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U.S., Europe Credit Marts Risk Split Over Guarantees

24 Mar 2003

The U.S. and European credit derivatives market may start allowing different obligations to be delivered in the event of default, a move which could deter new entrants. Lawyers estimated there is a 50/50 chance of the markets going different ways on this issue. Blythe Masters, North American chair of the International Swaps and Derivatives Association's credit derivatives market practice committee and credit official at JPMorgan in New York, concluded an ISDA dealer meeting on Thursday by saying the market would adopt language preventing the deliverable obligations having guarantees from a junior subsidiary to a parent company, according to several attendees. European-based dealers, however, may petition ISDA to allow all guarantees to be delivered. Officials at ISDA declined comment and Masters did not return calls.

The decision on whether to allow so-called upstream guarantees is critical as if they are not allowed it would increase the basis risk between trades executed based on the 1999 definitions and those on the new definitions. "We have a lot of swaps, that means it could be a lot of basis risk," said one trader. On the other hand, there is no legal certainty on the enforceability of the guarantees so it could increase uncertainty in that respect.

ISDA has carried out legal studies under both New York and English law to ascertain the legal position of upstream guarantees. There is a precedent under New York law for not allowing upstream guarantees, but the trade association did not find any such cases under English law, according to U.K. credit professionals. One U.K. lawyer argued that this case has its own peculiarities and should not be used to rule out upstream guarantees. Another, however, said most derivatives professionals know there is not the same degree of legal certainty around upstream guarantees but it should be up to banks to introduce safeguards against these rather than to ban them completely.

The main demand for allowing upstream guarantees comes from banks hedging their credit portfolios. The middle ground appears to be to opt for qualifying affiliate guarantees and include some special wording to include other forms of guarantee when necessary. One of the drawbacks with this proposal is it would still not cover all guarantees and may introduce too many options into the documentation.

24 Mar 2003