Clearing CDS for lift-off

A new single-name North American credit default swap (CDS) contract, due to be launched next month, is expected to bring greater standardisation to the market and pave the way for central clearing.

The contract, which is presently being negotiated by a working group of dealers and buy-side firms, will involve sweeping changes to standard documentation, particularly provisions for credit events. It will also lead to a change in common pricing and modelling conventions, making CDSs more bond-like, according to market participants.

"The measures simplify and standardise the contract, making it more fungible and ready for central clearing," said Karel Engelen, New York-based global head of technology solutions at the International Swaps and Derivatives Association.

Fungibility is critical to central clearing, as discrepancies in cashflows and contract terms complicate efforts to net opposing positions off against each other.

One change to the new contracts is likely to be the removal of restructuring as a credit event. A credit event determination committee is also expected to be set up, which will decide when a credit event has occurred on a particular entity and determine which of its obligations can be considered deliverable.

This may help allay legal wrangling and confusion over whether events of default have occurred and what can be delivered into standard CDSs - confusion that was recently in evidence in the cases of New York-based fashion firm Liz Claiborne and government-sponsored mortgage lenders Fannie Mae and Freddie Mac.

Although the composition of the committee has yet to be announced, it will include representatives both from the buy and sell side.

In line with efforts to integrate the cash-settlement auction process into all standard documentation, use of the auctions organised by New York-based brokerage Creditex and London-based data vendor Markit will also be hardwired into the new contracts. This will eliminate the need for Isda protocols when individual credit events happen.

Elsewhere, Isda is planning to launch a so-called 'big bang' protocol to incorporate the auction process into all outstanding CDS documentation by early March.

Currently, CDS trades typically become effective the day after trades are completed. However, it is anticipated the new North American contract will involve observation periods that become effective 60 days prior to the day trades are completed. The adoption of this standard is meant to alleviate the potential risks caused to a central counterparty by credit events occurring in the past, without the knowledge of the broader market.

Like the Markit CDX and iTraxx credit derivatives indexes, North American single-name CDSs will move towards fixed coupons, or strikes, of 100 and 500 basis points. Alongside this, the recovery rate assumptions employed by dealers will also be harmonised to 40% for senior-unsecured and 20% for subordinated debt.

Moves are also under way to encourage wider adoption of a standard pricing model. Although JP Morgan's CDS analytical engine is already broadly used in the market, Isda announced it would make the source code available to all market participants at the end of January.

These measures would make single-name CDSs more bond-like and aid transparency for investors, said Jason Quinn, head of US high-grade credit derivatives trading at Barclays Capital in New York. "Flat curves and 40% recoveries make it a lot easier for the investor base to understand what the price actually means. That was front and centre as things were extremely volatile recently, when curve shapes and prices changed really rapidly."

In enhancing the fungibility of contracts, the new North American CDS would make it possible to centrally clear and compress single-name trades between dealers, he added - trades that currently comprise 80% of the market's outstanding notional value.

Isda intends to have a draft of the new contract circulated to its members within the next two weeks. It is hoped the new standard will be implemented by the Markit CDX roll, which is due to take place on March 20.

Some market participants remain sceptical about the benefits of central clearing. Nevertheless, the redesign of North American CDSs is intended to instill confidence in the market, according to Barclays Capital's Quinn. "We're putting a ton of work into this process and are hopeful that these changes will heighten confidence around the market and the product."

See also: Cash-settlement auctions working, says Isda
Isda documentation to cover CDS settlement auctions
Fannie and Freddie auctions raise questions about CDSs