The Not-So-Secretive Circle

Thomas Jefferson once remarked: “When the press is free and every man able to read it, all is safe.” He knew how important an independent, critical press is to a free society.

He also knew the democratic process could be messy. “Error of opinion,” he said, “may be tolerated where reason is left free to combat it.”

It was in this spirit that we recently read and analyzed a Bloomberg News piece on ISDA’s Determinations Committee (DC) process. The more that people understand how the process works, the better. If the coverage leads to discussion of potential improvements (in addition to those that have been and are being made), then we welcome it. Transparency is essential to building trust in the DC process. That’s why the DC members, the DC rule book and every vote taken in every credit default swap (CDS) credit event is available to anyone on our website.

By the same token, though, when news coverage contains what we see as errors (either of opinion or of fact), then we need to exercise our right to point these out and correct them. Here are three worth noting.

The first is the article’s headline: Inside the Secretive Circle that Rules a $14 Trillion Market. We know headlines are meant to draw in readers. And we also know that Wall Street conspiracy theories are popular. But we’re not sure what the secret is here. The questions asked to the DC, the publicly available information used to make the determinations, and the CDS Definitions themselves are all available on ISDA’s website. A supermajority vote is needed for a credit event to be determined – that’s 12 out of the 15-strong panel of buy- and sell-side participants. The decision is made public. How each firm voted is also made public, which means these entities have to be sure they can justify their decisions internally and externally (and that includes to regulators). And where a supermajority decision is not achieved, the decision is referred to an external panel – the last of which was videoed and published on our website.

More importantly, though, the headline and the article make the credit event process seem arbitrary. They ignore the fact that the legal definition of what constitutes a credit event under an ISDA CDS contract is spelled out in ISDA’s CDS Definitions. The DC’s job is to look at publicly available information about a CDS reference entity, benchmark it against the Definitions and determine whether a credit event has occurred. The fact these decisions are taken by market participants with knowledge of the market and the sometimes-complex documentation used means these decisions can be taken quickly – important, as buyers of protection need to know whether their hedges will be effective. Uncertainty for months on end would dramatically reduce the effectiveness of this instrument as a hedge.

The second point relates to a quote offered by an “industry expert” that the article uses to advance its narrative: “You’ve got a self-regulatory organization that has handed authority over an entire market to those folks who have the greatest self-interest and have no prohibition for putting their interests ahead of the broader market.”

The third point relates to another quote in the story: “The problem is there’s no ability for an independent body to determine whether or not the process is fair.” This comes from the CEO of a “Washington-based non-profit watchdog group”.

The statements are so wrong in so many ways that it is difficult to figure out where to start in addressing them. But we will try: (1) ISDA is not an SRO; (2) no one handed anyone anything; (3) the CDS market is regulated; (4) in addition to regulatory oversight, market participants are also subject to fraud and anti-manipulation laws.

In other words, regulatory authorities are able to see the exposures and votes of the firms they supervise for each and every credit event.

Because the questions asked to the DC are published on the website, along with the publicly available information used to make the determinations, the CDS Definitions that set the legal definition of a credit event, and the votes of the DC members, anyone can do their own analysis and take issue with how a firm voted.

Now to be clear, we don’t think the DC process is perfect. While we do believe it’s robust and transparent, and that it has worked very well, we’re always thinking of ways to improve and strengthen it.

For example, the potential for a conflict of interest was recognized from the start. Rules were put in place to mitigate this issue (including the requirement for supermajority voting and transparency over how firms voted). But market sentiment has evolved since the DCs were created, and so additional measures are now being taken to further guard against conflicts. We think the ability to consider and make such changes underscores the strength of the DC process.

There’s more here that we could say, and we suggest that readers who want additional information click on the following links:

The Credit Derivatives Mailbag

Storm Warnings

The DC rules

Video of external review panel hearing