Europe prepares for changes to credit default swap contracts

An agreement between major dealers to shift to standardised fixed coupons for trading European credit default swaps (CDSs), following a similar initiative in North America, could speed global moves towards central clearing, say market participants.

The dealers - believed to include Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley and UBS - reached an agreement on April 17 to trade European CDSs with standardised coupons of 25 basis points, 100bp, 500bp or 1,000bp. A provisional target for implementation has been set at the end of June, just one month ahead of the industry's commitment to the European Commission to start clearing CDSs in the region by July 31.

Speaking during a panel discussion on credit derivatives at the International Swaps and Derivatives Association's annual general meeting in Beijing on April 23, Athanassios Diplas, New York-based global head of counterparty portfolio management, global markets at Deutsche Bank, said while there were similarities with the US initiatives, product differences between Europe and the US have required attention.

"We have restructuring included in European contracts. The optionality associated with that credit event makes the standard auction process more difficult. Therefore, we have to make some fundamental design choices that are different from the US," he explained. "We also have to come up with an auction process that can accommodate restructuring, and are close to finalising those proposals."

The agreement follows the introduction of a number of changes to the trading of North American CDSs on April 8. Single-name contracts must now be traded with fixed coupons of 100bp or 500bp, to be paid on a quarterly basis, making them more akin to credit derivatives indexes. Furthermore, modified restructuring no longer qualifies as a credit event, leaving only bankruptcy and failure to pay.

The North American changes have been seen as an important step towards standardisation that will facilitate central clearing. "All the changes in North America effectively make CDS contracts more straightforward in the way they operate. So if you're looking to compress trades or feed them into a central clearing process, it becomes much easier," says David Austin, director of credit products at London-based data vendor Markit.

The changes in North America were made alongside several modifications to the global CDS market, collectively known as the 'big bang' protocol. The protocol hardwires the auction settlement mechanism into contracts, introduces five regional determinations committees to decide whether credit or succession events have occurred, and implements rolling look-back periods of 60 days for credit events and 90 days for succession events. According to Isda, more than 2,000 parties had signed up to the protocol by the time it closed on April 7.

"It will take some time for all market participants to get accustomed to the various changes, but overall it's a big step forward and a move towards standardisation and operational efficiency that is needed in order to move to central clearing," says Jason Quinn, co-head of high-grade and high-yield flow trading at Barclays Capital in New York.

The introduction of determinations committees is intended to prevent future disputes over the occurrence of credit and succession events and the setting of auctions. The five regional committees - covering the Americas, Asia (excluding Japan), Australia and New Zealand, Europe, Middle East and Africa, and Japan - are each composed of the top eight global CDS dealers and top two regional dealers, in addition to five buy-side firms. The first meeting of the determinations committee for the Americas took place on April 16 and concluded credit events had taken place for both Chicago-based shopping centre owner General Growth Properties and Greenville, South Carolina and Montreal, Quebec-based newsprint manufacturer Bowater Incorporated.

"What it seeks to do is get the industry together to achieve consensus and agreement among market participants as to how any number of issues should be addressed, such as the existence of a credit event, succession event or what obligations should be deliverable," explains Robert Pickel, New York-based executive director and chief executive of Isda.

The implementation of look-back periods to set the effective dates for CDS contracts represents another step forward, as it allows dealers to more effectively hedge their trades. For example, if a dealer sells protection on July 1 then buys protection on the same underlying 30 days later, there would be a 30-day period during which a credit event would trigger one contract but not the other. Now the effective periods count back by 60 days, both contracts would be triggered. That will smooth the progress towards central clearing platforms, as they will not be forced to take on any of the risk.

"The changes to effective dates are paramount to getting the maximum benefit from a central clearing house," says Quinn. "We have eliminated the potential for basis risk and made the product more fungible by changing the effective dates."

The hardwiring of the auction mechanism, the final component of the big bang protocol, formalises a process that has existed for the cash settlement of CDS trades since 2005. It will now be easier for dealers to participate in the credit event auctions as they will no longer have to sign up to an individual protocol every time an auction is announced.

Joel Clark.