Friday, November 27, 2009

CDS changes considered in wake of Thomson restructuring

Posted on Risk.net by Mark Pengelly:

After a series of difficulties hit auctions to cash-settle credit derivatives referencing French media firm Thomson last month, dealers are considering making further changes to the European credit default swap (CDS) market.

Any alterations would follow the small bang protocol earlier this year, which changed the mechanism for dealing with restructuring credit events to make them compatible with central clearing. Thomson is the first restructuring to have occurred under the small bang protocol and was billed as the first real test of the new rules. But aspects of the auction didn’t work as smoothly as dealers had hoped.

“It was a lot of work. I can assure you people around here were glad to see the back of it,” remarks one senior London-based credit derivatives banker.

Thomson was a widely traded CDS reference entity and featured in many of the off-the-run Markit iTraxx credit derivatives indexes – including series 1-7 of the iTraxx Europe credit derivatives index, series 4-7 of the iTraxx Europe HiVol index and series 8-11 of the iTraxx Europe Crossover index. It was also heavily referenced in the structured credit market, ranking as the fourth most popular component of corporate synthetic CDOs in the US, according to a study by New York-based Standard & Poor’s in December 2008.

However, €1.1 billion of the company’s €2.839 billion in debt was privately placed, leading to confusion among trading desks and the organisers of the cash-settlement auction. A final list of deliverable obligations for the auctions was not published until almost eight weeks after a credit event was announced at the firm. Meanwhile, with no idea of where the company’s bonds were trading, market participants were unable to determine potential recovery rates.

In line with market changes brought in by the small bang, three separate auctions were held on October 22 for contracts of varying maturities: a two-and-a-half-year bucket, a five-year bucket and a seven-and-a-half-year bucket.

Prices of 65.125 and 63.25 were set for the five-year and seven-and-a-half year auctions, respectively. But the low volume of deliverable debt at shorter maturities skewed the outcome of the two-and-a-half-year bucket, which settled at 96.25. The result surprised market participants, and has caused some to call for the removal of restructuring as a credit event altogether.

“It does raise questions about the future of restructuring as a credit event in Europe. My guess is that banks will try to make restructuring a hard credit event in future,” says a London-based credit derivatives head at a large European dealer.

At the moment, restructuring does not automatically trigger most European CDSs, instead giving buyers and sellers of protection the option to trigger their contracts. Furthermore, the maturity of bonds that can be delivered into the CDS varies depending on which side triggers the CDS – something that further complicated the Thomson credit event.

Other market participants have proposed removing limits on the maturity of debt that can be delivered into CDS contracts, which would mean having a single auction for a wide variety of maturities. This would simplify the process and reduce the possibility of a squeeze in shorter-maturity buckets, as happened with Thomson. But dealers believe it would leave the process open to abuse, allowing protection buyers to deliver cheap long-dated debt – as occurred with Indiana-based life insurer Conseco in 2000.

Sellers of CDS protection have two days to trigger contracts after the final list of deliverables is published, while buyers of protection have five days. In the run-up to the final deadlines, dealers say they tried to trigger contracts as quickly as possible to ensure the process went smoothly. Nonetheless, last-minute triggering still posed a problem as dealers attempted to ensure they kept hedged books, says Guy America, London-based head of European credit trading at JP Morgan. “People smartly started triggering early, so a lot of that rush was avoided. But you did see people triggering at the last minute, often reacting to triggers they received themselves.”

As a result, dealers are keen to implement conditional triggers. This would mean nominating certain CDSs that banks would like to automatically trigger if other CDSs are triggered against the bank. A similar method was used to tear up offsetting trades on Thomson prior to the auctions. Run by Stockholm-based technology vendor TriOptima, the portfolio compression cycle eliminated $19.6 billion in single-name CDS notional. If conditional triggers were used more broadly, dealers believe this would eliminate a much greater volume of trades and help resolve the problem of last-minute triggers.

Other suggestions made in response to Thomson include preventing reference entities with thinly traded debt from being included in the major credit derivatives indexes.

Dealers caution that any discussions about market changes are unlikely to happen until at least the first quarter of 2010. An International Swaps and Derivatives Association working group is already looking into improvements for the treatment of index tranches – another issue that proved particularly problematic for Thomson due to its heavy inclusion in the indexes.

No comments: