The International Swaps and Derivatives Association last week unveiled a protocol that will allow cash settlement across a broad spectrum of credit derivative products - including single name index tranches and plain vanilla credit derivatives. The protocol is essentially the same as those used for half-a-dozen credit events since the May 2005 bankruptcy of automotive supplier Collins & Aikman Corp. to settle covered index trades.
The protocol is "on the shelf" until the first credit event occurs, said Louise Marshall, spokeswoman for the ISDA, and will be incorporated into the new set of credit derivative definitions the ISDA plans to release next year. The definitions will also address dispute resolution.
While several ad hoc cash settlement templates have emerged amid the growth in the credit default swap (CDS) market, incorporation of a permanent cash settlement option into the organization's credit derivative definitions highlights the notion that physical settlement - actually delivering the bond referenced by the trade - is becoming impractical because of the market's sheer size. The announcement came on Wednesday, as the 16 major derivative dealers sat down with the Federal Reserve Bank of New York for the third time to discuss progress toward strengthening the legal and technological infrastructure underlying derivative trades.
Demand outpaces supply
What began as a method for banks to transfer credit risk off their balance sheets, the CDS market has grown to encompass a wide swath of market participants, from CDO issuers to hedge fund managers. The ISDA estimates the total notional size of the CDS market at more than $26 trillion. The market posted an annual 122% gain in dollar volume in 2005, compared to 86% and 71% gains for 2004 and 2003, respectively, according to Fitch Ratings. Because trades have outpaced the availability of bonds they reference, industry participants have been working toward a permanent trading template that could minimize counterparty risk and provide an option for cash settlement in the event that a physical bond is not available for delivery.
"Nobody expected that the market for credit derivatives would take on a life of its own," said Anthony Nolan, a partner in Goodwin Procter's securitization and derivatives group. While the CDS market "grew up" with the practice of physical settlement, wherein the protection buyer delivers the physical bond to the seller following a credit event, growth in derivative trading has outpaced the bond market's supply in some cases, Nolan said.
In fact, management and technology consultant BearingPoint Inc. estimated there were eight times more derivatives contracts outstanding than bonds available to fill them last year, making regulators nervous about what would happen in the event of a bankruptcy filing at a widely referenced company such as General Motors Corp. So far, with more than $20 billion in total notional exposure, the bankruptcy of troubled U.S. auto supplier Delphi Corp. is known as the biggest corporate bankruptcy to rattle the CDS market to date.
You go first ...
While the ISDA first presented the option of cash settlement for covered index trades amid the Collins & Aikman Corp. credit event last year, it has been somewhat slow to take off, according to Fitch (ASR, 3/27/06). The cash settlement protocol uses an auction with a minimum of five dealers to determine a bond's market value. Which bonds, exactly, are used to gauge fair market value, and when those bonds are priced, have been items of contention, according to market sources. The ISDA's Marshall said the 2007 credit derivatives definitions will be addressing address any disagreement as to what constitutes a "deliverable bond," through a panel consensus.
The ISDA's 2003 credit derivatives definitions only allow for physical settlement. In the revised version expected next year, protocol users will have the option of either physical or cash settlement. "I think the market has been very happy with the way the option protocols worked
for the index trades, so I think it is basically going to institutionalize that," he said.
In the case of ABS CDS, the pay-as-you-go option works as an alternative to physical settlement. The ISDA in January published a revised template for ABS CDS that allows for either physical settlement or pay-as-you-go settlement; unlike rules under the initial template for CDS on ABS trades, the buyer does not have the luxury of choosing physical settlement.
Eventually, widespread use of cash settlement will help to "commoditize" the credit derivative market, according to BearingPoint. "In some degree, trades can be entered and exited, much quicker. A secondary market would develop that much quicker," said Robert Benedetto a managing director at BearingPoint, which works with companies to develop more efficient methods for trade processing. While derivative dealers have set a goal to clear trades within 30 days, the going rate is about 40, he said.
The ISDA has 750 member firms; Janet Tavakoli, chief executive of Tavakoli Structured Finance, estimates that the ISDA contracts are used in 90% of credit derivative trades.
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