DERIVATIVES: EC bail-in proposals threat to senior bank CDS contracts

Credit default swap market participants are busy digesting the unintended consequences of the European Commission’s bail-in proposals, which could render credit protection on European bonds worthless if implemented in their present form.

Under the current proposals, which are subject to a two-month comment period, lawyers say credit events would not be triggered when a bond is written down, while bonds that have been written down would not be deliverable under standard CDS contracts.

“The general expectation of the CDS market was a bail-in involving a write-down would constitute a restructuring credit event, and that the underlying bond would be deliverable in standard CDS to the extent not already written down. So if the bail-in happened, protection buyers would be able to realise some protection,” said David Benton, partner at law firm Allen & Overy in London.

 “The EC working paper caused a stir because it stated a statutory bail-in power should be included in the terms and conditions of the underlying debt. That is highly significant for CDS.”

On January 7, the EC mooted two potential approaches to boost the capital base of failing institutions, which would not be retroactive and would not apply until 2013 at the earliest. The “comprehensive approach” would endow resolution authorities with the power to impose write-downs or forcibly convert senior bonds into equity once existing equity and subordinated debt buffers had been exhausted. Under the “targeted approach” approach, banks would issue fixed volumes of debt with write-down or equity conversion triggers. 

Crucially for the CDS market, both approaches state that the debt documentation should acknowledge the potential for the bond to be written down or converted, which has potential ramifications for the triggering of a credit event and for the deliverability of bonds in CDS contracts.

In Europe, restructuring is classed as a credit event. However, if the potential for the debt to be written down is included in the terms and conditions of the debt - as per the EC’s bail-in proposals - then any write-down of the debt arguably does not constitute a restructuring, as this write-down was already contemplated when the debt was first issued. Similarly, bonds are only deliverable under standard CDS contracts if they are not subject to any contingencies. So if the terms and conditions state the issuer only has to repay the principal on the bond if the bond has not already been written down,  arguably the payment of the bond is contingent and does not meet the deliverability criteria stipulated by CDS contracts.  

“If the bail-in power is included in the terms of the debt, it could have the effect of not making the write-down a credit event, and making the debt non-deliverable and therefore effectively not protected, even if the credit event was triggered,” explained Benton.

Some market participants have been quick to underline that this is merely a consultation paper from the EC, and it is likely the final legislation, which the Commission aims to table in June, will be watered down or even scrapped altogether. Other analysts are not so sanguine.

“It is only a consultation paper, and some people have suggested it could be watered down significantly. However, our analysts think the proposals are unlikely to be changed significantly, because they are very much in line with what already exists in German, UK and Denmark Banking Acts, where regulators have the ability to haircut senior debt at failing institutions in periods of extreme duress. If it does go through, it could have implications for the CDS market,” said Zoso Davies, credit strategist at Barclays Capital in London.

Davies agreed the current form of the proposals could mean bonds issued under future regulation may not be deliverable into existing CDS contracts. “I think that is a hurdle the International Swaps and Derivatives Association would have to cross when it came to it,” he added.

Market participants in general say it is inconceivable the European CDS market would be allowed to die a slow death as a result of the forthcoming legislation. And while some European politicians have shown distaste for sovereign CDS over the past year, it never seems to have been the EC’s intention for these proposals to affect the asset class. In any case, once the final proposals are released, Benton seems confident the CDS market will find ways around them.

“There is almost certainly a way round this, but we need to first see how the proposals develop. It’s possible there will be a two-tiered CDS market: CDS for senior bail-in debt and CDS for senior non-bail-in debt. It ultimately depends on what the CDS market thinks is the right solution. But my expectation is that as and when this comes in, there will need to be some kind of adjustment to the standard trading terms of the CDS market for European banks,” said Benton.