No Evidence? No Problem

“To the market’s credit, there is no evidence that the process has become corrupted by big banks.”

That’s what an article in The New York Times Dealbook says about how credit events are determined in the CDS market.

The comment, unfortunately, is buried deep within the article. It’s easy to miss.

Most of the 800-word piece focuses on how the credit event process has the potential to be flawed. Its basic premise is that the ISDA Determinations Committees (DC) and credit event process appear to operate in a cartel-like fashion.

We stress “potential” and “appear to” for two reasons. First, the article doesn’t actually allege any wrongdoing. As noted above, it acknowledges that there is no evidence to this effect. Rather, the article merely posits that because of the way it operates, there is the possibility that problems might occur.

We’re not sure exactly how the DC process is or can be cartel-like. There are effective mechanisms built into it to ensure it isn’t and can’t be. Most notably, each DC is composed of 10 sell-side and 5 buy-side firms, and an 80% supermajority vote of the 15 members is required to make a credit event determination. Neither the sell-side nor the buy-side alone can force a decision its way; a broad market consensus is necessary.

What other flaws does the article cite?

One has to do with the claims that the DC “operates as a quasi-Star Chamber.” It would be great if we could cast Michael Douglas or Hal Holbrook (the stars of the 1983 movie of that name) in the lead DC roles. But we’re not sure the DC process would qualify as a theme for a remake of the movie. Virtually every part of the process is public: the rules governing the DC; the composition of the DCs; the determination requests made by market participants; the aggregate DC votes; the individual votes of DC members; the auction process and prices; adjustment amounts paid by firms as part of the auctions, and so on.

Another potential problem cited by the article isn’t a problem at all: it’s a source of strength. It has to do with the fact that DCs can be asked to consider and vote on a credit event multiple times as the facts of a situation change.

For example, in the recent situation involving Greece, the ISDA EMEA DC was asked to determine whether a credit event had occurred prior to the execution of the bond exchange. It determined at that time that it had not. Shortly thereafter, the deal was officially executed and the DC was again queried. It then ruled that a credit event had occurred.

This is hardly an example of “details shifting.” It is, rather, a prime example about how specific facts about specific situations involving specific Reference Entities can and do change. Prior to the use of the collective actions clauses (CACs) by Greece, there was no credit event. Following their use, there was.

In other words, facts matter. That’s why it is hard to say that one DC decision is precedent-setting for another.

The article opines that the DCs make decisions without having to publish their reasoning. It fails to note that most decisions are unanimous or close to it, obviating the need for explanations given that the consensus is so widespread. It does, though, note that ISDA and the DCs are currently discussing enhanced disclosures.

The “biggest concern” cited by the article is about potential conflicts of interest. These concerns stem from the fact that DC member firms may have an economic interest in the cases they are asked to rule on.

Two important points need to be made here. The first is that the DC rules incorporate the idea that market expertise – as evidenced by trading volumes – is a good thing to have on the DCs. So it’s no surprise that the DCs will be asked to make determinations on Reference Entities in which they have exposures. The second point is that regulatory disclosures and regulatory transparency provide an important check on any potential conflicts. Regulators have the ability to see a DC member’s exposures and benchmark it against its DC voting. This ability is enhanced under Dodd-Frank, which requires firms to report their OTC derivatives trades to trade repositories. This important check on the integrity of the process is cavalierly dismissed in the article.

At the end of the day, the article says that although there’s no evidence of wrong-doing, “trusting it to remain that way doesn’t seem like a good plan.”

The truth is, the DC process has always been built on the concept of “trust, but verify.” It was built with structural safeguards – checks and balances — to protect its integrity. Those safeguards are working. That’s why “there’s no evidence” of any problems with the process.

That, at least, is something we can all agree on.