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Credit Derivatives – Finance and Banking – United States – Mondaq News Alerts

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This practice note focuses on credit default swaps (CDS) (both
single-name and index) and provides a high-level overview of their
functioning, with a particular emphasis on corporate CDS. Although
the product may appear relatively simple at first sight, it is
governed by a complex set of rules. Investors should seek to fully
understand their terms before they trade the product in an effort
to avoid falling into a trap for the unwary.

Credit derivatives are financial contracts enabling market
participants to take, reduce, or transfer credit exposure on a
sovereign or corporate entity (Reference Entities), and typically
reference bonds and/or loans (Reference Obligations) of the
underlying reference entity. The universe of credit derivatives
encompasses a variety of derivatives and securitized products,
including CDS, total return swaps, and credit-linked notes.

Credit derivatives are primarily used by (1) banks and loan
portfolio managers to hedge the credit risk of their bond and loan
exposures, (2) hedge funds and other assets managers to gain
specific credit exposure to reference entities or in connection
with various credit trading or relative value strategies, (3)
insurance companies to enhance asset portfolio returns, and (4)
corporations to manage credit exposure to third parties.

For further information relating to International Swaps and
Derivatives Association (ISDA) documents, see ISDA Master
Agreement: A Practical Guide. For regulation of swaps by the
Commodity Futures Trading Commission and the Securities Exchange
see Swaps and SecurityBased Swaps under Title VII of the Dodd-Frank
Act: U.S. Regulation
Swap Dealer and Major Swap Participant External Business Conduct
. For cross-border transactions, see
Cross-Border Transactions Involving Swaps and Security-Based Swaps:
U.S. Regulation

CDS Basics

A CDS contract is a derivative contract under which one party
buys, and the other party sells, credit protection on a set of debt
obligations of an underlying corporate or sovereign reference
entity (single-name CDS) or a basket of reference entities (index
CDS). Upon the occurrence of certain events with respect to the
reference entity (Credit Events—see the section titled Credit
Events below), the CDS contract is triggered and the CDS protection
seller typically pays an amount to the CDS protection buyer in
order to cash settle the contract. This cash settlement amount is
typically determined by reference to the value of the reference
entity’s debt obligations set via an auction process (discussed
further in CDS Settlement below).

Credit Events are defined in the 2003 and 2014 Credit
Derivatives Definitions (Definitions), which are published by ISDA.
References to the Definitions and defined terms in this practice
note are to the 2014 Credit Derivatives Definitions. The parties to
the CDS contract specify applicable Credit Events, generally by
reference to the ISDA Credit Derivatives Physical Settlement Matrix
listing applicable Credit Events based on market conventions in the
location of the reference entity. In the U.S. for example, Credit
Events applicable to a CDS referencing a corporate entity are
Failure to Pay and Bankruptcy.

Determinations as to whether a Credit Event has occurred and
other material issues impacting the CDS contract or its settlement
are usually made by a 15-member ISDA Credit Derivatives
Determinations Committee (DC). The DC is comprised of the 10
largest CDS dealers (based on CDS notional amount written) in the
particular geographic area and 5 buy-side member firms (which are
the same in all geographic areas). The DC decision-making framework
is based upon the DC Rules, which are also published by ISDA. The
DC typically follows the DC Rules but it does have the flexibility
to deviate from those rules in certain instances if necessary

When entering into a CDS contract as an end user, a market
participant will typically face a swap dealer counterparty. Thus,
for purposes of settlement and performance, payments and/or
deliveries will occur between the market participant and its swap
dealer counterparty.

The volume of CDS on a specific reference entity is publicly
available, but not the identity of trading counterparties. It is,
therefore, difficult to assess which market participants are
actively trading the CDS product on any given reference entity and
in which size.

Credit Events

Credit Event determinations are typically made by the DC for the
relevant region (North America, EMEA, and Asia). Any CDS market
participant may request the DC to make such a determination. Credit
Events must have occurred within 60 calendar days preceding a
request (accompanied by the requisite information) to be taken into
account. This is referred to as a 60-day look-back period.

The Credit Events most commonly applicable in corporate CDS
contracts are as follows.

Failure to Pay

The Failure to Pay Credit Event is generally very clear on its
face. The low Payment Requirement ($1 million / €1 million) is
noteworthy because relatively benign payment failures can
potentially trigger settlement of the CDS contract. In addition,
the Definitions give effect to any applicable grace periods in the
underlying debt documentation or, if no contractual grace period
applies, the Definitions imply a three-business day grace period.
The definition is as follows:

“Failure to Pay” means, after the expiration of any
applicable Grace Period (after the satisfaction of any conditions
precedent to the commencement of such Grace Period), the failure by
the Reference Entity to make, when and where due, any payments in
an aggregate amount of not less than the Payment Requirement under
one or more Obligations, in accordance with the terms of such
Obligations at the time of such failure.

The term “Obligation” for the purposes of the Failure
to Pay definition is very broad. In the U.S. and Europe,
obligations include any form of “Borrowed Money,” which
covers any bond or loan obligation of the Reference Entity. That
said, CDS contracts are generally tied to the seniority of the
obligations they reference. As a result, a CDS contract written on
the senior obligations of a Reference Entity may not be settled
using subordinated obligations of the same Reference Entity. “Subordination” refers to contractual subordination,
disregarding security and collateral arrangements and the existence
of preferred creditors arising by operation of law.

Historically, Failure to Pay was perhaps the most clear-cut
Credit Event. However, the simplicity of the definition has been
taken advantage of in recent years in the context of defaults
engineered by market participants with the cooperation of the
reference entity (so-called narrowly tailored Credit Event). In
order to prevent misuse, narrowly tailored Credit Event terms have
been incorporated into corporate CDS contracts and now require a
payment failure to result from or in a credit deterioration of the
reference entity in order for a Failure to Pay Credit Event to
occur. The relevant amendment became effective on January 27, 2020,
for most CDS contracts. It specified that a failure to pay will not
be deemed a Failure to Pay Credit Event if it doesn’t directly
or indirectly result from (or in) the deterioration of an
entity’s creditworthiness or financial condition, as long as
the Confirmation includes a credit deterioration requirement.

ISDA also published interpretive
setting out certain factors that the relevant DC
should take into account when considering a Failure to Pay Credit
Event. These factors are only indicators of whether a deterioration
in creditworthiness is implicated (or not) and are not intended to
be exhaustive or conclusive.

This interpretative guidance introduces an element of
subjectivity (and, therefore, uncertainty) into the DC’s
determination for the Failure to Pay Credit Event. While the added
uncertainty is designed to serve as deterrent against market
participants’ misuse of the Definitions to their economic
advantage, it makes the product somewhat less predictable and
potentially more susceptible to inaccurate determinations.


The Bankruptcy Credit Event is, in most circumstances, a
clear-cut event as it typically involves a bankruptcy or other
insolvency filing. That said, certain prongs of the definition,
such as those relating to proceedings seeking “similar relief
under any bankruptcy or insolvency law or other law affecting
creditors’ rights,” are relatively complex and their
resolution may require fair amount of analysis. Bankruptcy is
defined as follows:

“Bankruptcy” means the Reference Entity (a) is
dissolved (other than pursuant to a consolidation, amalgamation or
merger), (b) becomes insolvent or is unable to pay its debts or
fails or admits in writing in a judicial, regulatory or
administrative proceeding or filing its inability generally to pay
its debts as they become due, (c) makes a general assignment,
arrangement, scheme or composition with or for the benefit of its
creditors generally, or such a general assignment, arrangement,
scheme or composition becomes effective, (d) institutes or has
instituted against it a proceeding seeking a judgment of insolvency
or bankruptcy or any other similar relief under any bankruptcy or
insolvency law or other law affecting creditors’ rights, or a
petition is presented for its winding-up or liquidation, and, in
the case of any such proceeding or petition instituted or presented
against it, such proceeding or petition (i) results in a judgment
of insolvency or bankruptcy or the entry of an order for relief or
the making of an order for its winding-up or liquidation, or (ii)
is not dismissed, discharged, stayed or restrained in each case
within thirty calendar days of the institution or presentation
thereof, (e) has a resolution passed for its winding-up or
liquidation (other than pursuant to a consolidation, amalgamation
or merger), (f) seeks or becomes subject to the appointment of an
administrator, provisional liquidator, conservator, receiver,
trustee, custodian or other similar official for it or for all or
substantially all its assets, (g) has a secured party take
possession of all or substantially all its assets or has a
distress, execution, attachment, sequestration or other legal
process levied, enforced or sued on or against all or substantially
all its assets and such secured party maintains possession, or any
such process is not dismissed, discharged, stayed or restrained, in
each case within thirty calendar days thereafter, or (h) causes or
is subject to any event with respect to it which, under the
applicable laws of any jurisdiction, has an analogous effect to any
of the events specified in Sections 4.2(a) to (g).

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Originally published by Practical Guidance

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.