also adhere to the Big Bang Protocol to the extent
that they have not previously done so. Adherence is voluntary; market participants
are free to customize CDSs so long as they are able to find a counterparty that has
not adhered to either the Big Bang Protocol or Small Bang Protocol.
The Small Bang Protocol is especially relevant for CDS trades in which restructuring
includes maturity limitations, as is the case in the standard CDS contract used in
European and certain emerging market CDS trades. The Small Bang Protocol
therefore constitutes the most recent global undertaking by ISDA to standardize and
centrally clear CDSs.
Background
Participants in the OTC market viewed the launch of the Big Bang Protocol by ISDA
earlier this year as an initial, major step in standardizing CDSs for central clearing.
The standardization and central clearing of CDSs continue to be a major global
undertaking by ISDA, regional clearing houses and key OTC market participants.
This effort aims to accomplish four principal objectives— (1) mitigating
counterparty credit risk through the use of central counterparties, (2) bringing
transparency to the USD30 trillion global CDS market, (3) making credit derivatives
Investment Management Alert
such as CDSs more fungible for trading and clearing
purposes, and (4) preventing problems that may
occur in the physical settlement of CDSs due to the
reality that, in many cases, the aggregate CDS
notional value is greater than the supply of bonds
that are to be delivered upon the occurrence of CDS
credit events.
In light of the recent market crises and the perceived
roles that CDSs and counterparty risk played in
those crises, regulators throughout the world called
for the central clearing of CDSs to bring
transparency to this important market. On February
17, 2009, major European dealers of CDSs —
Barclays Capital, Citigroup, Credit Suisse, Deutsche
Bank, Goldman Sachs, HSBC, JP Morgan, Morgan
Stanley and UBS — committed to the European
Commission that each would work to centrally clear
CDSs by July 31, 2009. While the Big Bang
Protocol and the parties that adhered to it laid the
foundation for many CDSs to be more fungible and
thereby easier to centrally clear, the deliberate
exclusion of CDSs with restructuring credit events
by ISDA from the Big Bang Protocol remained a
hurdle to making all CDSs fungible and available for
central clearing.
In order to understand why CDSs with the
restructuring credit event were not included as a
part of the Big Bang Protocol, it is necessary to
summarize briefly the mechanics and credit events
of CDSs, including the manner in which
CDSs settle.
In a CDS, one party, the protection seller, agrees to
compensate the other party, the protection buyer, for
the financial loss that the protection buyer incurs
upon the occurrence of a specified credit event. In
the 2003 Definitions, six credit events are listed:
bankruptcy, failure to pay, repudiation/moratorium,
obligation acceleration, obligation default and
restructuring. Parties to a CDS often include more
than one credit event in a CDS trade confirmation
(the “Confirmation”). CDSs may be physically
settled or settled by cash or auction.
Upon the occurrence of a credit event, the protection
buyer in a physically settled CDS delivers an asset, a
“Deliverable Obligation,” typically a bond, to the
protection seller in exchange for a payment (the
notional amount of the CDS) by the protection
seller. When parties to a CDS select restructuring
as a credit event, the protection buyer receives a
payment upon the occurrence of certain
developments relating to the reference obligation,
including a reduction in the interest rate or principal
of the debt, the deferral of interest or principal, the
extension of the maturity
or an adjustment in the seniority of the
reference obligation.
If a reference entity restructures or begins to
restructure debt, both the buyer and seller of
protection to the CDS with restructuring and
bankruptcy credit events may be incentivized to
trigger settlement of the CDS. A buyer of protection
in such a CDS can decide to trigger payment (i.e.,
become a “Notifying Party”) if a reference
obligation is in the course of being restructured by
the underlying obligor, but the buyer of protection
may also opt to wait to trigger the CDS upon the
bankruptcy of the obligor, in which case the payoff
in the settlement of the CDS could be greater than if
it were triggered by a restructuring. A seller of
protection may become a Notifying Party and
decide to trigger the CDS upon restructuring in
order to prevent a larger payoff later, should
the underlying obligor’s financial situation
further deteriorate.
Prior to the Big Bang Protocol, since either party
could claim that a credit event had occurred, there
were many disputes over the existence of credit
events. The Big Bang Protocol establishes
Determinations Committees, which, as their name
implies, determine key developments that trigger
CDS remedies and other key provisions in
Confirmations, including the determination of
whether a credit event has taken place and the asset
that may be delivered for settlement of the CDS.
In an effort to make CDSs more fungible and easier
to centrally clear, ISDA mandated the auction
settlement methodology in connection with the Big
Bang Protocol earlier this year, but found that
applying the auction methodology to CDSs with the
restructuring event was unworkable. A significant
complicating factor is the absence of a uniform
practice worldwide for determining the Deliverable
Obligation upon the occurrence of the restructuring
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Investment Management Alert
credit event. 1 To understand how the Small Bang
Protocol and Restructuring Supplement address
these issues, it is necessary to further describe the
process whereby parties settle CDSs mandating
restructuring as a credit event.
If a CDS contract with a restructuring credit event is
triggered by a protection seller, the protection buyer
is generally permitted to deliver bonds with
remaining maturities of up to thirty years. On the
other hand, if the protection buyer triggers
settlement in a physically-settled CDS, the maturity
of bonds that are permitted for delivery under the
CDS is typically agreed to be the longer of (a) five
years plus the remaining maturity of the restructured
obligation; and (b) two-and-a-half years plus the
remaining maturity of non-restructured obligations.
Thus, there are two variables to the settlement of a
standard CDS with a restructuring credit event:
(i) the party that triggers settlement of the CDS; and
(ii) the remaining maturity of the debt of the CDS
reference entity. These variables present a challenge
to the integration of CDS with restructuring credit
events into the auction methodology furthered by
earlier revisions to the 2003 Definitions and the Big
Bang Protocol, because the combination of these
two variables creates a potentially large number of
auctions that must be held to facilitate settlement of
such CDSs. These complications, coupled with the
regulators’ aggressive timeline for centrally clearing
CDSs, led ISDA to omit CDSs with restructuring
credit events from the Big Bang Protocol.
1
To date, the market for CDSs has not adopted a uniform
standard for determining Deliverable Obligations upon the
occurrence of a restructuring credit event due to differences in
bankruptcy law and banks’ inability to reach agreement on a
single standard for determining Deliverable Obligations.
Consequently, two categories of CDSs with restructuring as
the credit event developed over time. For CDSs in which the
underlying asset is an American credit, the market refers to the
restructuring as modified restructuring, or “Mod R.” If the
reference entity in the CDS is a European or Asian credit, the
market refers to the restructuring as a modified modified
restructuring, or “Mod Mod R.” The significant difference
between these two categories of CDSs lies in the different
standard for determining the permitted maturity of the
Deliverable Obligation upon the occurrence of a restructuring
credit event. In this bifurcated market of CDSs with
restructuring credit events, conducting a streamlined auction
and centrally clearing these CDSs were not attainable goals
prior to the Small Bang Protocol. Auctions, which are
important for centrally clearing CDSs, require a single list of
Deliverable Obligations.
The Small Bang Protocol
Earlier this year, following the launch by ISDA of
the Big Bang Protocol, OTC market participants
began to develop a practice for integrating the
restructuring credit event into the auction settlement
methodology. What evolved in that process was a
grouping together of CDSs into “buckets”
depending on the maturity of the underlying debt
obligation that is referenced in the CDS.
ISDA generally accepted and codified this evolving
practice into the Restructuring Supplement, which
will be incorporated into new and existing ISDA
documentation between adhering parties for
transactions covered by the Small Bang Protocol.
Under the Restructuring Supplement’s mechanics,
CDSs would be included in one of many buckets
that “hold” CDSs with remaining maturities of 2.5,
5, 7.5, 10, 12.5, 15, 20 and 30 years after the
restructuring date, with an additional bucket for
settling CDSs that terminate within 2.5 years of the
restructuring date. The Restructuring Supplement
effectively “hardwires” the auction method of
settlement into the Confirmations evidencing
covered transactions between parties that adhere to
the Small Bang Protocol.
Following a restructuring, CDSs will be assigned to
maturity buckets according to the following process.
The Determinations Committee identifies the bonds
or loans that correspond to the CDSs in the maturity
buckets, and then ISDA will publish a listing of
maturity buckets and Deliverable Obligations.
Parties that adhered to the Small Bang Protocol will
have five business days within which to decide to
trigger their CDSs. In CDSs between two parties
that have adhered to the Small Bang Protocol, both
parties retain their respective rights to trigger the
settlement provisions of the CDS. If the protection
buyer triggers the CDS, certain maturity limitations
apply to the selection of the Deliverable Obligation;
if the protection seller triggers the CDS, the same
maturity limitations do not apply.
This aspect of the Restructuring Supplement is
designed to replicate the current settlement process
for CDSs with a restructuring credit event and to
maintain the right of the buyer and seller of
protection to trigger CDS. The protection buyer
that triggers CDS settlement will continue to be
limited in its ability to select Deliverable
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Investment Management Alert
Obligations for settlement. In the current practice
for settling standard CDSs with restructuring credit
events, if a protection buyer becomes a Notifying
Party and as such declares a restructuring credit
event, then the protection buyer is permitted to
tender to the protection seller a Deliverable
Obligation. However, not all debt—with any
maturity— may be tendered for settlement in that
case; Deliverable Obligations are restricted in terms
of maturity.
On the other hand, if the protection seller declares a
restructuring credit event, the foregoing maturity
limitations that are imposed on the buyer when it is a
Notifying Party do not apply; the protection buyer in
that case is free to deliver the Deliverable
Obligations as it would for a bankruptcy or failure to
pay credit event. The protection buyer typically
tenders to the protection seller a Deliverable
Obligation with a maturity of up to 30 years. The
rationale for this practice is that, in the case where
the protection seller brings about settlement of the
CDS by declaring a restructuring credit event, the
protection buyer should be permitted to exercise
discretion in the selection of Deliverable
Obligations. Conversely, a protection buyer that
triggers CDS settlement should be limited in the
selection of Deliverable Obligations that it tenders to
the protection seller for settlement in order to
discourage the protection buyer from triggering a
restructuring credit event in a way that may
inequitably further its own interests. The concepts
and rationale underlying this current practice are
generally retained by ISDA in its Restructuring
Settlement, with the small difference that the
maturity limitations on Deliverable Obligations are
imposed via the maturity buckets.
Under the Restructuring Supplement, if the
protection buyer triggers the CDS, the CDS and the
corresponding Deliverable Obligation will fall
within a maturity bucket. The protection buyer will
have to tender the Deliverable Obligation designated
within a corresponding maturity bucket. Conversely,
if the seller of protection triggers settlement, the
CDS will be held in the 30-year bucket. Thus,
similar to the current practice, the protection buyer
will not be able to exercise complete discretion in
the selection of Deliverable Obligations by
triggering settlement of the CDS. Determinations
Committees assist in the allocation of CDSs to
maturity buckets and the designation of
corresponding Deliverable Obligations and ISDA
announces whether an auction is to be held for
settlement. If no auction is held for a given
maturity bucket holding a CDS that a protection
buyer is attempting to trigger, the Restructuring
Supplement entitles the protection buyer to “roll
down” the CDS to the next maturity bucket with
shorter maturity.
If 500 or more CDSs are triggered and if five or
more dealers are parties to those CDSs, an auction
will take place. This new regime attempts to limit
the number of auctions to only one auction for each
bucket of CDSs, thereby increasing the fungibility
of CDSs for central clearing. Buyers and sellers of
protection will then have five business days to
become Notifying Parties and trigger the CDS for
settlement. CDSs that are not designated for auction
will continue until a subsequent credit event takes
place.
As with the Big Bang Protocol, adhering to the
Small Bang Protocol is voluntary and not all credit
derivative transactions are covered by the Small
Bang Protocol; the following credit derivative
transactions are specifically excluded — Loan Only
transactions, U.S. municipal credit derivative
transactions, credit derivative transactions with
asset-backed securities as the underliers, and credit
derivative transactions that are based on indices
entered into between dealers (listed in the Small
Bang Protocol) relating to trust certificates linked to
any Dow Jones CDX.NA.HY Index or
CDX.NA.HY Index.
Adherence to the Small Bang Protocol must be
effected by 5:00 P.M. EDT on Friday, July 24,
2009. There is no fee for adherence. Adhering to
the Small Bang Protocol does not prevent an
adhering party from negotiating and entering into a
CDS that does not incorporate the revised 2003
Definitions; two adhering parties can separately
agree that select credit derivative transactions are
not “Protocol Covered Transactions,” and as such
the Confirmations for those transactions will not
incorporate revisions to the 2003 Definitions from
the Big Bang and Small Bang Protocols. The parties
may evidence their intent to do so in Confirmations
or in a separate side agreement. ISDA recommends
that parties that previously specified certain
July 2009
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Investment Management Alert
transactions as excluded from the Big Bang Protocol
should also exclude those transactions from the
Small Bang Protocol for the sake of clarity, in order
to evidence their intent to not incorporate the revised
2003 Definitions. As of the time that this Alert went
to press, 359 parties have adhered to the Small Bang
Protocol, including many of the major credit
derivatives dealers. This suggests that end users that
do not adhere to the Small Bang Protocol may
experience difficulty in negotiating CDSs that do not
incorporate revised definitions published in
connection with the Big Bang and Small
Bang Protocols.
The Restructuring Supplement will take effect for
adhering parties on Monday, July 27, 2009.
* * *
In the event that you have questions concerning
Small Bang Protocol adherence or the mechanics of
the Restructuring Supplement, please do not hesitate
to contact the author.
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©2009 K&L Gates LLP. All Rights Reserved.
July 2009
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