It’s not easy, being Isda | FT Alphaville

It’s not easy, being Isda

Or, “how to get it right, or at least make more of an effort, the second time.”

It’s not easy to lobby for organise an over-the-counter derivatives market. At the heart of the beast is customisation of every risk and whim. But with extreme customisation comes extreme risks. It’s like buying the yellow three-wheel car of your dreams — you may love it, but that doesn’t mean it’d be easy to sell if you needed the money pay the mortgage.

So while OTC derivatives may fit like a glove, to at least some users, particularly those who deal in large volumes of them, it can be useful to standardise. Such standardisation can also aid valuation — something that’s needed to managing margin amounts and hence manage counterparty risk.

Standardisation can also mean having the rules of the game in writing. Remember that annoying kid on the playground at elementary school who was always trying to change the rules when he/she was losing? They’d shout, “that’s a do-over!” And you’d protest calmly, “no, it’s not.” Then they’d come back with, “well, I don’t know what rules you are used to, but the one’s that everyone else uses mean that that’s a do-over!” Yeah, whatevs.

Bring forth, the ISDA master!

It may seem kinda crazy to people that the Greek bond swap doesn’t trigger a credit event for CDS. It certainly doesn’t right now, and it may or may not at some point in the future, and if it does, it’ll be rather indirect. In short though, in order for the CDS to be triggered, it has to be proven that something bad happened to a debt holder that they didn’t “voluntarily” ask for. And it has to happen in the context of a deterioration of creditworthiness of the issuer. At least the second part is easy to prove.

This is, however, by no means the first time when the ISDA master, which sets forth the rules for CDS, has come up short.

We aren’t trying to say that the rules are written badly. Rather that it’s in the very nature of CDS that this happens.

Think about what CDS are and think about what the bond universe looks like. The bond universe is incredibly diverse. Bonds can take all sorts of forms, with all sorts of different coupons, can be based on different legal systems, have different covenants, and triggers, etc, etc. varying from contract to contract.

Then CDS rock up and someone magically compacts all that variation into relatively few factors: reference entity, tier (i.e. senior vs sub), currency, and maturity. How do they do that?

By having a document that connects the contract to the underlying bonds, stating all the things that can happen to the bonds and what each of those things mean for the CDS contracts which are based on them.

Bring forth, your inner caveman bond trader!

Sit down somewhere nice with a pen and paper and write down all the things that can happen to bonds.. and debt generally, while you’re at it.

Was “politicians request financiers to engineer a way to restructure bonds without triggering a credit event for CDS” one of them? — Didn’t think so.

Traditionally the way that Isda dealt with this kind of problem, seeing as it is by the dealers for the dealers, is to amend the documentation. There are different versions of the definitions, amendments, confirmations, and protocols, covering different types of OTC derivative. Isda is reactionary, and will try to sweep up the mess afterwards, where mess occurs.

Here are some cases that shaped the CDS market, as we know it today.

Conseco, the gang’s all here

Back in 2000, Conseco extended the maturities on its loans. It’s OK though, the lenders didn’t mind! They were holding CDS contracts, so in a classic have-your-cake-and-eat-it scenario, they could charge a bit more on the loans and get a big, fat CDS payout. They managed such a high payout because they delivered long-dated bonds that were trading at a significant discount to par.

The protection sellers were none too happy.

This prompted a change in the definitions that altered the way restructuring credit events happen. Namely, there are limits on the maturity of deliverable obligations in the auctions that determine the settlement price for the contracts. (However, these modifications to restructuring were not applied to Western European sovereigns.)

There is also a “multi-holder requirement” such that the debt that has been restructured wasn’t restructured with just a limited set of debt-holders (who may be tempted to do this in order to trigger the contracts). Call it the “anti-conspiracy clause” if you are feeling racy.

The squeeze of Delphi

In 2005, Delphi filed for bankruptcy, triggering the most vanilla of credit events. However, there were relatively few bonds outstanding compared to the amount of protection that had been bought, causing a short squeeze on the bonds. One hell of a technical factor.

This would have caused the payouts to be lower than that they should have been, so instead the industry got together and agreed on a cash settlement protocol that just relied on a small amount of the bonds being available. Cash settlement went on to become the industry standard and was baked into the Big Bang Protocol, thus cementing it into the mechanics of the market.

And so on, and so on

There are many other cases out there that shaped how CDS related to bonds by way of the Isda master and associated paraphernalia. There was a special protocol for deliverables for monolines in 2008, and convertibles managed to become deliverable after Railtrack filed for bankruptcy back in 2000 with such bonds being the cheapest-to-deliver.

And then there are some curious cases that look similar, but are completely different when it comes to CDS triggers. Which of these experienced credit events: Bradford & Bingley, AIG, and Frannie/Freddie? (Answers here.)

The point being that the market is nimble by nature. Cut off its tail and it has a tendency to grow one back. Such is the way (or rather the definition) of financial ‘innovation’.

Whether Isda will react to developments in the sovereign CDS market remains to be seen. That is, beyond statements saying that they are still playing by the rules.

We suspect they’ll let things die down for awhile anyway, and then start talking to their membership about what they want. And who knows, maybe when everyone’s attention has shifted somewhere else, the sovereign CDS market will just keep truckin’ along anyway. After all, this is the same market where CDS are written on Saudi Arabia (that has no debt) and the US (that has a printing press). It’s easy to get distra..

Oh look, a squirrel!!






Related links:
Product descriptions and FAQs – ISDA
Mandatory Greek CDS Post – Dealbreaker
Dealers reassess value of sovereign CDS after Greece plan – IFR
Derivatives laboratory – FOW