Lessons Learned

A week has passed since the auction for Greek CDS. Perhaps it’s now time to reflect on the credit event process. Toward that end we wanted to share our thoughts in a combined derivatiViews and media.comment post, and we also encourage our readers to offer their views.

In our minds, the most striking thing about the entire situation was the wholesale shift in sentiment regarding the potential risks of a credit event. In the space of a few months, it went from being a big issue to a non-issue (though it really should not have been an issue at all). We – and anyone who looked at the DTCC’s trade repository website – knew all along that the level of Greek CDS exposure was relatively small. In addition, while it was published in aggregate on the DTCC’s site, it was known on an individual firm level to regulators. The credit event truly was a non-event.

One of the major reasons why it was a non-event is because of the significant amount of work that ISDA and the Determinations Committees have put into ensuring that the credit event process is fair and robust. This process has been tested many times since it was introduced a few years ago and continues to work well for all market participants.

Our biggest disappointment throughout the process was the lack of understanding by some of two important points about the credit event process. The first point relates to the structure, composition and workings of the Determinations Committees. Apparently, the fact that the names of the individual firm representatives serving on the DCs are not disclosed makes them “secretive” to some. This is despite the fact that the names of the firms serving on the DCs are public, their votes are public, and the rules governing how the DCs function are public. It’s important to note that the individual firm representatives can and do change from credit event to credit event; there is no “list” per se.

The second point relates to the nature and definition of a credit event. As we said repeatedly, particularly here, a contract is a contract. One can speculate about what might be or what should be – and many did. But we repeatedly urged people to read and understand the contract as written. If they had, then there would have been little surprise that the DC could really not act until the collective action clauses (CACs) were invoked by the Greek government. This important step meant that the Greek restructuring was binding on ALL holders, which is a condition required for a credit event to occur under the restructuring clause. In addition, until the Greek government acted – and posted their action in the official government gazette – the CACs were not officially invoked. This too is required before a credit event can be declared. That’s because the DCs do not vote prospectively on credit events.

The Greek credit event also demonstrates to ISDA that we have more work to do. Some market participants legitimately raised the question of whether the package of obligations issued in exchange for old Greek bonds should be considered in the Greek credit event auction, arguing that this was the “right” economic result. Yet among those obligations were certificates issued by the European Financial Stability Facility, not the Greek government, so the package was not considered in the auction.

The fact that the package was not included in the auction was picked up in the blogosphere as evidence that CDS are somehow fundamentally flawed. We beg to differ with that broad characterization.

We believe that it is important to adhere to the terms of contracts as written and agreed between parties as to do otherwise would adversely impact the market. Also, we knew there would be good deliverables for the auction. But we at ISDA also have a long track record of learning from and adapting to market experiences, particularly ones as significant as this.

We are also committed to considering changes going forward, not just for new contracts, but where there is market consensus for a change, for existing contracts as well. One need only look at the 2009 Big Bang Protocol for evidence, when the structure for CDS for both new and existing CDS was agreed broadly by market participants.

Whether, when and how to change the contract to address this recent experience is already being debated by market participants. As we have on many occasions before – for CDS and for the whole range of OTC derivatives – ISDA will play a central role in facilitating the evolution of products that we believe are an essential part of the fabric of the credit markets and of the financial system as a whole.

Stay tuned!

Psst! I’ve Got a Secret

Today we were treated to two news stories in two newspapers on one topic:  the process for determining whether a credit event has occurred with respect to Greek sovereign CDS.

On the one hand, there’s The Washington Post:  “For Greece, a critical conference call between London and New York.”  (A follow-up story is here.) On the other hand, there’s The Wall Street Journal’s “Hushed Up: Secret Panel Holds Fate of Greek CDS.”

An important part of the credit event process – and an important element in each story – are the ISDA Determinations Committees (DCs).  The DCs are 15-member panels of representatives from banks and investment firms.  A supermajority (12 of 15) of each DC’s members is required to make a determination.  Here’s how the Post describes the process and the DCs:

“The banks and other investors who buy and sell the swap contracts have agreed to the arrangement as a way to centralize what had been an ad hoc, company-to-company process of deciding whether a credit default swap payment was warranted.

“The committees are set up with competing interests in mind. The group meeting in London and New York on Thursday includes representatives of major European institutions like Deutsche Bank, as well as private investment funds like Blue Mountain Capital, that might have different points of view.

“A supermajority of 12 committee members is needed to make a determination either way, and if the panel deadlocks the issue would be sent to a new group of three outside arbiters. Some 59 cases have gone before ISDA committees so far without follow-up litigation, and only one has been referred to an outside panel.”

Contrast this with the Journal’s take.  First, there’s the headline about a “Secret Panel.”  The DCs are said to be “secretive” and “rarely elaborate on decisions.” “No outsiders can participate in the meeting…No transcript will be made public. When a decision is announced, expected before Monday, the committee doesn’t have to provide an explanation. There is no opportunity for investors to appeal.”  Critics “question the impartiality of the process.”

It’s a bit of a mystery why the story characterizes the process as so “secretive.”  The names of the firms on the DC are public, as are their votes.  The process by which the DC members are selected, and the rules governing the DCs, are also public.  Their decisions are publicly announced.  At times, public explanations for those decisions are provided, but often this does not appear to be necessary (such as when the vote is 15-0).

In addition, the process, as the Washington Post article notes, was built to address conflicts of interest.  The credit event/DC process has worked extremely well for 3+ years.  It has handled dozens of credit events without incurring a single legal challenge.  If a supermajority isn’t reached, the decision goes to a panel of outside experts.  A supermajority has not been reached only twice in all the times the DCs have agreed to consider a question.

In sum, we think the credit event/DC process is fair, transparent and well-tested.  There’s simply no evidence to the contrary.  Perhaps after today this non-secret secret will be a secret no more.

Note: ISDA’s EMEA Determinations Committee determined today that a credit event has not occurred with respect to recent questions on the Hellenic Republic restructuring. A copy of the press release is available on ISDA’s website.