In a continuing effort to address the advent of narrowly tailored credit events, or NTCEs, in the credit default swap market, the International Swaps and Derivatives Association is now preparing for the implementation of the changes designed to deter market participants from running these strategies.

After receiving feedback from market participants, ISDA has now finalized the proposal and released the final changes that will be made to the credit derivatives definitions.

This article addresses how those changes will be implemented, and certain issues market participants should take into account in deciding to adopt the changes.

Background

Over the past few years, a number of issuers in financial distress and their investors have used refinancing and restructuring strategies that capitalize on CDS contracts written on the issuer, as reference entity, to achieve a better economic outcome. These strategies take various forms, but the ones that attracted market attention, NTCEs, involve the triggering of the CDS contract via a failure-to-pay credit event.

The ensuing monetization of the CDS contracts for the benefit of CDS protection buyers can enable those CDS protection buyers to extend financing to the reference entity on more favorable terms. At the same time, the relatively low failure-to-pay threshold in the standard CDS contract of $1 million often enables CDS contracts to be triggered without hitting cross-default thresholds across the reference entity's capital structure. Failure-to-pay credit events of this type are unconventional because they result from voluntary, rather than unavoidable, payment defaults.

These NTCEs have emerged as one of the most controversial opportunistic CDS strategies in recent years. In the cases of Codere SA, iHeartCommunications Inc., and Hovnanian Enterprises Inc., voluntary payment failures were criticized as artificial defaults not reflecting the spirit of the credit derivatives definitions. In addition, the case of Hovnanian also resulted in a widely publicized market manipulation claim and criticism from regulators.

Following the Hovnanian litigation and subsequent interest in the CDS market from regulators, the ISDA Credit Derivatives Steering Committee proposed a change to the CDS contract intended to prevent artificial defaults (i.e., defaults that do not necessarily reflect a genuine inability of a reference entity to make a payment) from triggering the CDS contracts.

The updated definitions subject any failure-to-pay credit event determination to a creditworthiness deterioration requirement, which will be determined based on a number of factors specified in a related guidance note. In addition, certain changes were made to the definition of outstanding principal balance to deal with prebankruptcy original issue discount issues.

The original issue discount-related changes prevent market participants from taking advantage of debt issued with an original discount that would not be taken into account under the current definitions, and could potentially artificially impact settlement amounts under the CDS contract. The updated definitions will impact the determination-making process and the predictability of determinations, among other things.

Implementation Timeline and Process

The primary information contained in the most recent ISDA updates centers on the implementation process for the updated definitions. As with any significant market changes, ISDA will be issuing a protocol enabling market participants to amend, en masse, the terms of their CDS contracts with all other swap counterparties adhering to the protocol.

On July 26, ISDA confirmed that the protocol will be released on Sept. 16, and will be open for adherence through Oct. 14. A pre-adherence period runs from Aug. 26 through Sept. 13. The pre-adherence period is intended to allow key market participants to adhere to the protocol by the time it is published on the ISDA website on Sept. 16, ensuring that the protocol is published already with significant backing. The updated definitions will then become effective on Jan. 13, 2020.

Market participants should be prepared for their swap dealers to begin actively reaching out in the coming weeks. Dealers are likely to release summaries of the updated definitions, as well as notices encouraging adherence when the protocol is released. In addition, given the relatively short timelines, market participants should begin conducting the analysis that will be needed to obtain internal approvals to adhere to the protocol.

Scope

The updated definitions are intended to impact both new and existing trades. The protocol will update the terms of legacy trades, whereas the physical settlement matrix will be updated to include the updated definitions for all trades entered into after the updated definitions become effective. With respect to legacy trades, the protocol does not provide market participants with the ability to cherry-pick which trades are impacted. This means that market participants will need to consider the advantages and disadvantages of the updated definitions for their CDS book as a whole.

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