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.

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!