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Rolling into the new ISDA protocol

Home / Spectrum / Rolling into the new ISDA protocol

Mitch Reznick, CFA, Co-Head of Credit and Head of Credit Research
29 August 2014

On 21 August, the International Swaps and Derivatives Association (ISDA) launched its 2014 Credit Derivatives Definitions Protocol. Such an announcement may seem a prime candidate for the “Important but Boring” Outlook folder, but credit fund managers and broker/dealers are reading the protocol very closely. It will apply the new definitions for credit derivatives, which ISDA published in February this year, to existing transactions from 22 September. Participants in the credit default swap (CDS) market, such as Hermes Credit, have until 12 September to agree to it. We will sign the protocol for two major reasons: the 2014 definitions will make contracts more liquid than the legacy 2003 contracts, and we advocate the important changes to the definitions of subordinated CDS contracts for financial institutions.

Now sub financial CDS will actually insure against… credit events

The treatment of subordinated CDS for financial institutions is a meaningful and welcome change. Under the 2003 protocol, a government-led bail-in of a bank did NOT trigger a credit event – even though it is quite obvious that a financial institution that requires state aid has failed. This created a disconnect between where the subordinated bonds and subordinated CDS of an institution traded, and led to a valuation anomaly whereby subordinated bond spreads traded far wider than subordinated CDS spreads – witness SNSS Reaal, where the recovery rate for the Dutch lender’s the subordinated debt was the same as for its senior debt! Consequently, subordinated CDS were precluded from being an effective instrument for hedging default risk. However, the new protocol’s governmental intervention clause states that bail-ins WILL be viewed as a default event. Also, thanks to its asset package delivery mechanism, the recovery rates of subordinated CDS will more accurately reflect the change in value of subordinated debt.

We agree with these changes. They allow for the pricing of jump-to-default risk to be much more efficient, and they strengthen the ability of subordinated CDS to hedge default risk. Given that the introduction of the European Union’s so-called bail-in directive, the Bank Recovery and Resolution Directive, gives regulators (and governments) much more flexibility in dealing with failing financial institutions, this is especially important. Consequently, subordinated CDS could become an even more important instrument to indemnify investors from default events at this level of the capital structure. Finally, it is important to note that such an event at the subordinated level will not trigger a default at the senior level – unless there is also an impairment at that level, too – as shown by Irish banks during the financial crisis.

Investment implications

This will drive spread compression in this part of the capital structure. Spreads on subordinated CDS for financial institutions will widen as the market recognises that the securities will cover an additional event of default. We believe that this will cause the spreads between financial institutions’ subordinated bonds and subordinated CDS to converge. As such, investors must price in more risks when valuing the “new” subordinated CDS as defined by the 2014 protocol.

See the ISDA links below for more information:

Press release:
The ISDA 2014 Credit Derivatives Protocol:

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Mitch Reznick, CFA Co-Head of Credit and Head of Credit Research Mitch joined Hermes in February 2010 as head of research on the Hermes Credit team. Prior to this he was co-head of credit research for the global credit and hybrids team at Fortis Investments. Other roles at Fortis included portfolio manager of European high yield funds, based in London, and senior credit analyst, based in Paris. Before this he worked as an associate analyst in the leveraged finance group at Moody’s Investors Service in New York. Mitch earned a master’s degree in International Affairs at Columbia University in New York City and a Bachelor’s degree in History at Pitzer College, one of the Claremont Colleges in California. He is a CFA® charterholder and a member of the Capital Markets Advisory Committee of the IFRS Foundation and the High Yield Buyside Forum of AFME.
Read all articles by Mitch Reznick, CFA

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