08 Septembre 2014

An improved CDS market

On the next index roll date, i.e. on 22 September 2014, the International Swaps and Derivatives Association (ISDA) is bringing changes to the CDS financials contracts. This follows months of discussions and exchanges with various credit market participants. What seems to be a technical and obscure topic at first glance is actually a major improvement of one of the key credit instruments that we use in the Fund, in our view.

Specifically, the “2014 CDS definitions” significantly upgrade the existing ISDA CDS definitions, as they address the deficiencies of the existing contracts which have stopped some CDS paying out as buyers of credit protection anticipated upon certain events. The New Definitions enact a multitude of changes modifying the nature and behavior of the product; we see the most important changes as (i) Government Intervention Credit Event, (ii) Asset Package Delivery, (iii) removal of Subordinated / Senior Cross Trigger, and (iv) difference of treatment between Subordinated and Senior debt during debt transfers:

(i) The new contract creates a brand new class of Credit Event, known as “Governmental Intervention” (GI). A GI event will occur when a Governmental Authority impairs debt through law or regulation via changes to the maturity, notional, currency, coupon or subordination of a debt instrument. The need for this new Credit Event became obvious in February 2013 when Netherlands-based bank SNS Reaal (SNS) was nationalized and all of its subordinated bondholders were expropriated by the Dutch government. As government bail-in was not expressly covered by the Restructuring Credit Event under the old CDS definitions, this action created significant market uncertainty around a potential CDS trigger and generated huge losses for subordinated investors hedged with CDS. Going forward, the new Credit Event will provide more certainty to market participants when governments do take bail-in actions and would allow for a more robust investment framework in European banks.

(ii) Following a GI Credit Event, holders of protection will be able to deliver the proceeds of this event into the auction. In Restructuring events, the proceeds of the Reference Obligation will be deliverable. In the case of SNS – where subordinated bonds were expropriated – holders of protection would have been able to deliver a potential claim against the Dutch government – worth very close to zero – under the new documentation rather than senior debt instruments – worth slightly below par – as it was the case when the event occurred in 2013.

(iii) In the new contracts, Restructuring or GI events on Subordinated Obligations will not trigger Senior CDS. In old CDS contracts, the cross-trigger feature penalized sellers of senior protection; their contract was triggered and they often had to take a – limited – loss although the underlying credit instruments of their contract were still performing.

(iv) From the next roll date, Subordinated CDS will follow subordinated debt and Senior CDS will follow senior debt during succession scenarios. Under current contracts, both Senior and Subordinated CDS would usually track Senior debt “destination” given the larger amount of senior debt outstanding in the stock of bank liabilities. The recent BES situation is a case in point; when BES bonds were split as part of the €4.9bn bail-out by the Bank of Portugal, senior bonds and CDS were transferred to a new solvent entity – Novo Banco – whereas subordinated instruments remained with BES, the “bad bank” in runoff. As a result, holders of Subordinated CDS could not recover the losses incurred on the underlying subordinated cash instruments and were left holding devalued contracts. Under the new rules, CDS will follow the debt which they are designed to protect more closely, even in succession situations.

Overall, we see all those changes as positive developments for the CDS market, allowing investors to better track the changing market and regulatory environments in which banks now operate. With new financial CDS contracts more robust and better aligned with the cash market, their use and liquidity should be enhanced and pave the way for an increase in the number of members in the March 2015 Series of the iTraxx financial index.