The International Swaps and Derivatives Association (ISDA) updated its credit derivative definitions earlier this month, and while market participants agree that the changes are welcome, the documentation is still largely regarded as a work in progress.

The new definitions do little to resolve the ongoing debate among European market participants over the restructuring of credit events. "Some of the changes are very practitioner based, but [the ISDA] has, for the first time, updated definitions to include the "modified modified" restructuring scheme that would apply to European credits," said one analyst.

According to the British Bankers Association (BBA) the credit derivatives market reached an estimated $1.189 billion at the end of last year, and should increase to $4.799 billion in 2003. In its survey of 25 leading banks, the BBA found a dramatic increase in credit events - at least 23 of the 25 contributors had experienced credit events, and some of the leading houses had experienced up to 25.

Fueling the restructuring debate is the question of whether protection buyers should be allowed to deliver long-dated obligations priced at a deep discount - the old restructuring definition allowed deliverable obligations to have a maturity of up to 30 years for physically settled contracts. "The main purpose of having flexibility with maturity is to broaden the scope of the deliverable obligations, making CDS a generic tool for hedging or investing in credit risk," reported Credit Suisse First Boston.

For a physically settled contract, if a party selling one-year protection on a corporate entity that restructures one or more loan facilities triggers a credit event after 10 months, the protection buyer has the option to deliver a bond and not a restructured loan of the same entity that is the least expensive and likely longer-dated. "This essentially turns a credit risk exposure with a two-month remaining maturity into one with considerably longer-dated risk, which the protection sellers then have to bear," reported CSFB.

CSFB noted that this "cheapest-to-deliver" situation typically does not exist in other non-restructuring default cases such as bankruptcy, failure to pay, or obligation acceleration. The discord arises in the restructuring of companies going into default that may choose to restructure in an attempt to regain financial strength and to avoid default and obligation acceleration, resulting in equally ranked obligations with varying maturities ranked differently. According to the report, this situation creates a level of subjectivity in choosing deliverable obligation.

A restructuring supplement published in May 2001 provided additional guidelines on restructuring credit events. "It imposes some maturity limitations on deliverable obligations, and this to some extent mitigates the cheapest to deliver' problem in both cases," said CSFB. In the U.S. credit derivative markets, the modified restructuring scheme has become the standard for investment-grade corporates.

The push in Europe, however, has been to adapt what's known as the modified modified restructuring scheme, which would have less restriction and include broader restructuring credit event definitions. European bank protection buyers, who are required to include broader restructuring credit events in credit derivatives contracts for regulatory capital purposes, are the main supporters of this approach.

"Now we have modified modified restructuring in Europe, but the issue is still not resolved; the current definition still has options in place," explained one analyst. "In a sense the clause does not matter - at least not from a rating agency perspective - because we are only trying to assess the risk, and that can even be done on something that is more tailored."

More documentation

leads to standardization

Still, the banking community has welcomed the changes incorporated in the latest revamp. A spokesperson at the BBA said that the initial reaction among participating bankers was that there is a need to clarify the situation, and that the recent changes make way for harmonization. The BBA will host a conference in London in March that will feature the changes to be made to the documentation early that month.

The new ISDA definitions also include a new test for identifying the successor to a reference entity and amendments to various credit events including bankruptcy, repudiation/moratorium and restructuring. "In the context of sovereign credit default swaps, the repudiation/moratorium credit event was amended following discussions among members after the Argentina debt crisis in 2001 and 2002," said ISDA. "Under the 2003 definitions, a more specific trigger for credit events is offered."

Possibly the most important change involves the definitions covering guarantees. The new definitions formally define the roles of guarantees and guarantors, but the definitions are restricted to parent company coverage and exclude monoline coverage. "Increasing standardization and documentation is generally viewed as a good thing; as the market grows, it will provide increased liquidity for this product," said one market source.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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