This post continues the discussion of changes in the credit default swap (CDS) since 2007. Part 2 and part 3 of this series of articles discussed changes in the mechanics of CDS trading. This part will discuss changes around how credit events are handled, and future changes in the market.
Changes in the CDS Market re Credit Events Since 1997
- Determination committees (DCs) have been set up to work out if a credit event has occurred, and to oversee various aspects of dealing with a credit event for the market. A ‘determination committee’ is simply a group of CDS traders of various kinds, although overseen by ISDA (the standards body). The parties to one of the new standard contracts agree to be bound by the committee’s decisions.
- Auctions are now conducted to determine the price to cash-settle credit default swaps when there is a credit event. For this we need to determine the current price of the bonds in default. To do this we get a group of dealers to quote prices at which they are prepared to trade the bonds (and may have to), and then calculate the price via an averaging process. This can get quite complicated. The determination committees oversee these auctions.
- Classes of events that lead to credit events have been simplified. In particular whether ‘restructuring’ is a credit event has been standardized (although the standards are different in North America, Asia and Europe). ‘Restructuring’ means such things as changing the maturity of a bond, or changing its currency.
- There is now a ‘lookback period’ for credit events regardless of when a CDS is traded. What this means is that credit events that have happened in the past 60 days (only) can trigger a contract payout. This simplifies things because the same CDS traded on different days is now treated identically in this regard.
Terminology and a Little History
The changes described so far in this article were introduced in 2009. For North America, which went first, this was known as ‘CDS Big Bang’. The standard contract terms thus introduced were known as the ‘Standard North American CDS Contract’ or ‘SNAC’ (pronounced ‘snack’). The later changes in Europe were known as the ‘CDS Small Bang’. The final standardization of Asian contracts occurred later still.
Much more detail on all of this can be found on the links to the excellent MarkIt papers above.
Further standardization in the credit default swap market will occur as a result of the Dodd-Frank Act in the USA. This mandates that standard swaps (such as standard CDS) be traded through a ‘swap execution facility’ (SEF). It further mandates that any such trades be cleared through a central clearing house. Europe is likely to impose a similar regulatory regime, but is behind the United States. More detail on SEFs and clearing houses is below.
The primary aims of these changes are:
1/ Greater transparency of trading. Currently many swaps are traded over-the-counter with no disclosure other than between the two counterparties. This makes it different to assess the size of the market, or the effects of a default.
2/ Reduced risk in the market overall from the bankruptcy of one participant.
The exact details of these changes are still being worked on by the regulators.
Swap Execution Facilities (SEFs)
At the time of writing it’s not even clear exactly what a ‘SEF’ is. The Act defines a SEF as a “facility, trading system or platform in which multiple participants have the ability to execute or trade Swaps by accepting bids and offers made by other participants that are open to multiple participants”. That is, a SEF is a place where any participant can see and trade on current prices. There are some additional requirements of SEFs relating to providing public data relating to price and volume, and preventing market abuses.
In many ways a SEF will be very similar to an existing exchange. As mentioned the exact details are still being worked on.
A number of the existing electronic platforms for the trading of CDS are likely to become SEFs.
Central clearing houses are another mechanism for reducing risk in a market.
When a trade is done both parties to the trade can agree that it will be cleared through a clearing house. This means that the clearing house becomes the counterparty to both sides of the trade: rather than bank A buying from bank B, bank A buys from the clearing house, and bank B sells to the clearing house.
Obviously the clearing house has no risk from the trades themselves. The clearing house is exposed to the risk that either bank A or bank B goes bankrupt and thus can’t pay its obligations from the trade. To mitigate this the clearing house will demand cash or other assets from both banks A and B. This is known as ‘margin’.
The advantage of this arrangement is that the clearing house can guarantee that bank A will be unaffected even if bank B goes bankrupt. The only counterparty risk for bank A is that the clearing house itself goes bankrupt. This is unlikely since the clearing house will have no market risk, be well capitalized, and demands margin for all transactions.
Clearing houses and exchanges are often linked (and may be the same entity), but they are distinct concepts: the exchange is the place where you go to get prices and trade, the clearing house deals with the settlement of the trade. Usually clearing houses only have a restricted number of ‘members’ who are allowed to clear trades. Anyone else wanting clearing services has to get them indirectly through one of these members.
At the time of writing there are already a few central clearing houses for credit default swaps in operation, and more are on the way.
Since 1997 contracts for credit default swaps have been standardized. This has simplified the way in which the market works overall: it’s reduced the scope for difficulties when a credit event happens, simplified the processing of premium payments, and allowed similar CDS contracts to be netted together more easily. At the same time it has made understanding the mechanics of the market more difficult.
Further changes are in the pipeline for the CDS market to use ‘swap execution facilities’ and clearing houses.