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.

Tropical Storm

Sometimes a story comes along that is so emphatically off-base that it makes you just shake your head and wonder. And sometimes it makes you write a riposte.

A recent opinion piece in the American Banker is a prime example. The main thrust of the article is that the credit default swaps (CDS) market is troubled because it does not function like the equity or options market ‒ you can’t get a CDS quote “on a website like Yahoo or Google.”


It’s hard to believe this is a serious point of discussion. Of course these markets function differently. From June 7 to June 13, 2012, between 7 and 8 million trades on NASDAQ-listed issues were executed each day. On the NYSE Euronext, about 1.6 million trades in European equities have been executed on average per day over the course of 2012.

In the CDS market, by contrast, about 6,400 contracts are executed each day. Globally. On all reference entities. It would take 1,172 trading days for CDS trading volumes to equal one day’s worth of trading volume for NASDAQ-listed issues. It would take 250 trading days for CDS trading to equal one day’s worth of European equity trading on the NYSE Euronext.

Anyone who knows anything about the CDS market realizes that CDS volume is relatively small, and that trading in most reference entities is not very liquid. A brief look at the DTCC data, for example, reveals that in a recent week (of May 15), the number of reference entities that traded more than 20 CDS contracts per day was 27 out of more than 800. In other words, on the order of 97% of CDS reference entities traded less than 20 contracts per day during that week.

Despite this public data, the article posits that:

“That leads us to perhaps the most saddening question of those posed above: Has there been tacit cooperation among market participants and data vendors to preserve the status quo in the CDS mud pit?

Yes. Perhaps the most egregious form of cooperation is the effort to preserve the impression that there is active trading in a large number of reference names when in fact there is not. I know this having reviewed trading volume reported by the DTCC for all CDS reference names, including U.S. banks, sovereign issuers, and regional and local governments.”

“Preserve the impression?” This is ludicrous. Market participants have been telling anyone who will listen about the dynamics of CDS trading volume.

What could possibly account for this gap in understanding? Particularly given that it comes from a well-respected firm (that is lucky enough to be based in Hawaii)?

Could it be that the signals of CDS trading are sometimes misinterpreted? Or that they conflict with the firm’s own default probability solutions? Witness this:

“Breathless reporters or rating agencies claim ‘Dell’s CDS widen 42%’ when, in fact, there were only 9.6 trades of any kind per day and 1.75 non-dealer trades in Dell during the week ended May 25, according to the DTCC.

Reporters need a story, and the CDS mud pit provides material. Rating agencies need a product that is not a rating, and the CDS mud pit provides one.”

We agree that the trading volume of the CDS market needs to be better understood. And we agree that CDS price signals need to be viewed with the proper perspective. CDS do not aim to predict the probability of default, but they do accurately depict the cost of hedging against default. That is their intended purpose…and it is widely known. Even in Honolulu.

Half Empty or Half Full?

An article in the Financial Times on Monday treated us to another take on the empty creditor hypothesis. Professors Marti Subrahmanyam (NYU) and Pablo Triana (ESADE) write that:

“Bond or loan holders using CDS to gain credit protection qualify as empty creditors: if the borrower gets into trouble, the CDS, if triggered, would cover any losses on the underlying position; if the borrower honours its obligation, the investment is made whole (minus the cost of the CDS protection).”

So what’s the problem? In the opinion of the authors, it’s this:

“Empty creditors are lenders (to a corporation or government) that cease to be concerned about whether the borrower fares well or poorly. Their interests are not aligned with those of other creditors, who prefer that the debtor does well, so that the debt is repaid…

“In a more extreme scenario, the empty creditor may benefit even more by “over-insuring” – purchasing a proportionately larger amount of CDS protection than the debt owned (there is no real limit on the amount of CDS “protection” investors can buy). Obviously, those who did not enter into CDS are not indifferent to bad news as they have a more asymmetric pay-off.”

Our research department wrote a piece that addresses many of these issues a few years ago. We won’t repeat the entire argument, except to highlight a few key points from that piece.

The first relates to whether CDS do indeed lead creditors to prefer bankruptcy over restructuring. It posits that if the ability to hedge using CDS tends to make restructurings less likely than a bankruptcy filing, the correlation between number of defaults and restructurings as a percent of defaults should be lower when CDS are available than when they are not. The paper stated:

“The data show that the correlation between number of defaults in a given year and restructurings relative to defaults in the same year is about 9 percent over the entire sample period. But restricting attention to the period of liquid credit default swap markets, which arguably began in 2003 with the publication of the 2003 ISDA Credit Derivative Definitions and the subsequent initiation of trading in the CDX and iTraxx credit indexes, the correlation jumps to 90 percent. While correlations within small data sets should be interpreted carefully, the correlation statistics presented here would not appear to support the empty creditor hypothesis, according to which the availability of credit default swaps would make restructurings less likely.”

But wait, there’s more:

“Further evidence comes from the list of restructurings that occurred during 2008 and the first half of 2009… During that time, twenty-one firms underwent out-of-court restructurings; credit default swap protection was available on eleven of them (52 percent). And of the restructurings that occurred during that period, four subsequently filed for Chapter 11 bankruptcy; of those four, two had liquid CDS available and two did not. Again, the evidence thus far does not appear to support the empty creditor hypothesis.”

The second point we would make has to do with what the FT article referred to as “over-insuring” and our paper described as “negative economic ownership.”  Again, our paper stated:

“…one may reasonably question the plausibility of the second hypotheses on the basis of how the credit default swaps market treats distressed credit. If an investor were actually to try to build up a negative economic ownership position through overhedging, the strategy would be expensive and unlikely to yield a high return.

…[a]n overhedging strategy is likely to be profitable only if an unusually prescient hedger were to foresee accurately the failure of an investment grade company while the company’s credit default swaps still traded at a low spread. In such a case, the gain might be regarded as a windfall but would not lead to behavior that might affect the functioning of credit markets. And if the anticipated bankruptcy did not occur, the large hedge position could lead to large losses.

…Further, it is not clear how the investor would have been in a position to influence the likelihood of a bankruptcy, and thereby make a positive return more likely, other than by failing to support a restructuring if one were proposed. And as shown already, the evidence regarding restructurings does not support the contention that credit derivatives have had a negative effect on restructurings.”

A final thought: it’s interesting to note that a recent paper by Professor Subrahmanyam (“Does the Tail Wag the Dog?  The Effect of Credit Default Swaps on Credit Risk”) also addresses the empty creditor issue in considerably more detail. The paper is the first empirical work to “formally address the empty creditor concern.”

There is nothing in that paper to change our view that there are many factors influencing the likelihood of an out-of-court restructuring even before considering the effect of hedging using credit default swaps. And beyond the evidence we have provided – which thus far does not appear to support the empty creditor hypothesis – the new evidence they offer is interesting but not conclusive, as there are so many other factors in play. There’s still plenty of doubt regarding whether the empty creditor hypothesis is valid or its impact is negative.

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!

Pay It Forward

An editorial in today’s Financial Times on the Greek debt situation contained this little gem:

“It is a false concern that triggering CDS may set off market contagion. The market is too small – and perverting the course of the swaps’ rules actually carries the bigger risk…”

To which we at ISDA say: Amen! We’ve been making similar points, and believe greater clarity about the CDS market is important, particularly as the Greek debt story continues to play out.

This story from CNBC will also help improve clarity. It outlines how the CDS credit event process works in a clear fashion. (One small note for viewers: the DC consists of 10 sell-side and 5 buy-side members).

With Friends Like This….

It’s one thing to get criticized by those who don’t understand or like the financial markets. It’s another when the criticism comes from someone who does. A recent Forbes op/ed is clearly in the latter camp. It’s unfortunate and disappointing that it is based on an outdated, inaccurate view of the CDS market.

Contrary to the article’s assertions, CDS trading volumes are publicly available, via the DTCC Trade Information Warehouse. This and other trading information has been available for some time and levels of activity in the CDS market are no surprise to financial market professionals.

In addition, market participants have long maintained that CDS prices should be viewed in context. They are just one indication of credit risk. Would anyone – Mr. Forbes included – buy a stock based on one metric?