Credit-linked note issuers using default swaps to hedge credit exposure will be exposed to significant basis risk under the International Swaps and Derivatives Associations' proposed 2003 credit derivatives definitions, which are due to be implemented May 6, according to lawyers. Some European dealers have asked ISDA to amend the definitions, but an official at the trade association said there is no intention to issue an amendment on this point, adding the definitions were discussed at length and had support up to their publication. Credit-linked notes account for around 8% of the credit derivatives market, according to the British Bankers' Association (DW, 9/22).
The key difference in the proposed definitions is that there is no cut-off period by which obligations must be delivered under a credit default swap in section 9.9 and 9.10. This means that, in the event of a default, a CLN issuer may be exposed to the risk of a defaulted obligation falling in price after the CLN has expired but before the issuer settles the off-setting swap with its counterparty. A memo circulated late last month by the London-dealer community said, "Sections 9.9 & 9.10 are unworkable in the context of investor securities, as there is no ultimate cut-off date for these fallbacks."
Credit lawyers said if ISDA does not agree to amend the document or suggest alternative wording, firms will have to write bilateral agreements. Generally, dealers try to avoid this as small differences in wording can result in basis risk.
Restructuring Language
Another problem with the definitions is that they could exclude Eurobonds as deliverable obligations. ISDA has drafted a standalone statement and will recommend firms include it in their contracts to rectify this. Eurobonds, which make up the vast majority of the European debt market and effect some of the largest names, such as British Telecom, could have been ruled out as deliverable obligations in the event of a default as part of lawyers' attempt to exclude bilateral loans.
The Multiple Holder Obligation clause requires at least two-thirds of a minimum of four debt holders to agree to a restructuring. This was introduced to prevent protection buyers, who are also party to a bilateral loan, restructuring loans with the intention of triggering protection, according to an ISDA document. The terms of most Eurobonds, however, mean they can be restructured with the consent of less than two-thirds of the holders, ruling them out as a deliverable obligation. The bonds often require a quorum of 75% of bond holders to agree to a restructuring by a 75% majority, which only makes 56% of the total bond holders.
