August 8, 2011 / 4:52 PM / 7 years ago

IFR-Defending the ISDA Determinations Committee

Aug 6 (IFR) - Lawyers and dealers have defended the International Swaps and Derivatives Association’s Determinations Committee, the group responsible for calling a credit default swap event, against criticism that it does not have a robust and transparent process in place for determining credit events.

There has been increased scrutiny of the Determinations Committee in recent times due to uncertainty over whether Greek CDS would trigger when restructuring its debt. However, one head of European credit trading has argued stringent in-house compliance procedures along with the nature of the DC mechanism itself make it hard for dealers to bring about blatantly partial decisions.

“It’s fair to say there is a concern that somebody might be biased towards their book, but in reality it’s 15 firms making the decision, and the net effect tends to be pretty neutral. If someone’s arguing something clearly biased, they’ll lose all credibility. People know there is a huge public and regulatory focus on the DC, and no one wants to be that person,” he said.

While lawyers and traders acknowledge the potential for uncertainty regarding restructuring credit events in particular, most argue that the DC has brought an important measure of standardisation and predictability to the market since the committee’s birth in 2009.

“Most credit events - like bankruptcy - are pretty obvious. Restructuring, on the other hand, is the problem child of credit derivatives - you get borderline situations where it’s hard to come to a conclusion,” said Edmund Parker, global co-head of the derivatives and structured practice at Mayer Brown.

“As restructuring credit events can involve some judgement, that alone makes it vulnerable to criticism. The DC is new, so any time there is a grey area you’re going to get tension between dealers and buyside. But the DC has helped bring some certainty to the process, and it’s a massive improvement on each individual party making its own decision and people holding off in the market to see what others do,” he added.

WEIGHTED MAJORITY

The DC came into being in 2009, meaning counterparties would no longer decide on a bilateral basis whether credit events had occurred. The committee currently comprises 10 dealers and five buyside firms. Questions on credit events are submitted to the ISDA website, at which point the DC will discuss and vote on the issue. An 80% majority is needed - to ensure dealers can’t gang up on the buyside - and the result of the vote is made public.

“There may be different views in the DC on less obvious issues, but generally speaking they prefer to come to more or less a consensus view before voting,” explained David Geen, general counsel at ISDA. “You can never know for certain the result of a DC meeting in advance, particularly with regard to a restructuring credit event, as you have to apply a certain set of facts to a certain set of definitions.”

“It’s no secret that you can avoid a restructuring credit event occurring, although this has been the first time there has been so much focus on it,” said Geen.

“We haven’t had a groundswell of people saying it has to be fixed, but we wouldn’t want to be complacent about it. If it’s clear that the thing isn’t working as a hedge for what people wanted, then we would need to fix it. We’re going to review CDS definitions anyway as they’re due an overhaul, and while ISDA doesn’t believe the restructuring credit event is defective, we will look at it if that’s what is wanted,” Geen added.

Although there is no formal obligation, there are supposed to be Chinese Walls between the people sitting on the DC and traders that know the firm’s position on a given name. There still is, however, concern from some industry members that these Chinese Walls are not always respected in practice.

“Some people are certainly concerned they’re being manipulated by the dealers,” said one derivatives lawyer. “On technical points, the DC is fine. The problem is for larger decisions like Greece, where people are clearly going to vote their own self-interest. It’s not a perfect mechanism for big issues that affect a large amount of people to be decided by a small portion of the overall market.”

While manipulation on this kind of a scale has yet to be alleged, lawyers highlighted that the track record of the US DC, in particular, is not entirely spotless.

“There are a few instances where the US DC followed the spirit rather than the letter of the law, such as being quite inventive in reaching what were actually sensible results in the end with some of the succession events determinations,” said a senior London-based derivatives lawyer. “However, while there’s obviously a certain amount of interpretation when applying any sort of legal terms, the DC doesn’t have the ability to re-write the rules or make stuff up and I think the process works pretty well.”

WHAT ALTERNATIVE?

There is also a lack of viable alternatives to the DC as a way of deciding on credit events for the entire market. “If you want a product that everyone can trade that isn’t reliant on bilateral triggers then you need a public committee. And it makes sense for the people most interested in the product to be on that,” said Saul Doctor, credit derivatives strategist at JP Morgan.

“I think the DC is one of the most transparent committees of any product in the world.”

Lawyers say the longer the DC is around, the fewer uncertainties will remain. Another senior derivatives lawyer pointed to the Bradford & Bingley credit event in 2009, which came to be the basis for determining credit events on Irish banks earlier this year. Likewise, the decision that the IMF had not triggered a credit event, by subordinating Irish bondholders when extending its loan to Ireland, should set a precedent for similar events in the future.

“There are cases you don’t know, but as we gather more history those become fewer,” said Geen.

“From a practitioner’s point of view the DC has been a fantastic success,” added the derivatives lawyer. “There were previously a lot of things we didn’t know the answer to, because things would go to court so rarely that we would never get a final resolution on these points. Now, we’re building a body of know-how from what the DC has decided and we can resolve questions far more quickly.”

Avoiding the triggering of CDS when restructuring debt has come under scrutiny over the past few months, as fears have increased that Greece would look to deliberately avoid a CDS credit event when reorganising its debt. A debt restructuring needs to bind all holders for it to trigger CDS, although questions remain over the extent to which bondholders can be coerced into participating in sovereign debt exchanges that are supposed to be voluntary.

Despite these concerns, though, few participants called for tweaking of the restructuring credit event definitions. “If bondholders don’t want to roll the debt, then that’s their right. I would discourage ISDA to change the rules to ensure there is a triggering in the case of a voluntary restructuring,” said a senior credit trader.

Geen also indicated broadening the restructuring credit event definitions could be difficult. “There are so many ways a company or sovereign can restructure that you’re never going to catch them all,” he said. “Maybe you could plug some gaps, but you’d have to be careful because if you’re too broad you’d be in danger of catching things you wouldn’t want to catch.”

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