* Choice of 4 coupons — 25, 100, 500 and 1,000 bps
* Standardised settlement process to come by end-July
* Dealers expected to pick one coupon type for each name (Adds details, background, byline)
By Jane Baird
LONDON, June 8 (Reuters) - New trading conventions on European credit default swaps will come into action on June 22, traders and Markit officials said on Monday, in further efforts to standardise contracts and prepare for a central clearing house.
The new convention will mean that CDS on individual corporate borrowers will be priced based on fixed coupons, similar to the way that the Markit iTraxx European indexes already trade.
There will be a choice of four fixed coupons for new trades — 25 basis points, 100 basis points, 500 basis points and 1,000 basis points, Markit officials said at an industry conference. The latter is not expected to be traded heavily.
The changes are aimed at standardising credit derivatives contracts to help dealers net their positions and cut the number of outstanding contracts in a process known as compression, and also to help a central clearing house balance its different positions to reduce risk.
Under the current system, single-name CDS contracts trade at a par spread — the level that makes the contract’s value at the outset equal to zero for both the buyer and seller of protection.
The new convention will instead fix a coupon at the outset of a contract. For example, a CDS now quoted at 150 basis points would be quoted with a coupon of 100 basis points plus an additional upfront payment equal to the 50 basis points.
The fixed coupon and variable price makes it easier for the dealer or central counterparty to match trades on the same underlying name, even though they are executed at different times and at different spreads.
The U.S. market took the lead in adopting the new trading conventions in early April but with only two available coupon options at 100 and 500 basis points.
The European approach will offer four coupons for new trades and two other coupon options to remake existing trades, traders said. The two other coupons are 300 and 750 basis points, they said.
The greater the number of coupon options, the less potential for standardisation, however.
Traders said that they expect dealers will quickly settle on one preferred coupon level for each corporate name to head off the potential for arbitrage between different coupon types.
The new trading regime officially becomes effective when single-name contracts are scheduled to roll over on June 20, a Saturday, and will start to impact trading two days later.
In the United States, the new pricing was introduced at the same time as a move to standardise the auction process for defaults and include it in the wording of CDS contracts, known as the “Big Bang.”
Europe has not yet come up with its equivalent changes to the settlement process for defaults.
One big difference is that while the U.S. CDS contracts eliminated restructuring as a potential credit event, Europe’s standardised settlement process will continue to include restructuring as a potential trigger for payment under CDS contracts.
The International Swaps and Derivatives Association is due to publish the new European protocol, being called the “Small Bang,” next week, with the aim to have it adopted by the industry by end-July, Markit officials said.
That would be just in time to meet the industry commitment to European regulators to begin using central clearing houses by July 31. (Additional reporting by Natalie Harrison)