The publication of the 1999 ISDA Credit Derivatives Definitions represented an important step in addressing issues of legal, operational and basis risk in the credit-default swap market. However, since that publication, a series of credit events affecting the relatively limited universe of frequently-traded names has highlighted areas where the 1999 definitions are overly permissive or insufficiently precise. This resulted in the publication by the ISDA Credit Derivatives Market Practice Committee of three supplements, relating to the identification of successors to reference entities, the scope of the insolvency credit event, the treatment of exchangeable and convertible debt securities and, most controversially, the vexed issue of restructuring.
The 2002 ISDA Credit Derivatives Definitions were conceived initially as an exercise in consolidation to reflect these developments. However, over the course of almost a year of preparation, new issues have been discussed and in some cases addressed, while the restructuring debate continues. This process is now almost complete, with adoption of the revised definitions scheduled for March. Accordingly, it seems an appropriate moment to identify firstly some of the salient developments from the 1999 definitions, and secondly, some of the areas that the revised definitions do not address.
Restructuring
The drafting of the 2002 definitions has taken place against a background of continued debate as to the consequences of the Restructuring credit event. Hopes that a market-wide standard might evolve have faded in the light of the positions taken by various market participants. Given this, the 2002 definitions provide for a menu of possible approaches, being:
Restructuring Maturity Limitation and Fully Transferable Obligation: this tracks the restructuring supplement to the 1999 definitions, adopted in relation to North American names, and limits the range of obligations deliverable under a physically-settled transaction to "Fully Transferable" obligations (that is, transferable without any requirement for consent) maturing no later than 30 months following the scheduled termination date of the relevant transaction.
Modified Restructuring Maturity Limitation and Conditionally Transferable Obligation: this reflects the European modified-modified restructuring approach, and permits the delivery of loan obligations where consent to transfer is required but is not to be unreasonably withheld or delayed. Maturity limitation here is the later of the scheduled termination of the relevant transaction and (in the case of a bond or loan) 60 months following the occurrence of the relevant restructuring.
Non-Inclusion Of Restructuring
As A Credit Event
Finally, the 2002 Definitions invite the parties to specify whether or not Multiple Holder Obligation is applicable (the default position being that it is). If applicable, this will exclude, for example, restructuring of bilateral loans from constituting a credit event--again, this reflects the provisions of the restructuring supplement.
This seems the correct solution, in that it leaves the market free to develop, given strongly held views and regulatory constraints, in diverse directions.
There have also been changes to the restructuring credit event itself. The Obligation Exchange concept has been dropped, and redenomination of an obligation into a Permitted Currency (being a currency of a Group of Seven member state, or any other Organisation for Economic Co-Operation and Development member satisfying certain ratings criteria) will no longer constitute a restructuring.
Repudiation
The other credit event which has seen significant change is Repudiation/Moratorium, following concerns that it could be inadvertently triggered. There is now a two-stage test; declaration of a moratorium or repudiation of obligations by an authorized officer, followed by a Failure to Pay within a given period (60 days in the case of obligations other than bonds, or the later of 60 days and the first payment date in respect of any bond). Where necessary, the credit protection period will be extended while the position is assessed.
Notice Of Physical Settlement
The Notice of Intended Physical Settlement under the 1999 definitions is, as its name suggests, merely indicative of an intention to deliver a specified asset or assets, the intention being to facilitate settlements. Under the 2002 definitions, there has been a conceptual shift towards treating the Notice of Physical Settlement as an express delivery undertaking. Consistently with this, section 9.9 of the 2002 documents give the seller a right to close-out all or a portion of the relevant transaction by buying-in bond assets where the buyer fails to comply with its delivery obligations, so triggering its obligation to make payment to a corresponding extent of the Physical Settlement Amount.
Guarantees
The 2002 definitions deal much more consistently with guarantees, and in particular, rationalize the application of obligation categories and characteristics as between the underlying obligation and the guarantee itself. Due to concerns as to the enforceability of upstream or side-stream guarantees, there are now two available concepts--Qualifying Affiliate Guarantee encompasses classical downstream parent/subsidiary arrangements, while Qualifying Guarantee is a broader category. Neither encompasses letters of credit or financial guaranty insurance policies. Although sensitivities as to enforceability were cited, this seems curious, and the drafting result less than perfectly precise.
Operational Issues
The inclusion of stand-form notices should make the task of operating credit-default swaps easier. Likewise, the latest draft of the 2002 Definitions contains novation provisions which reference ISDA's standard form of novation agreement and provide for streamlined transfer of transactions by way of a Novation Confirmation.
Miscellaneous
Although the above are arguably the most significant developments from the 1999 definitions, there have been a host of other more or less significant changes, including:
* incorporation of previously published supplements
(successors, credit events, convertible, exchangeable and
accreting obligations)
* exclusion of undrawn revolving loans from the definition
of Borrowed Money
* a more sophisticated definition of Not Subordinated to
replace the existing Pari Passu Obligation Characteristic
* partial quotations to be taken into account in determining
a weighted average quotation in cash-settled transactions
are required to be approximately equal in aggregate to the
applicable Quotation Amount
* inclusion of the right, absent certain criteria, for the buyer
to deliver bonds or assignable loans in substitution for loan
assets where, despite reasonable efforts, the buyer has failed
to obtain any necessary consent and a right, subject to
conditions, for the seller to require such delivery
* deletion of the rarely used dispute resolution provisions
What's Not There?
Given developments in the credit-default swap market, it is surprising the requirements of portfolio transactions or first-to-default baskets are not addressed, and that there has been no clear demand for this. Currently market participants address these and other variants to the basic cash or physically-settled single-name default swap with a varying degree of documentary sophistication.
Other proposals which have been debated, but which are not reflected in the final draft include the Master Credit Derivatives Confirmation Agreement, and changes to the scope of Publicly Available Information.
And Why Is It So Difficult To Read?
The 2002 definitions build on their 1999 predecessor. This has advantages; in particular, practitioners familiar with the base document have an accurate yardstick to judge developments. It also means, however, that dense language has gotten denser, and that the opportunity to fundamentally reshape some provisions, notably relating to valuation, has been missed.
Conclusion
Despite the caveats expressed above, there is no doubt that the 2002 definitions address issues exposed by market stress. Once published, it will be for market participants to choose how they are applied. It will be interesting to see whether, on this basis, the credit-default swap market can continue to replicate its level of growth over the past three years.
This Documentation Focus was written by James Coiley, an associate at Ashurst Morris Crisp in London.
