ISDA is consulting on a proposal to add another credit event for financial credit default swaps in order to adapt to sweeping changes in regulation that will give supervisory authorities the power to bail-in the debt of floundering institutions.
The proposal forms part of a wider overhaul of the CDS definitions, which are being revisited for the first time in a decade to fix a number of flaws in the instruments, including the way they react to sovereign debt restructurings such as that of Greece (see article).
Along with sovereign CDS, amending financial CDS to account for the new bail-in regime is seen as a top priority in overhauling the contract to ensure it remains a viable hedging product.
“The background regime for credit instruments is changing at the moment with the introduction of recovery and resolution regimes enabling regulatory authorities to write down bank debt to avoid bankruptcies,” Mark New, assistant general counsel at the International Swaps and Derivatives Association in Washington, told IFR.
“This proposal introduces a new credit event for financials to address this new regime, by CDS triggering on a bail-in type event.”
Global authorities want to be able to write down bank debt of ailing financial institutions to ensure bondholders shoulder bank losses rather than taxpayers. European policymakers originally signalled senior debt would be subject to a bail-in from 2018 onwards, but bankers now speculate this could be brought forward to 2015.
Supervisors wrestling with Europe’s under-capitalised banking sector have already provided previews of how this new regime may play out in practice. The Irish bank restructurings in 2011 saw subordinated debt written down by 80%, while the Dutch government nationalised mid-tier lender SNS Reaal earlier this year, completely wiping out sub bondholders in the process. Cyprus’ bungled EU bailout went a step further by insisting on writing down senior debt and haircutting uninsured depositors.
Other bank restructurings may well be waiting in the wings, but there are concerns the CDS definitions may not capture future reorganisations. While SNS Reaal triggered CDS, some lawyers at the time said that under a strict reading of the credit definitions, a nationalisation should not qualify as a credit event.
“The problem is that while write-downs may be caught as restructuring credit events under the current definitions, it’s not always clear, and you may get a trigger event in some circumstances and not others. By including a new, separate credit event you will get a better clarity of outcome,” said New.
The proposals were drafted by ISDA’s Credit Steering Committee and will now be put out to its members for consultation. The trade association has previously indicated it is aiming to roll out the new credit definitions by the end of the year, while some participants have expressed concern over imposing the reforms on legacy trades (see article).
I don't believe that whatever rule they adopt is ever going to unleash the CDS bomb.