An (EFSF) credit derivative is born | FT Alphaville

An (EFSF) credit derivative is born

Anyone remember the EFSF’s ersatz CDS?

They announced it back in November 2011. Another measure to eke the bailout fund’s resources out a bit more in a bad patch of the eurozone crisis.

A societe anonyme would be hived off the EFSF, to sell “Protection Certificates” (let’s call them PCs) to cover a certain portion of new debt issued by a sovereign facing a debt crisis. Who would buy the PCs? “Institutional investors willing to detain European Sovereign with credit enhancement,” according to the EFSF’s own FAQ.

Anyway, the main thing was that the contracts sounded an awful lot like credit default swaps. However it wasn’t clear just how much they would resemble CDS.

As of Friday, we know a lot more… sort of.

The European Sovereign Bond Protection Facility now has its own website! More to the point, the Summary Terms for the certificates can be found here, and a Base Prospectus here.

So we know how the PCs are going to attempt to be different, yet similar, and how they are going to bifurcate the market for credit derivatives on eurozone sovereigns.

In short, the EFSF PCs will probably trade very differently to the normal way of buying protection on a sovereign, which is to buy CDS. Thus leaving a “basis” between the two derivatives. Reading through the documents released on Friday one cannot help but be left with the impression that the PCs are like a rebellious teenager — having all sorts of identity issues while having the potential to trash your house/the market.

A cap on your insurance

Sorry to use the i-word in relation to credit derivatives (something of a faux pas) but the thing with the PCs is that there will be a cap on the amount that can be paid out under them if there is a default.

The “Maximum Loss Protection Cap” is, according to the Summary Terms:

Up to a maximum amount (expected to be 20-30% of the Settlement Notional Amount) as specified in the relevant Final Terms for the Certificates

CDS have no such cap, hence:

-> Reason for basis between PCs and CDS #1.

No naked trading

This was a bit of a funny one. When the PCs were announced it was stated that they could be detached and traded separate to their respective bonds. But there are proposed rules coming in next fall that will prohibit buying CDS protection if the holder of protection doesn’t hold the underlying (or something highly correlated with it), i.e. no naked sovereign CDS trading allowed.

It has since been clarified that:

The holder of a Certificate will need to certify beneficial ownership of a principal amount of bonds issued by the relevant euro-area Member State at least equal to the Settlement Notional Amount prior to receiving any settlement payment

Interesting… “settlement payment” is the amount paid out in a credit event. So if the naked short ban isn’t itself broad enough to catch the PCs, then by the rules of the PCs themselves maybe you can buy them (go short) as a bet. Just as long as you aren’t the one holding them when a credit event actually occurs? We’ll file that under:

-> Weird, who knows?

Credit event triggers

Ok, here we go. You ready?

Determinations of Credit Events triggering settlement of the Certificates will be made with reference to the relevant ISDA Credit Derivatives Determinations Committee’s determination of Credit Events for the over-the-counter credit derivatives market.

Actually that doesn’t sound too bad. But it goes on:

In certain circumstances where the relevant ISDA Credit Derivatives Determinations Committee does not or may not deliberate whether a Credit Event has occurred, settlement of the Certificates following a Credit Event can be effected by holders of at least 25% of Certificates

What?!!! What does that mean??

Let’s look in the Base Prospectus:

If the Determination Agent determines that terms applicable to a “Standard Western European Sovereign” Transaction Type and/or market practices applicable to credit derivative transactions referencing the Reference Sovereign have been amended, changed, modified or replaced following the Issue Date, and either:

(i) the Determination Agent (acting in its sole and absolute discretion in a commercially reasonable manner) forms the opinion that it is reasonably unlikely that the CDDC will determine the question of whether a Credit Event has occurred in respect of one or more Obligations of the Reference Sovereign in accordance with the Credit Derivatives Framework; or

(ii) the Determination Agent has submitted a request to ISDA asking it to put a question to the CDDC to determine whether a Credit Event has occurred in respect of one or more Obligations of the Reference Sovereign in accordance with the Credit Derivatives Framework and ISDA has announced that the CDDC has declined to determine such question,

then settlement under the Certificates could be triggered by a direction by a requisite number of Certificateholders if a Credit Event has occurred. Certificateholders should be aware that the failure or inability of the CDDC to determine whether a Credit Event has occurred (for any reason) could make it more difficult or even impossible for a settlement under the Certificates to occur.

So, if something changes about the way trade organisation Isda or the market goes about things, and the Isda Determinations Committee (“CDDC” in the above) is unlikely to rule on a credit event or refuses to, then a mystery (“requisite”, not capitalised, hence undefined) number of certificate holders can trigger? We couldn’t find the 25 per cent from the Summary Terms in the Base Prospectus.

The Isda definitions go quite a way to describe the rights of buyers and sellers since they have different interests, so just saying “25 per cent” and not clarifying at all is awfully bizarre.

[Update, 11:53 London: Khare pointed out to us, in the comments below, where the “25%” is in the Base Prospectus… We needed to Ctrl+F “quarter” to find it after not spotting in on our read through. D’oh! So, similar to the above which is in another part of the doc, but with the last paragraph being:

…then the Conditions to Certificate Settlement may be satisfied by notice by no later than 5 Business Days prior to the Maturity Date of the occurrence of a Credit Event to the Principal Paying Agent by holders of at least one quarter of outstanding Certificates.

So the protection buyers, i.e. PC holders, can gang together to try to push a credit event in particular circumstances. Wonder if there’s any requirement for the 25 per cent to be held by more than one investor…

Thank you, Khare!]

These strange, and unclear auxiliary rights to the side of the usual Isda DC process get filed under:

-> Reason for basis between PCs and CDS #2.

Wrong way, wrong currency, wrong, wrong, wrong

Funny thing about the sovereign CDS market… it predominately trades in USD. Not euros! And yet:

Think about it. Why would you buy protection on the UK in sterling? Or Italy in euros? Usually, people don’t do that. Big deteriorations in the creditworthiness of countries tend to be accompanied by deteriorations in their currencies. So just when the hedge is needed the most, just when it should become more valuable because a credit event is more probable, the value of the hedge goes down with the domestic currency it’s denominated in, rendering the hedge far less effective.

It’s not that CDS in euro on eurozone countries don’t trade at all, it’s just that they are worth less than their USD counterparts, and they are less liquid.

Also, the eurozone is a rather unique situation, whereby the default of a member like Greece wouldn’t do as much damage to the currency as say a default by Italy, and as such the “quanto” spread is greater for Italy.

In any case, having the PCs in euros would introduce a rather different beast into this USD-dominated market. Funny considering that we’re pretty sure politicians are not especially keen on credit derivatives. Hence:

> Reason for basis between PCs and CDS #3.

To read up on the wrong-way risk, please look at the guarantee commitments to the EFSF on page 95 of the base prospectus. See how much Italy and Spain are responsible for, not to mention Greece, Ireland, and Portugal. A holder of an eurozone sovereign bond has a guarantee on the sovereign bond from eurozone countries. Together we uhhh… stand strong…

Tombstone at the ready

But to which sovereign will we owe the creation of these new derivatives?

With the ECB’s bond-buying at a standstill and a number of hurdles in front of the Greek bailout we can’t help but wonder whether sovereign markets will get spooked enough in the coming weeks that a peripheral will try this out in order to get better interest rates.

Frankly though we may shed a tear (while looking angry) to see politicians birth a new credit derivative.

By Lisa Pollack and Joseph Cotterill

Related links:
EFSF to write CDS (with a two-way CSA and ISDA master)? – FT Alphaville
EFSF CDS, not your standard credit derivative – FT Alphaville
Quantos: when CDS met the monetary union – FT Alphaville