Dealers have dismissed suggestions they use their position on the International Swaps and Derivatives Association Determinations Committee to manipulate credit default swaps credit event decisions in their favour.
There has been increased scrutiny of the Determinations Committee in recent times due to uncertainty over whether Greek CDS would trigger when restructuring its debt (see Top News story). However, one head of European credit trading has argued stringent in-house compliance procedures along with the nature of the DC mechanism itself make it hard for dealers to bring about blatantly partial decisions.
“It’s fair to say there is a concern that somebody might be biased towards their book, but in reality it’s 15 firms making the decision, and the net effect tends to be pretty neutral. If someone’s arguing something clearly biased, they’ll lose all credibility. People know there is a huge public and regulatory focus on the DC, and no one wants to be that person,” he said.
The DC is made up of 10 dealers and five buyside firms. Questions on credit events are submitted to the ISDA website, at which point the DC will discuss and vote on the issue. An 80% majority is needed – to ensure dealers can’t gang up on the buyside – and the result of the vote is made public.
“There may be different views in the DC on less obvious issues, but generally speaking they prefer to come to more or less a consensus view before voting,” explained David Geen, general counsel at ISDA.
Although there is no formal obligation, there are supposed to be Chinese Walls between the people sitting on the DC and traders that know the firm’s position on a given name. “You would hope that everyone would respect that,” said a senior executive at a major buyside firm, who declined to comment further on the robustness of the DC, apart from to note that “any process in the world can be improved upon”.
There still is, however, concern from some industry members that these Chinese Walls are not always respected in practice.
“Some people are certainly concerned they’re being manipulated by the dealers,” said one derivatives lawyer. “On technical points, the DC is fine. The problem is for larger decisions like Greece, where people are clearly going to vote their own self-interest. It’s not a perfect mechanism for big issues that affect a large amount of people to be decided by a small portion of the overall market.”
While manipulation on this kind of a scale has yet to be alleged, lawyers highlighted the track record of the US DC, in particular, is not entirely spotless.
“There are a few instances where the US DC followed the spirit rather than the letter of the law, such as being quite inventive in reaching what were actually sensible results in the end with some of the succession events determinations,” said a senior London-based derivatives lawyer. “However, while there’s obviously a certain amount of interpretation when applying any sort of legal terms, the DC doesn’t have the ability to re-write the rules or make stuff up and I think the process works pretty well.”
There is also a lack of viable alternatives to the DC as a way of deciding on credit events for the entire market. “If you want a product that everyone can trade that isn’t reliant on bilateral triggers then you need a public committee. And it makes sense for the people most interested in the product to be on that,” said Saul Doctor, credit derivatives strategist at JP Morgan. “I think the DC is one of the most transparent committees of any product in the world.”
Possible review of restructuring
Meanwhile, ISDA sais last week that it would review the definitions of restructuring as a credit event if there is sufficient demand from CDS users.
Geen said there had not been widespread calls to reassess the definitions, but it would not ignore requests if they did emerge.
“It’s no secret that you can avoid a restructuring credit event occurring, although this has been the first time there has been so much focus on it,” said Geen.
“We haven’t had a groundswell of people saying it has to be fixed, but we wouldn’t want to be complacent about it.”
“We haven’t had a groundswell of people saying it has to be fixed, but we wouldn’t want to be complacent about it. If it’s clear that the thing isn’t working as a hedge for what people wanted, then we would need to fix it. We’re going to review CDS definitions anyway as they’re due an overhaul, and while ISDA doesn’t believe the restructuring credit event is defective, we will look at it if that’s what is wanted,” he added.
Avoiding the triggering of CDS when restructuring debt has come under scrutiny over the past few months, as fears have increased that Greece would look to deliberately avoid a CDS credit event when reorganising its debt. A debt restructuring needs to bind all holders for it to trigger CDS, although questions remain over the extent to which bondholders can be coerced into participating in sovereign debt exchanges that are supposed to be voluntary.
Despite these concerns, though, few participants called for tweaking of the restructuring credit event definitions. “If bondholders don’t want to roll the debt, then that’s their right. I would discourage ISDA to change the rules to ensure there is a triggering in the case of a voluntary restructuring,” said a senior credit trader.
Geen also indicated broadening the restructuring credit event definitions could be difficult. “There are so many ways a company or sovereign can restructure that you’re never going to catch them all,” he said. “Maybe you could plug some gaps, but you’d have to be careful because if you’re too broad you’d be in danger of catching things you wouldn’t want to catch.”