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ISDA May Reopen Debate On Credit Definitions

The International Swaps and Derivatives Association is likely to revisit the debate about how documentation on restructuring and bankruptcy credit event triggers should be worded because of pressure from protection sellers. A decision to review the triggers would most likely happen at the next meeting of ISDA's market practice committee, which is expected to take place next month.

The credit event definitions have been a thorn in the side of the industry body since credit derivatives referenced to Conseco were triggered in 2000. The Conseco restructuring exposed flaws in the definitions that ISDA had been trying to fix ever since.

Paul Varotsis, European chair of the credit derivatives market practice committee and head of CDOs at Barclays Capital in London, said any review will look at what qualifies as a bankruptcy or restructuring credit event. He stressed, however, that if ISDA goes ahead it will aim to minimize changes. Traders are generally opposed to amendments to existing documentation because these could introduce basis risk to their portfolios.

The reason credit professionals cannot agree on a definition is they cannot see eye-to-eye on why credit derivatives exist, according to one New York lawyer. He added that ISDA members should decide whether they want a pure form of credit risk with only so-called 'hard' triggers, such as failure to pay, or whether they want a way to hedge corporate risk with 'soft' credit events, for example, when a corporate restructures its liabilities in order to stave off bankruptcy.

That debate aside, insurers say they are pushing for this review because the credit triggers, as defined in the ISDA document that went live in June, are too vague. One insurer said the room for doubt is likely to lead to disputes and less liquidity.

The main objection with the bankruptcy definition appears to be a clause, which reads, "'Bankruptcy' means a Reference Entity...makes a general assignment, arrangement or composition with or for the benefit of its creditors." Bankers said this is vague because a general assignment could mean anything from half to all its creditors and a restructuring is normally for the benefit of the debtor rather than the creditor.

The protection seller community is still set on making a firmer link between a deterioration of the reference entity's credit quality and the restructuring event. Protection sellers also want to tighten the language so that there is minimal risk that they will have to pay out for market losses, rather than credit losses.

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