New agreement on restructuring for European credit default swaps

European credit derivatives dealers have revised the details of a proposal to integrate restructuring as a credit event into the auction settlement process for credit default swaps (CDSs), in preparation for the launch of the so-called 'small bang' protocol on July 27.

In May, the major dealers agreed on a provisional framework for restructuring (Risk June 2009, page 9), but a revised proposal published by the International Swaps and Derivatives Association on June 23 reveals a number of significant changes. Market participants will have two weeks to adhere to the protocol, which is set to take effect just five days before the July 31 deadline agreed with the European Commission for the central clearing of CDSs. As trading with standardised fixed coupons of 25 basis points, 100bp, 500bp and 1,000bp began in Europe on June 22, the treatment of restructuring represents the final hurdle in the drive towards central clearing.

"It's a race against the clock to get everything done. We'll definitely meet the deadline, but the important thing for market participants to understand is what the changes to restructuring will actually mean," says Athanassios Diplas, global head of counterparty portfolio management, global markets, at Deutsche Bank in New York.

Under current trading conventions in Europe, if a protection buyer triggers a CDS after a restructuring, the maturity of the bonds that can be delivered to the seller 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. If the protection seller triggers the contract, bonds can be delivered with a remaining maturity of up to 30 years. As the maturity limitation is determined by both the party that triggers the CDS and the maturity of the contract, it could be necessary to run a large number of auctions to cover the full range of outcomes.

The provisional solution agreed in May created five 'maturity buckets' to limit the number of auctions that would need to take place after a restructuring. These included: one for CDSs with a remaining maturity of up to two-and-a-half years, including restructured obligations of up to five years and non-restructured obligations of up to two-and-a-half years (under modified-modified restructuring); one for CDSs with a remaining maturity of between two-and-a-half and five years, which would include restructured and non-restructured obligations up to five years; one for CDSs with a remaining maturity of between five and seven-and-a-half years, which would include 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 obligations up to 10 years; and a seller trigger bucket, which would include restructured and non-restructured obligations of up to 30 years.

Three major changes have been made as a result of discussions among the dealers. First, the number of maturity buckets increases from five to eight, with the addition of a bucket for CDS contracts with a remaining maturity of between 10 and 12.5 years, including restructured and non-restructured obligations of up to 12.5 years, one for CDSs with a remaining maturity of between 12.5 and 15 years, which would include restructured and non-restructured obligations of up to 15 years, and a bucket for contracts with a remaining maturity of between 15 and 20 years, including restructured and non-restructured obligations of up to 20 years. The other five buckets remain more or less unchanged, although a pre-two-and-a-half-year bucket can be added if necessary to settle contracts with modified restructuring, if the termination date of the contract is prior to the latest final maturity date of any restructured bond or loan, where that maturity date is less than two-and-a-half years.

Although the change does create the possibility of more auctions, they are unlikely to be held for all the buckets. "Realistically, there will be little to no volume traded at the maturity of the top three buckets, but we have put them in place to anticipate any future changes to the market. The idea is to create a finite number of buckets, only a few of which will have enough trades to warrant an auction," explains Diplas.

A caveat stipulates an auction should only normally be held if a minimum of 500 contracts are triggered across five dealers. The holding of an auction will be decided by the regional determinations committee, which will have the ability to override the threshold and run an auction with fewer trades if appropriate.

The second change to the framework introduces a so-called 'rounding down convention', meaning if a CDS is assigned to a maturity bucket that contains no deliverable obligations between the bucket's start date and the maturity of the CDS contract, it would be shifted down to the bucket below. "Currently, if you have an eight-year trade, you can only deliver up to eight-year bonds, but the bucketing system allows you to deliver up to 10-year bonds. If there are no bonds in that bucket shorter than the swap, having the longer bonds available for delivery feels like a windfall gain for the buyer. Through the rounding down convention, the eight-year swap will be settled in a shorter bucket that most closely mimics how the contract would have been settled under pure physical settlement," explains Diplas.

The final change, a 'movement option', allows that if a contract is assigned to a particular bucket for which there will be no auction, the contract can either be moved to the shorter bucket for which there is an auction, or taken out of the system altogether and physically settled.