This practice note focuses on credit default swaps (CDS) (both single-name and index) and provides a high-level overview of their functioning, with a particular emphasis on corporate CDS. Although the product may appear relatively simple at first sight, it is governed by a complex set of rules. Investors should seek to fully understand their terms before they trade the product in an effort to avoid falling into a trap for the unwary.
Credit derivatives are financial contracts enabling market participants to take, reduce, or transfer credit exposure on a sovereign or corporate entity (Reference Entities), and typically reference bonds and/or loans (Reference Obligations) of the underlying reference entity. The universe of credit derivatives encompasses a variety of derivatives and securitized products, including CDS, total return swaps, and credit-linked notes.
Credit derivatives are primarily used by (1) banks and loan portfolio managers to hedge the credit risk of their bond and loan exposures, (2) hedge funds and other assets managers to gain specific credit exposure to reference entities or in connection with various credit trading or relative value strategies, (3) insurance companies to enhance asset portfolio returns, and (4) corporations to manage credit exposure to third parties.
For further information relating to International Swaps and Derivatives Association (ISDA) documents, see ISDA Master Agreement: A Practical Guide. For regulation of swaps by the Commodity Futures Trading Commission and the Securities Exchange Commission, see Swaps and SecurityBased Swaps under Title VII of the Dodd-Frank Act: U.S. Regulation and Swap Dealer and Major Swap Participant External Business Conduct Rules. For cross-border transactions, see Cross-Border Transactions Involving Swaps and Security-Based Swaps: U.S. Regulation.
A CDS contract is a derivative contract under which one party buys, and the other party sells, credit protection on a set of debt obligations of an underlying corporate or sovereign reference entity (single-name CDS) or a basket of reference entities (index CDS). Upon the occurrence of certain events with respect to the reference entity (Credit Events—see the section titled Credit Events below), the CDS contract is triggered and the CDS protection seller typically pays an amount to the CDS protection buyer in order to cash settle the contract. This cash settlement amount is typically determined by reference to the value of the reference entity's debt obligations set via an auction process (discussed further in CDS Settlement below).
Credit Events are defined in the 2003 and 2014 Credit Derivatives Definitions (Definitions), which are published by ISDA. References to the Definitions and defined terms in this practice note are to the 2014 Credit Derivatives Definitions. The parties to the CDS contract specify applicable Credit Events, generally by reference to the ISDA Credit Derivatives Physical Settlement Matrix listing applicable Credit Events based on market conventions in the location of the reference entity. In the U.S. for example, Credit Events applicable to a CDS referencing a corporate entity are Failure to Pay and Bankruptcy.
Determinations as to whether a Credit Event has occurred and other material issues impacting the CDS contract or its settlement are usually made by a 15-member ISDA Credit Derivatives Determinations Committee (DC). The DC is comprised of the 10 largest CDS dealers (based on CDS notional amount written) in the particular geographic area and 5 buy-side member firms (which are the same in all geographic areas). The DC decision-making framework is based upon the DC Rules, which are also published by ISDA. The DC typically follows the DC Rules but it does have the flexibility to deviate from those rules in certain instances if necessary
When entering into a CDS contract as an end user, a market participant will typically face a swap dealer counterparty. Thus, for purposes of settlement and performance, payments and/or deliveries will occur between the market participant and its swap dealer counterparty.
The volume of CDS on a specific reference entity is publicly available, but not the identity of trading counterparties. It is, therefore, difficult to assess which market participants are actively trading the CDS product on any given reference entity and in which size.
Credit Event determinations are typically made by the DC for the relevant region (North America, EMEA, and Asia). Any CDS market participant may request the DC to make such a determination. Credit Events must have occurred within 60 calendar days preceding a request (accompanied by the requisite information) to be taken into account. This is referred to as a 60-day look-back period.
The Credit Events most commonly applicable in corporate CDS contracts are as follows.
Failure to Pay
The Failure to Pay Credit Event is generally very clear on its face. The low Payment Requirement ($1 million / €1 million) is noteworthy because relatively benign payment failures can potentially trigger settlement of the CDS contract. In addition, the Definitions give effect to any applicable grace periods in the underlying debt documentation or, if no contractual grace period applies, the Definitions imply a three-business day grace period. The definition is as follows:
"Failure to Pay" means, after the expiration of any applicable Grace Period (after the satisfaction of any conditions precedent to the commencement of such Grace Period), the failure by the Reference Entity to make, when and where due, any payments in an aggregate amount of not less than the Payment Requirement under one or more Obligations, in accordance with the terms of such Obligations at the time of such failure.
The term "Obligation" for the purposes of the Failure to Pay definition is very broad. In the U.S. and Europe, obligations include any form of "Borrowed Money," which covers any bond or loan obligation of the Reference Entity. That said, CDS contracts are generally tied to the seniority of the obligations they reference. As a result, a CDS contract written on the senior obligations of a Reference Entity may not be settled using subordinated obligations of the same Reference Entity. "Subordination" refers to contractual subordination, disregarding security and collateral arrangements and the existence of preferred creditors arising by operation of law.
Historically, Failure to Pay was perhaps the most clear-cut Credit Event. However, the simplicity of the definition has been taken advantage of in recent years in the context of defaults engineered by market participants with the cooperation of the reference entity (so-called narrowly tailored Credit Event). In order to prevent misuse, narrowly tailored Credit Event terms have been incorporated into corporate CDS contracts and now require a payment failure to result from or in a credit deterioration of the reference entity in order for a Failure to Pay Credit Event to occur. The relevant amendment became effective on January 27, 2020, for most CDS contracts. It specified that a failure to pay will not be deemed a Failure to Pay Credit Event if it doesn't directly or indirectly result from (or in) the deterioration of an entity's creditworthiness or financial condition, as long as the Confirmation includes a credit deterioration requirement.
ISDA also published interpretive guidance setting out certain factors that the relevant DC should take into account when considering a Failure to Pay Credit Event. These factors are only indicators of whether a deterioration in creditworthiness is implicated (or not) and are not intended to be exhaustive or conclusive.
This interpretative guidance introduces an element of subjectivity (and, therefore, uncertainty) into the DC's determination for the Failure to Pay Credit Event. While the added uncertainty is designed to serve as deterrent against market participants' misuse of the Definitions to their economic advantage, it makes the product somewhat less predictable and potentially more susceptible to inaccurate determinations.
The Bankruptcy Credit Event is, in most circumstances, a clear-cut event as it typically involves a bankruptcy or other insolvency filing. That said, certain prongs of the definition, such as those relating to proceedings seeking "similar relief under any bankruptcy or insolvency law or other law affecting creditors' rights," are relatively complex and their resolution may require fair amount of analysis. Bankruptcy is defined as follows:
"Bankruptcy" means the Reference Entity (a) is dissolved (other than pursuant to a consolidation, amalgamation or merger), (b) becomes insolvent or is unable to pay its debts or fails or admits in writing in a judicial, regulatory or administrative proceeding or filing its inability generally to pay its debts as they become due, (c) makes a general assignment, arrangement, scheme or composition with or for the benefit of its creditors generally, or such a general assignment, arrangement, scheme or composition becomes effective, (d) institutes or has instituted against it a proceeding seeking a judgment of insolvency or bankruptcy or any other similar relief under any bankruptcy or insolvency law or other law affecting creditors' rights, or a petition is presented for its winding-up or liquidation, and, in the case of any such proceeding or petition instituted or presented against it, such proceeding or petition (i) results in a judgment of insolvency or bankruptcy or the entry of an order for relief or the making of an order for its winding-up or liquidation, or (ii) is not dismissed, discharged, stayed or restrained in each case within thirty calendar days of the institution or presentation thereof, (e) has a resolution passed for its winding-up or liquidation (other than pursuant to a consolidation, amalgamation or merger), (f) seeks or becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee, custodian or other similar official for it or for all or substantially all its assets, (g) has a secured party take possession of all or substantially all its assets or has a distress, execution, attachment, sequestration or other legal process levied, enforced or sued on or against all or substantially all its assets and such secured party maintains possession, or any such process is not dismissed, discharged, stayed or restrained, in each case within thirty calendar days thereafter, or (h) causes or is subject to any event with respect to it which, under the applicable laws of any jurisdiction, has an analogous effect to any of the events specified in Sections 4.2(a) to (g).
To view the full article click here.
Originally published by Practical Guidance
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.