Dealers agree restructuring for standardised European CDSs

European derivatives dealers have agreed on a provisional framework to integrate restructuring as a credit event into the auction process for the cash settlement of credit default swaps (CDSs), taking the market a step closer to central clearing.

On February 17, nine major dealers - Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley and UBS - made a commitment to the European Commission that they would strive to centrally clear CDSs by July 31. The treatment of restructuring was one of the major barriers to meeting that goal.

Under the current framework in Europe, if a protection seller triggers a CDS contract after a restructuring, the protection buyer can deliver bonds with a remaining maturity of up to 30 years. However, if the protection buyer triggers the contract, the rules are more complicated. The maturity of the bonds that can be delivered is restricted to the longer of five years and the remaining maturity of the contract for restructured obligations, and two-and-a-half years and the remaining maturity of the contract for non-restructured obligations.

This creates huge problems for any credit event auction conducted after a restructuring. As the maturity limitation is a function of both the party that triggers the CDS and the maturity of the contract, it would potentially be necessary to run a large number of auctions to cover the full range of outcomes, which would have a knock-on effect on liquidity.

"It is simply not practical to run a different auction for every possible outcome without damaging liquidity in the auction process," says Jonathan Adams, managing director at JP Morgan in London. "The challenge has been to design a process that closely replicates the economics of the underlying contracts while addressing those practical concerns."

Other dealers have shared the desire for an effective solution to the restructuring problem. "The current framework for restructuring doesn't make for easy clearing of the product, so what has to happen is a grouping together of contracts into buckets for the purposes of settling in an auction," says John Cortese, head of European high-yield trading at Barclays Capital in London.

The proposed solution creates five 'maturity buckets' - in effect limiting the number of auctions that would need to take place if a restructuring event occurred. An auction would be run for each of the five buckets, based on obligations that closely replicate those that would be deliverable if the contract was settled by physical delivery.

The buckets include: one for CDSs with a remaining maturity of less than two-and-a-half years, which would include restructured obligations of up to five years and non-restructured up to two-and-a-half years; one for CDSs with a remaining maturity of between two-and-a-half years and five years, which would include restructured and non-restructured obligations up to five years; a bucket for a remaining maturity of between five and seven-and-a-half years, which would include restructured and non-restructured obligations up to seven-and-a-half years; one for CDSs with a remaining maturity of more than seven-and-a-half years, which would include restructured and non-restructured obligations up to 10 years; and a seller trigger bucket, which would include restructured and non-restructured obligations up to 30 years.

Market participants could opt to cash settle by referencing the auction result of the relevant bucket, or decide to physically settle with bonds or loans that fall within the bucket.

"There may be some growing pains in switching to this framework, but any move towards increased transparency, liquidity and ease of settlement in the product will be a positive step for the market," says Cortese.

Joel Clark.