DERIVATIVES: US CDS trigger still uncertain – ISDA

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It is not clear whether credit default swaps referencing the US would trigger if politicians failed to agree to lift the debt ceiling before August 2, said the International Swaps & Derivatives Association’s top lawyer.

“It’s not necessarily clear whether US CDS would trigger if they did not manage to resolve the debt ceiling negotiations successfully and then subsequently failed to make coupon payments on Treasuries,” said David Geen, general counsel at ISDA. “Usually it would be a clear failure-to-pay credit event if payments were not made by the end of the grace period. The problem is that there does not appear to be clarity about grace periods on Treasuries and we are currently researching this issue.”

“In order for there to be a credit event there has to be publicly available information that says this payment was due on this day and it wasn’t made, and that may not be that easy to demonstrate,” he added.

The lack of clarity over what may happen if Washington fails to lift the debt ceiling is unlikely to be welcomed by the market. Traders have reported bumper volumes of US CDS over the past few months as fears over the political deadlock have increased. Gross and net notionals have more than doubled over the past year from US$11.5bn and US$2.3bn in July 2010 to US$26.1bn and US$4.8bn respectively, according to the DTCC.

“There has been a massive surge in US CDS volumes – particularly in the one-year maturity – with many concerned that the US will trigger,” said one senior credit trader at a major financial institution. (See IFR 1886, Scrap adds to CDS action, p50). “It’s always difficult to know if it will trigger or not though because there are so many ways [they can try and avoid it] – it’s anyone’s guess.”

There has been increased focus on CDS triggers since it emerged that policymakers may try and avoid a CDS credit event when restructuring Greek debt. This has led some to question the value of CDS, with net notionals in wider sovereign names tailing off lately. However, CDS volumes have boomed in tighter names such as Italy and Spain recently, suggesting participants still believe it represents an effective hedge for mark to market fluctuations.

Christopher Whittall