CDSs get subjective

Legal certainty loses out to commercial objectives in race to fix manufactured defaults

Fixing flaws in the credit default swap (CDS) market is always a tall order. For every crack that is papered over, a vast sinkhole usually opens up somewhere else.

When it comes to stamping out manufactured defaults – in which CDSs pay out despite no material deterioration in the financial position of the reference entity – market participants face a dilemma: preserving legal certainty around the default rules, or meeting their underlying commercial objectives.

Under the terms of a proposed remedy from the International Swaps and Derivatives Association, guardian of the CDS rules, the market has opted for the latter. The fix would require any failure-to-pay credit event to be accompanied by a test for a deterioration in creditworthiness – crucially undefined – in order for a CDS to pay out.

That marks a notable shift from the preference for so-called ‘bright line’ rules-based tests, which have helped keep legal challenges at bay but have also delivered predictable outcomes that have been gamed time and again by those with an encyclopaedic knowledge of the rules, a touch of creative flair, and a hefty dose of audacity.

The addition of a subjective test throws a deal of uncertainty into the mix, and means those looking to game CDSs are playing with fire if they embark on complex and costly financing arrangements with the sole aim of a fat derivatives payout that may not materialise.

Perhaps Blackstone’s GSO unit would have thought twice before offering favourable financing to US homebuilder Hovnanian – now the poster child of manufactured defaults – if it had had doubts over whether its CDSs would trigger in response to a missed payment that hardly caused a ripple in cash markets.

The addition of a subjective test throws a deal of uncertainty into the mix, and means those looking to game CDSs are playing with fire

In one sense, it’s a smart and simple fix. The same causation test is already written into restructuring credit events, and with good reason: it allows for differentiation between restructuring events that stem from an improved financial position, such as a merger with a more financially robust entity.

But it also raises concerns. While restructuring has always been a grey area, the failure-to-pay has not – at least until now. For the credit determinations committee (DC) – the 15-strong group of sell-side and buy-side firms that rule on whether or not credit protection will pay out, it’s yet another departure from bright-line tests – a favoured Isda buzzword for strict legal certainty of outcome, which the trade body claims has contributed to liquidity in the contracts.

The status quo is no longer tenable, however: regulators led by the Commodity Futures Trading Commission have called out the market’s failings. What’s more, liquidity is on the wane. Gross notional CDSs outstanding currently stands at $8.3 trillion, down from more than $60 trillion a decade ago.

Common sense

The latest proposal is not the only sign of common sense trumping strict legal interpretations, as recent DC deliberations around Dutch telco Ziggo attest.

Credit default swaps written on Ziggo Bond Finance became orphaned after the entity transferred obligations to Ziggo Bond Company in March 2018 and protection holders missed the 90-day window to trigger a succession of contracts to the new entity. Nine months later, the entity was acquired by VodafoneZiggo. CDS holders suddenly became aware their credit protection may be worthless, forcing them to rely on a “universal successors” rule, which overrides the 90-day cutoff where a successor assumes all obligations of the reference entity.

But certain liabilities had not been part of the original transfer. On a strict legal reading, CDS holders could easily have been left high and dry – but with just one dissenting voice, the DC ruled in their favour.

“It seems likely that commercial considerations played a part in the outcome of the Ziggo determination,” said law firm Mayer Brown in a commentary note on the issue.

The outcome seemed sensible to most participants – except perhaps those who spotted a free lunch in selling protection that was technically worthless. According to Mayer Brown, the DC appeared to give more weight to the intended purpose of a contract than a court might have done, to avoid outcomes that could be perceived as unfair. But common sense has no legal basis.  

“For lawyers trying to provide guidance to their clients on the interpretations of their contracts, weaving contract law with the emerging CDS lore presents a significant challenge,” says the law firm.

Arm’s length

Alongside a rise in principles-based decision-making, it is perhaps no coincidence that Isda recently fulfilled a long held ambition to put some distance between itself and the DC. In late 2018, the trade body offloaded its role as DC secretary following a failed agreement with Ice Benchmark Administration (IBA).

Instead, the duties have been assumed by a newly created Delaware-incorporated Isda subsidiary, with management services provided by securitisation and project finance outfit Citadel SPV.

It’s a structure that IBA is understood to have sought in its own negotiations; but the benchmark provider, which also administers the crucial Libor rates, backed out over concerns that it could be on the hook for decisions made in closed door meetings where firms vote on the outcome of the very contracts they may have bought or sold.

It’s not clear whether the new direction of travel will ultimately deliver a more robust CDS market. But there’s little doubt that somewhere in a dark corner of an office block on New York’s Park Avenue, Blackstone’s collective cerebral cogs are in overdrive, as they dream up ever more ingenious paths through an increasingly complex labyrinth.