Lawyers welcome CDS panel proposals

IFR 2534 - 18 May 2024 - 24 May 2024
5 min read
Natasha Rega-Jones

Legal experts have broadly welcomed proposals that look to improve the transparency and governance of derivatives industry bodies that rule on matters in the US$8.5trn credit default swap market, while debating whether all the potential changes are strictly necessary.

Law firm Linklaters on Monday published the results of its five-month review of the Credit Derivatives Determinations Committees in response to the International Swaps and Derivatives Association commissioning the first review of these decision-making panels since they were established after the 2008 financial crisis.

The creation of the committees, which comprise a mix of bankers and investment managers, marked a watershed for the CDS market. Empowering a central body to adjudicate on CDS issues meant traders no longer had to agree among themselves whether events had occurred that triggered payouts to holders. This greater standardisation also smoothed the path towards central clearing – one of the landmark regulatory initiatives following the crisis.

But controversy has long dogged the committees, not least because their members are among the largest firms that trade credit derivatives. Dwindling committee membership in recent years has also raised questions about whether they remain fit for purpose – prompting calls for reform.

“[Linklaters’] report is well put together and long overdue,” said Emma Dwyer, a partner in the derivatives and structured finance team at law firm Fieldfisher. “The [committees have] been in play for 15 or so years now without any significant amendment and quite a lot has happened in that time, so it’s certainly good to be taking stock of what’s worked well and where improvement may be needed.”

There is broad-based support for many of the proposals that seek to improve transparency around committees’ decision-making process and potential conflicts of interest. That includes the suggestion of adding an independent chairman and up to two independent members to the committees, alongside requiring the panels to provide reasons for all their “material” decisions.

Such recommendations “should largely be welcomed”, said Dwyer. “In a world where more and more transparency is required, it seems right that a body as important as the [committees] should produce more communication around how long it will take for a question to be decided and some detail as to how the outcome of the question has been decided."

Independent panel

Nevertheless, some lawyers are unsure about Linklaters’ proposal to set up an external panel of independent lawyers that could address more contentious CDS questions if a simple majority of committee members vote to do so – a suggestion designed to reduce conflicts of interest within the committees.

Their concern is that such a move wouldn't hugely improve the current mechanism while potentially undermining the role committee members play in the decision-making process. Committee decisions must reach an 80% supermajority of member votes to be passed and queries that fail to meet that threshold are passed to an external independent panel for review.

“Having an independent panel make [committee] determinations, even if on a voluntary basis, could be the harbinger of a directional shift from the current framework and lead to unintended consequences,” said Julia Lu, a partner at law firm Ashurst. “So far the [committee] process has worked well enough for a reasonable view that no drastic changes are necessary or desirable.”

Simon Firth, capital markets partner at Linklaters who led the review, said one of the reasons the external panel has rarely been used is because it still requires a full debate to take place, followed by a vote. The new process would enable decisions to be referred to an external review panel at the beginning.

"This suggestion actually came from a couple of members of the [committees] who said they would value the opportunity to be able to refer difficult decisions to an independent panel,” said Firth. “I can see the benefit of that from a logistical perspective, as well as to demonstrate that conflicts of interest haven’t affected the decisions.”

Linklaters’ final report forms the basis of a public consultation that ISDA launched last week in conjunction with Boston Consulting Group, designed to give CDS market participants the opportunity to say which of the potential changes – if any – they support.

Once concluded, ISDA will use feedback to suggest specific changes to the committee members, who themselves are solely responsible for agreeing and implementing any proposals.

“Having a robust [committee] process is critical to the smooth functioning of the credit derivatives market,” ISDA chief executive Scott O’Malia said in a statement on the trade group's website. “Without it, market participants would have to return to the messy process of bilateral settlement, which was operationally cumbersome, frequently led to disputes and resulted in inconsistent outcomes across the market.”