Regulators keen to make CDS panel 'completely independent'
Financial regulators want to make the industry panels that rule on events in the US$9trn credit default swap market “completely independent”, according to the lawyer who led a review of the controversial decision-making body, in the clearest sign yet that the set of proposed changes to CDS market infrastructure may be a precursor to a more radical overhaul.
Simon Firth, a partner at law firm Linklaters, drew attention to longstanding concerns over the “significant” conflicts of interests inherent in credit derivatives determinations committees, a group of banks and investment funds that adjudicate on matters that are crucial to the everyday functioning of CDS markets.
These firms often hold positions in the derivatives contracts that they’re ruling on, meaning they may stand to lose or gain financially from decisions such as whether CDS payouts to holders have been triggered after companies run into trouble.
The determinations committee has various safeguards aimed at managing those conflicts, and Firth said they have been handled well, though regulators would still prefer a system in which there aren’t any conflicts in the first place.
“Regulators are very keen on that idea [of a completely independent DC],” Firth told the ISDA annual general meeting in Amsterdam on Thursday. “They see the advantages of the DC process absolutely, but they would like to see more independence and they really would like to see a completely independent DC. So I actually think that that is the direction of travel.”
The creation of the DCs in the aftermath of the 2008 financial crisis marked a watershed for the CDS market. Users previously had to agree among themselves whether credit events had occurred, often leading to disputes and uncertainty. The DCs imposed greater standardisation across the market, helping to soothe regulatory nerves over a product that had become a byword for the financial excesses of the years leading up to the 2008 financial crisis.
The DCs were designed to comprise representatives from 10 banks and five investment managers. Having knowledgeable people who were deeply involved in these complex markets – and with a vested interest in their future – was supposed to deliver fast and fair decisions. Many saw that as preferable to dragging matters through the courts for months at great expense.
Various mechanisms were embedded into the DC to avoid foul play. Only lawyers, not traders, could participate. Decisions needed an 80% supermajority to carry and inconclusive votes would be sent for external legal review.
Even so, the process remains unique in financial markets and inevitably has attracted criticism over the years. In the end, it was a decline in DC membership that started to raise questions about whether they are still fit for purpose, prompting ISDA to commission Linklaters to carry out a review.
Linklaters stopped short of recommending a transition to a fully independent DC, while proposing amendments to bolster the integrity and resilience of the process. However, Firth indicated the current proposals may be a staging post to a more dramatic revamp.
Perceptions matter
“From the perspective of an outside observer, [the DC] looks pretty funny. And perceptions do matter,” Firth said. “I don't think it's ideal to have a situation, especially when you're trying to get market confidence in a process, to have a perception that there could be conflicts there.”
Moreover, he said, there is always the risk that something goes wrong. “And if something does go wrong in a significant way, that would undoubtedly have a big impact, not just on the DC process, but on the entire credibility of the market,” Firth said.
Linklaters has recommended adding three independent members to the current set-up – as well as an independent governance committee to oversee the DC. Firth said someone like a retired commercial court judge would be an appropriate candidate to be an independent DC member, who could also act as chair of the DC.
“I think that would go a long way towards addressing that issue,” he said.
Judging time
Firth said Linklaters had thought it would be better to see how things developed following the proposed changes rather than recommend moving directly to a fully independent DC without any banks or investment firms involved, where the three independent members took all the decisions. One concern over such a move would be finding appropriate people to take the roles.
“We have to be upfront about some of the challenges,” said Paul Allan, a partner at A&O Shearman, at the ISDA AGM. “It is not that easy or cheap, frankly, to find English retired judges … available to sit on panels.”
Firth said he may have to eat “enormous quantities of humble pie”, but he thinks it will be possible to identify suitable people to take on the role.
“I think it’s a very attractive role for someone like a retired commercial court judge,” he said. “And I don't think it's going to be impossible to find people who are able to take decisions at short notice, at least if the infrastructure is put in place to help them."
This could involve lawyers collating information around a CDS event and presenting it in a package to the DC members. “I’m cautiously optimistic that this is going to be possible,” he said.
