Thomson restructuring causes headache for CDS index tranches

Market participants are uncertain how to deal with index tranche products referencing the iTraxx credit default swap (CDS) indexes following the restructuring credit event at French media company Thomson, which was a member of the indexes.

The International Swaps and Derivatives Association's Credit Derivatives Determinations Committee for Europe, the Middle East and Africa, said on August 12 that a restructuring credit event had occurred in respect of Thomson, following an agreement with the majority of its creditors to postpone payment on its 6.05% senior notes.

This was the first time a restructuring credit event had occurred under Isda's Small Bang Protocol, which was implemented on July 27. It was also the first time restructuring had been applied to CDS index tranches since the market's inception.

Prior to the Determinations Committee's announcement, Thomson was a member of series 1-7 of the iTraxx Europe indexes (the indexes were reversioned to exclude Thomson on August 12), and therefore also a reference entity in collateralised debt obligations referencing the indexes. Market participants say these index tranche products are causing operational challenges in terms of liquidity and fungibility.

Suraj Tanna, a credit derivatives strategist at Banc of America Securities-Merrill Lynch in London, explained that restructuring is viewed as a 'soft' credit event because, unlike bankruptcy or failure to pay, there is no mandatory trigger for CDS contracts. As a result, restructuring can lead to multiple outcomes depending on whether the CDS was triggered, and by which party.

"For any given maturity there could be three different tranches depending on who triggered the contracts [protection buyer, protection seller, or neither party]. The liquidity of that particular maturity of that particular series of iTraxx will then be separated into three different pools," he explained. "This is likely to result in tranches with different attachment and detachment points depending on both the tenor and whether the buyer, the seller, or neither triggered the contract first."

Another problem market participants face is fungibility, Tanna said, because increasing the number of possible tranches at each maturity reduces the potential for them to be netted off against one another.

"One thing that investors and dealers may be concerned about as well is how easily tranche transactions can net off against one another. This is particularly important as the CDS market moves towards a centralised clearing platform. Different sets of tranches at the same maturity for the same iTraxx series clearly reduces the number of identical trades and thus makes netting more difficult."

Isda has set up a working group to look at the settlement of tranches under a restructuring credit event. Its proposals have not been published, but sources close to the discussions say two ideas are on the table, both of which seek to remove Thomson from the tranche in a similar way to the removal of a single name from a CDS index in the case of a default.

"One suggestion is to take the name out of the index tranche so you are left with a tranche of 124 names. You may have to pay for that to happen, but you will get the money back when you trigger," explained Saul Doctor, head of European credit derivatives strategy at JP Morgan in London. "Other people recommend changing the subordination in the tranche to ensure that you have an equivalent recovery rate whether you trigger or not, or a recovery rate sensitivity."

Doctor anticipates Isda's plans will not be implemented in time for the Thomson auction, and also raised concerns over the success of a standard approach to tranches. "I'm a bit dubious as to whether there will be a standard mechanism for addressing tranches in the future, other than the majority of market participants simply doing the same thing," he said.

Tanna also expressed reservations at Isda's proposals. "Splitting a non-linear instrument such as a tranche into a combination of new non-linear (tranche without Thomson) and linear (Thomson single-name CDS) securities is by no means straightforward. Hence, although the proposals were put forward with the correct intentions, they both inevitably fail to replicate the economics of trades that undergo the normal settlement procedure."

However, despite these potential difficulties, "we do not expect the eventual outcome to be as disastrous for liquidity and fungibility as first feared", Tanna concluded. "In every maturity bucket, liquidity will centre on where the greatest open interest has been created. If for example, 90% of the buyers trigger their CDS contracts in one bucket, then clearly liquidity will focus there. The remaining tranches, the 10% that are either seller-triggered or not triggered at all, will most likely be classified as bespoke tranches. In theory, as long as buyers and sellers act on their incentives at each bucket, there shouldn't really be too much of a liquidity issue."

Whatever the outcome, the first restructuring credit event will be a useful test for the Small Bang Protocol and the CDS market, Doctor said. "Thomson is a good test for the market because if 50% of people do one thing and 50% do another, there might be some impetus for a more standardised approach. Perhaps it could lead to the micro bang protocol."

See also: Isda declares first Small Bang restructuring credit event
New agreement on restructuring for European credit default swaps
Dealers agree restructuring for standardised European CDSs