Imagine playing a game where you bet on the outcome of a certain event. Most of the time the final outcome is unambiguous: you play, and afterwards, it’s clear whether you won or you lost. But every now and then, the result is hazy. Did the ball go into the goal? Was there a handball? Did he reach base?
This is usually where a referee steps in to decide.
So, it’s worth asking, how should referees be chosen?
Knowledge of the game is a sensible prerequisite. Also, the referee shouldn’t be conflicted. For example, anyone who has bet on the outcome of a match probably shouldn’t be the one who awards penalties.
And there’s no reason why what’s true of sports referees shouldn’t also be true of market referees, such as the International Swaps and Derivatives Association (Isda).
However, Isda picks the members of a committee that determines who has won and lost in the game of credit derivatives by selecting those who have the greatest potential to be conflicted. (And then it indemnifies them.)
Seem like a problem to you? Are no knowledgeable people to be found who aren’t conflicted? Would it not benefit an industry plagued by allegations of being run as a cabal to try to make decisions look a touch more impartial?
All of this has come up now because Isda’s Determinations Committee (DC) had an awful time trying to agree on whether an Italian company called SEAT Pagine Gialle had defaulted on its debt in a manner that would “trigger” credit default swap contracts — meaning that those who had bought protection would get a big payout from those who had sold it to them.
In the end, the payouts proved were worth some $465m in total. Luckily for the DC, the initially ambiguous situation was resolved by the company committing a more serious infringement on its debt. (In case you were wondering, there was a dispute on whether the firm had 3 or 30 days grace to make an interest payment, but it went over 30 days making it a moot point.)
That didn’t happen quick enough though and allegations of committee members voting in a way that would financially benefit their institutions, rather than objectively, have come to light, thanks in no small part to some brilliant work by Chris Whittall at IFR.
What it comes down to is that the decision of the DC, which is by supermajority (80 per cent), affects all CDS holders. It used to be that the triggering of the contracts occurred between counterparties, i.e. on a bilateral basis. It was, admittedly, rather tiresome to send so many “Credit Event Notices”, proving and arguing about the same thing over and over again, so the industry decided to make it a bit easier for themselves by having one group make all the decisions on behalf of everyone. These mechanics were locked into place with the Big Bang Protocol in 2009.
This may seem sensible… until you realise that way the committee is constructed insures maximum conflicted-ness. Here’s how it works, courtesy of an explainer from Markit:
There are separate criteria for membership on a DC depending on whether the member is a dealer or buy side member. To become a dealer member, the dealer institution must fulfil three requirements. First, the dealer must be a participating bidder in auctions. Second, the dealer must adhere to the “Big Bang” protocol. Last, the composition of dealer members will be based upon notional trade volumes as reported by Depository Trust and Clearing Corporation (DTCC) data via their Trade Information Warehouse (TIW).
In summary, 10 out of the 15 members of the committee are picked because they are likely to have the biggest positions in any CDS contract under examination. What about the five buyside members that make up the rest of the committee?
To become a buy side member of a determination committee is a two-tier process. Buy side members of a DC will be randomly selected from a buy side pool. To qualify to be in the buy side pool, the institution must have at least $1 billion in assets under management (or the equivalent), have single name CDS trade exposure of at least $1 billion, and be approved by one-third (1/3) of the then-current buy side pool. The buy side members of the DC will be randomly selected from the buy side pool and serve for staggered one year terms. The buy side members on the DC must include at least one hedge fund and one traditional asset manager at all times. No institution can serve a second term until all eligible institutions have served. The proposal gives the buy side a direct voice and formal, permanent representation.
That is, they are also chosen on the basis of size, both in terms of assets under management and CDS trades.
By way of contrast, the DC rules go to great lengths to ensure that the back-up mechanism for the DC is unbiased. When the committee cannot agree, as was initially the case with SEAT, the case is sent to “external review”. All of a sudden, (ostensibly) unconflicted people get involved! From the committee rules:
4.3 Composition of the External Review Panels
(a) Conflicts. Upon the existence of an Eligible Review Question, any Convened DC Voting Member may identify any Pool Member from the External Review Panel List for the same Region as such Convened DC for purposes of analyzing their availability and potential conflicts of interest with respect to such Eligible Review Question (each such Pool Member, a “Potential External Reviewer”). Each Potential External Reviewer shall notify the Convened DC, via the DC Secretary, by 5:00 p.m. Relevant City Time on the first Relevant City Business Day after being designated a Potential External Reviewer or such other time as the Convened DC Resolves by a Majority, of its availability and disclose to the Convened DC any conflict of interest which exists or is foreseeable with respect to either the Reviewable Question or the related DC Questions which may be deliberated by the Convened DC. Any 46 Convened DC Voting Member or Convened DC Consultative Member may also raise an existing or potential conflict of interest with respect to a Potential External Reviewer or may ask for additional information to be disclosed.
FT Alphaville understands that it looked like it was potentially going to take a bit of time with SEAT to find knowledgeable people who weren’t conflicted given how many law firms were tied up with one side or another. For this reason, the “unconflictables” tend to be academics (with prior industry experience, mind you).
And what does Isda have to say about what went down with SEAT? Chris Whittall asked Isda’s general counsel, David Geen:
“We are working on some kind of best-practice policy to ensure proper Chinese walls are in place, because there can be a perception that sometimes people are voting their book. We need to make the process as robust as possible,” said Geen.
Most firms also say their representation on the DC is from their legal department, which does not know the trading position of the firm. However, some bankers suggested that ISDA’s decision to bolster best practices was an admission that the current process was not independent.
“Do firms [currently] have proper Chinese walls? It’s a tricky question. Maybe when you go into a grey area, the temptation is to play with [it],” said a third senior trader at a firm with DC representation
But with waivers like these also baked into the mechanics, just how motivated do you think DC members are about minding the Chinese walls? Again from rules:
5.1 Waivers and Disclaimers
(b) Disclaimer by the DC Parties. No DC Party and no outside legal counsel or other third-party professional hired by any DC Party in connection with any DC Party’s performance of its duties under the Rules shall undertake any duty of care or otherwise be liable to any party to a Relevant Transaction for any form of damages, whether direct, indirect, special, consequential or otherwise, that might arise in connection with any DC Party’s performance of its duties, or any advice given in connection with any DC Party’s performance of its duties, under the Rules, except in the case of gross negligence, fraud or wilful misconduct on the part of the relevant DC Party, legal counsel or other third-party professional, as applicable.
In other words, if you have a problem with Isda, sit down and be quiet.
Or, with apologies to Kafka, “the Isda DC wants nothing from you. It receives you when you come and it dismisses you when you go.”