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Credit Derivatives
Understanding and Working with the 2014 ISDA Credit Derivatives Definitions
By Edmund Parker Globe Law and Business Ltd
Copyright © 2017 Globe Law and Business Ltd
All rights reserved.
ISBN: 978-1-78742-027-4
CHAPTER 1
Types of credit derivative products used with the 2014 ISDA Credit Derivatives Definitions
1. Introduction
The range of credit derivative products developed quickly between the release of the 1999 Definitions and the start of the financial crisis in late summer 2007. Complexity rocketed too: single name credit default swaps evolved into:
• basket, constant maturity, constant proportion and portfolio credit defaults swaps;
• full and tranched index trades;
• collateralised debt obligation (CDO) squared;
• CDO cubed;
• constant proportion portfolio insurance (CPPI); and
• consent proportion debt obligation (CPDO) transactions.
Each year the trade press heralded a 'hot' new thing. Credit magazine's "The 2006 ABC of CDOs" reported that: "The growing popularity of certain types of asset backed securitisation ... has given rise to a thriving market in CDOs of ABS". On the arrival of CPPI products, it stated that it was "[n]o surprise that [they are] being talked about as 2006's hot ticket". And Credit magazine was right: these were exciting times. We are still in exciting times, and keeping up to date with a maturing product universe remains difficult, even for the most dedicated practitioner.
But just as with evolution itself, the initial basic species did not die. The financial crisis may have brought an end to CDO cubed transactions, CPDOs and much of the synthetic CDO transaction market, at least for a long time. The basic species of single name credit default swaps is growing and developing. So too, index and portfolio credit default swaps.
This chapter provides an overview of the products which are used in conjunction with the 2014 ISDA Credit Derivatives Definitions. For historical purposes, it also touches on some of the now obsolete products: their technology may return.
2. The credit derivatives product range: unfunded OTC and cleared credit derivatives
Unfunded 'OTC'/'over-the-counter' credit derivatives are bilateral, privately negotiated credit derivatives contracts, which do not have the benefit of a linked securities issuance to 'fund' credit protection payments. A bilateral credit derivatives contract which is standardised and traded on a stock exchange is an 'exchange traded contract'. There is presently no significant market for exchange traded credit derivatives.
The most common example of an unfunded OTC credit derivative is a simple single name credit default swap between a bank (as a credit protection buyer) and a corporate (as a credit protection seller). The credit default swap is described as 'unfunded' because the seller (the corporate) makes no upfront payment to specifically cover its potential future credit protection payments; and the swap does not have the benefit of funds provided by a third party (eg, noteholder investors).
Privately Negotiated and Standardisation
Credit derivatives have become increasingly standardised, and the pace of standardisation has increased since the financial crisis. Much of this has come from the demands of regulators and politicians, as well as a desire for liquidity from the industry itself.
So when we refer to a 'privately negotiated' contract, the contract will usually be documented based on elections set out in the ISDA Physical Settlement Matrix.
The elections applied will depend on the 'Reference Entity Type' specified in the contract's confirmation, eg, North American Corporate.
The level of negotiation will also usually be limited to the quantum of credit protection premium payable by the seller. At least one of the counterparties will also usually be a market-making financial institution, which will insist on trading on the basis of 'market terms'. Going off 'market terms' will increase the costs of the transaction, as the market-makers hedging activities will become more expensive.
That is not to say that there are not highly negotiated OTC credit derivatives contracts. It is just that both by number and size of notional market, OTC credit derivatives are based on highly standardised norms. The most standardised products will also become increasingly subject to central clearing.
The seller will make a payment in an unfunded OTC credit derivative only if an event determination date has occurred; and where physical settlement applies, a notice of physical settlement has been delivered.
Unfunded credit derivatives include: single name credit default swaps; index trades; basket products; credit spread options; swaptions; constant maturity swaps; recovery credit default swaps. An overlap exists with funded credit derivative products, in that these OTC products are usually embedded into a note structure when creating a funded credit derivative.
A funded credit derivative involves the issue of a debt obligation either by a special purpose vehicle (SPV) or a financial institution, which is purchased by the effective seller – the noteholder. The proceeds of the notes are 'collateralised' by investing their proceeds in highly rated securities, such as OECD country government bonds, or in a GIC (guaranteed investment contract) account.
The note proceeds are used to fund the payment of any cash/auction settlement amount or physical settlement amount. This must either be paid pursuant to a credit default swap entered into by an SPV issuer, or absorbed by the issuer pursuant to the conditions of the notes.
A funded credit derivative involves embedding a credit derivative product into the structure of the transaction. The type of credit derivatives embedded may include many of the unfunded derivatives products mentioned above. Funded credit derivatives are generally credit-linked notes or synthetic CDOs.
2.1 Single name credit default swaps
The single name credit default swap is the cornerstone credit derivatives product. Most other credit derivatives products have been adapted from, or have evolved from it.
A solid understanding of single name credit default swaps is essential for an understanding of the more complex credit derivatives products such as constant maturity credit default swaps, portfolio credit default swaps and synthetic CDOs. The following chapter is dedicated to single name credit default swaps and covers that product in more detail.
Single name credit default swaps are bilateral, usually standardised, contracts between a 'buyer' and a 'seller', referencing the third-party credit risk of a single reference entity.
The parties agree that the buyer will purchase a pre-agreed notional amount of protection against the credit risk of a third-party reference entity's credit obligations. The category of obligations against which the seller sells credit protection are decided at the outset. The category may be a specific named security of the reference entity, a single obligation such as a &8364;200 million floating rate note, or it may be a category of obligation, such as borrowed money, displaying certain characteristics (eg, listed bonds of the reference entity with a maximum maturity date of less than 30 years).
The credit risk against which the seller sells credit protection covers only the risk of certain pre-agreed credit events occurring in relation to a minimum amount of the obligations (or, in the case of the bankruptcy credit event, the reference entity itself). Credit events are likely to match a significant deterioration in the reference entity's credit quality: they will be any agreed combination of bankruptcy, failure to pay, the acceleration of an obligation, an obligation default, a repudiation or moratorium of debts, a governmental intervention or a debt restructuring. In return for the seller assuming this credit risk, the buyer will periodically pay a premium. This will usually be a percentage of the credit default swap's notional amount, expressed in basis points. The amount of the premium will reflect the credit risk of the particular reference entity, with greater risks reflected in higher premiums.
The parties document their transaction by entering into an ISDA Master Agreement and Schedule, and setting out the transaction's terms in a confirmation incorporating the 2014 Definitions. All of the market standard variables are set out in the 2014 Definitions. The parties select the applicable credit events, business days and other variables in accordance with market practice, which in turn will likely rely on the reference entity's jurisdiction of incorporation and/or its characterisation.
Credit default swaps can be auction settled, cash settled or physically settled. When a credit event occurs the seller (and often the buyer) has the right to trigger a credit event. If 'Auction Settlement' is the applicable settlement method this right will be triggered automatically by the occurrence of a credit event announcement by an ISDA Determinations Committee.
If Auction Settlement is not applicable (eg, instead cash or physical settlement, is the applicable settlement method), or for certain restructuring credit events, then there will be a right to trigger a credit event only and not an obligation to do so. Here, the party triggering the credit event is called the notifying party and the date on which it delivers a credit event notice is the event determination date. The event determination date for auction settled transactions is usually the date that an ISDA appointed Determinations Committee is requested to make a decision.
Where the credit event does not occur automatically, due to a Determinations Committee resolution, a credit event notice is addressed to the non-notifying counterparty, specifying that a credit event has occurred and giving the facts relevant to that determination. A notice of publicly available information is usually incorporated into the credit event notice. It cites publicly available information from public sources (usually two), such as Bloomberg and the Financial Times, confirming facts relevant to the credit event's determination.
Where a transaction specifies 'Auction Settlement' as the settlement method: Determinations to be made in the transaction rely on the determinations of an objective ISDA appointed Credit Derivatives Determinations Committee, composed of the great and the good of the sell and buy side of the market who objectively determine, among other things, whether credit events have occurred in the credit derivatives market generally.
If it is determined that a credit event has occurred, the Credit Derivatives Determinations Committee will also determine whether or not to hold an auction of the reference obligations. A Determinations Committee is not obliged to declare whether a particular credit event has occurred. Once a credit event has been determined by a Determinations Committee, ISDA will also usually organise an auction of defaulted bonds and loans related to the credit event, and through an observance mechanism, determine a final price. Auction Settlement is discussed in detail in the chapter on Understanding Auction Settlement.
Where a transaction specifies 'Cash Settlement' as the settlement method: On settlement, the calculation agent (usually the seller) selects and values a reference entity obligation. Either the reference obligation is specified in the confirmation or the confirmation will provide a selection mechanism similar to that for establishing the reference entity's obligations, in which case the calculation agent will notify the counterparties of the reference obligation in a reference obligation notification notice.
The transaction will detail when the reference obligation will be valued. Usually, this valuation date is sufficiently far from the event determination date to allow a reference obligation's trading price to settle.
On the valuation date (which may be on one date or several dates), the calculation agent will go into the market and ask for quotations from dealers for a pre-agreed amount of the reference obligation. The calculation agent will then calculate the reference obligation's final price. The 2014 Definitions provide numerous options and fallbacks for the number of valuation dates, the amount of quotations that must be sought (and from whom), and how the final price is to be calculated.
The final price is expressed as a percentage (ie, the percentage value of the current value of the reference obligation compared to its nominal amount or a reference price), and is calculated using a pre-selected valuation method. The calculation agent notifies the parties of the final price in a final price notification notice. The transaction is then settled an agreed number of days later. The cash settlement amount paid by the seller will usually be the transaction's notional amount multiplied by the reference price (usually 100%), minus the final price (eg, 50%). The transaction will then terminate.
Where a transaction specifies 'Physical Settlement' as the settlement method: In the settlement process, the buyer has 30 calendar days to serve a notice of physical settlement. The transaction confirmation will set out either a specific obligation or the deliverable obligation category and the deliverable obligation characteristics which a reference entity obligation must satisfy for it to be a deliverable obligation. The notice of physical settlement sets out the actual deliverable obligations that the buyer will deliver on the physical settlement date. These deliverable obligations will usually be equal in face value to the transaction's notional amount.
The physical settlement date will be either as agreed by the parties or within the longest period customary in the market. On the physical settlement date, the buyer will deliver the deliverable obligations and the seller pays an amount equal to their face value.
Hypothetical case study: a single name credit default swap
Baularte Limited holds 800,000 of floating rate notes issued by a Portuguese drinks distributor, Donnel plc. The company is one of Baularte's largest clients and the debt holding has helped enhance the client relationship. Baularte is reluctant to sell its holdings but has become worried about the size of its exposure and the credit quality of Donnel. Baularte decides to protect itself by entering into a single name credit default swap with Castle Bank, with Donnel as the reference entity. Castle wishes to increase its exposure to the Portuguese beverage market, having had problems attracting clients from this sector to its corporate loan business. Donnel is unaware of the transaction's existence.
Although Baularte was initially looking only to protect itself against the risk of default on the 800,000 bond issue, it has decided that by buying credit protection in relation to a wider range of Donnel obligations it will help to insulate itself against any business disruption should Donnel collapse. The obligations that are the subject of credit protection are defined as being any bond or loan of Donnel.
Baularte purchases 1 million of credit protection on Donnel for a three-year period, so the swap has a notional amount of 1 million and a maturity date three years ahead. The parties select as credit events Donnel's bankruptcy, a failure to pay principal or interest on any of its bonds or loans above 1 million or any debt restructuring.
Donnel and Baularte use an ISDA standard credit default swap confirmation incorporating the 2014 Definitions. The confirmation incorporates a 2002 ISDA Master Agreement (as amended by a schedule), which the parties have also entered into.
To compensate Castle for taking on the Donnel risk, Baularte makes annual credit protection payments of 2% of the notional amount of the swap. This is similar to the margin over its lending costs that Castle would have expected to make if it had entered into a loan transaction directly with Donnel.
Unfortunately for Castle, one year later Donnel defaults on an interest payment for an issue of $100 million 5% bonds due 2019 (the '2019 debt'). Donnel moves into restructuring talks with the creditors of the 2012 bonds. The value of Baularte's bonds plummets from 95% of their face value to 45%.
Several things could now happen. Donnel could restructure its 2012 debt, which could further devalue the value of Baularte's bonds; it could declare bankruptcy; or it could fail to make the interest payment on Baularte's bonds in a few months' time. Baularte is also likely to suffer business disruption in relation to its key client. Donnel is a thinly traded reference entity and so the parties at the outset specified that auction settlement was not applicable, instead specifying cash settlement as the settlement method.
Donnel decides to trigger a credit event on its credit default swap and delivers a credit event notice to Castle. The credit event notice refers to their transaction and states that a 'failure to pay' credit event occurred when Donnel failed to pay an interest coupon in relation to the 2012 debt. The credit event notice incorporates a notice of publicly available information and attaches two pieces of publicly available information confirming that a credit event has taken place. One is a report from Bloomberg and the other is an article from the Financial Times.
(Continues...)
Excerpted from Credit Derivatives by Edmund Parker. Copyright © 2017 Globe Law and Business Ltd. Excerpted by permission of Globe Law and Business Ltd.
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