UPDATE 1-ISDA eyes CDS overhaul to mend market flaws

Tue Mar 5, 2013 12:09pm EST

Related Topics

* First change in 10 yrs

* Aim to bolster sovereign CDS

* Restructuring 'events' seen as key weakness

* Changes to financials' CDS also looming (Adds additional background)

By Christopher Whittall

LONDON, March 5 (IFR) - The International Swaps and Derivatives Association on Tuesday proposed the first major overhaul of credit default swaps in a decade, looking to fix perceived flaws in the CDS market in the wake of Greece's troubled restructuring and the sovereign debt crisis.

The primary change concerns how to make sure that those who purchase sovereign CDS are adequately compensated, after it became clear that some who bought protection on Greece might not have received a sufficient payout.

CDS have often drawn the ire of policymakers since the 2008 financial crisis, which in part was driven by the bubble in structured finance products. Traders say that an EU-wide ban on speculative sovereign CDS that was imposed in November has halved sovereign CDS volumes overall.

"This is part of ongoing work: to look at the CDS definitions and see what changes might need to be made in light of the events of the last 10 years, and more recently the financial crisis and European sovereign debt crisis," Mark New, assistant general counsel at ISDA, told IFR.

GREECE IS THE WORD

The biggest flaw in the current set-up concerns restructuring credit events in which a debt exchange is carried out before any CDS auction is held.

In the most high-profile such example - Greece's EUR100bn restructuring last year - the payout on CDS following the auction was actually in line with bondholder losses.

But credit experts said this was a fluke, because at the time of the auction, the new bonds happened to be trading at the same depressed level (around 20) as where the old bonds had been previously.

Otherwise, those holding CDS contracts might have taken a severe loss.

Under the new proposals, an asset package of securities (rather than just bonds or loans) could be delivered into the sovereign CDS auctions, which help determine CDS payouts.

In Greece, for example, this would have meant permitting the GDP warrants that investors received in the debt exchange along with their new bonds to be delivered into the CDS auction - an asset package that should have ensured a fair payout on CDS.

New said there were three other proposed changes aimed at fixing technical glitches with CDS contracts: one regarding succession events, another on qualified guarantees and one on the list of deliverable obligations for liquid CDS names.

It is not clear when ISDA, an industry group, would be able to finalise the changes to CDS contracts will be finalised.

"There is no concrete time frame, but there is still a lot of work to do and any feedback on the proposals would have to be incorporated into any re-drafting of the credit definitions," said New.

And while ISDA vowed to implement a wider overhaul of CDS contracts after the Greece credit event, the new proposals only concern sovereigns and not financials.

The recent case of Dutch bank SNS Reaal has illustrated the shortcomings of the restructuring credit event are also apparent in financial CDS, after the Dutch government expropriated all of the lender's subordinated debt in February before a CDS auction could be held.

"The [ISDA working] group has not yet considered a proposal for asset packages on financials, but we expect that to happen soon," said New.

"Having seen Greece, we have more data on sovereign restructurings and what an asset package may look like. A proposal for financials could take a bit longer to put together - Basel III has not been implemented in the US or Europe and so there is limited information around what bail-ins may look like."

CDS notionals have remained on a downward trend since the market's peak of USD58trn notional outstanding at the end of 2007, hitting a new low of USD27trn at the end on June 2012, according to the Bank for International Settlements. (Reporting By Christopher Whittall; Editing by Alex Chambers and Marc Carnegie)

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