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Private Credit 

Dan Alderson

An overhaul of market infrastructure is about to impact high yield and distressed credit markets, yet may have gone under the radar. It will also provide morbid fascination for onlookers if — as seems likely — the plans encounter pushback from those who operate that very market infrastructure.

We are talking about the world of credit derivatives, and specifically the mechanism by which single name credit default swaps are handled and settled when a credit event question arises. Change will come to who has the authority to rule on whether a credit event has occurred and, with this (it is hoped) fairer, less contentious outcomes than have happened in the past.

But wait, you interject, are single name CDS even used much these days? Or, I’m a long-only HY bond investor, why should I care?

Stay with us, because that question of CDS liquidity and utility goes right to the heart of what’s at stake in this market makeover, and why a battle could ignite like we haven’t seen since the 2008 financial crisis.

The International Swaps & Derivatives Association will imminently publish findings of an independent review of the Credit Derivatives Determinations Committees, which it created back in 2009 when it hardwired credit event auctions into CDS settlement as part of the Big Bang Protocol. Some observers are calling this the biggest moment in 15 years for the CDS market, and say it could be make or break for single name CDS. The hope is proposed changes will reinvigorate investors’ confidence about using CDS and avoid scrutiny from regulators, which in turn will promote bond liquidity since CDS allow traders to hedge as well as synthetically replicate long bond exposures.

This is pertinent when various distressed corporate borrowers — Altice, Ardagh, Atos and Intrum among them — are credit event candidates. Atos already merits CDS protection buyers at least taking a shot at triggering the contracts, sources have told 9fin. As such, uncertainty around the outcome of the Determination Committees’ (DC) review may be what's holding investors back — and, barring an Adler Real Estate successor question, there has been almost no DC activity since the review began.

The question is how far the proposals can reasonably go and how much change the DCs are willing to accept. Some key findings of the review emerged at Isda’s Annual General Meeting (16-18 April) (more below) but the publication will kickstart the debate proper. This is just the first step, after which further market consultation will follow. Crucially, any changes to DC rules require the backing of a supermajority of its members. That presumably puts a rather hefty obstacle in the way of any proposal to, say, completely replace the DC with another mechanism.

For the uninitiated, the five DCs (assigned to the Americas, Europe, Asia-Ex Japan, Japan, and Australia/New Zealand) are adjudicating panels comprising several banks and a few big buyside firms. These field questions from market participants on whether CDS entities have triggered a credit event or if there is successor reference obligation to CDS when underlying bonds disappear (say, in the case of a buyback or M&A transaction).

This has been the essential set up to rule on credit events since the financial crisis. But the outcome of some credit events over the years has drawn criticism — sometimes constructively but often not — around a lack of transparency, impartiality, and protections against participants gaming the system. More and more, credit event uncertainty has become the first thing people mention when giving an explanation for why single name CDS trading has not returned to volume in the way CDS index trading has — or why they personally don’t use it.

“CDS is in a difficult place,” says one hedge fund manager. “Indices are easy, but not single names. Investment grade CDS have very wide bid/offers relative to their tight spreads, while with high yield the bid/offers are better in relation to their wider spreads but then you don't have certainty when it comes to settlement. This puts people off.”

9fin heard similar thoughts from other market participants. It has been given as a reason why relative value strategies such as basis and skew have become less common, and is among the hurdles besetting new formation of synthetic bespoke portfolios.

(Formerly commentators might have mentioned a perception issue emanating from the product’s association in the noughties with synthetic CDOs of ABS, but corporate CDS was never the villain of the piece and those days have long passed. Counterparty risk has been painstakingly dealt with in post-crisis regulation and central clearing infrastructure.)

Isda, which used to oversee the DCs, moved to disassociate itself in the post-crisis years. In October 2018, it transferred its secretary role to DC Administration Services, which has ‘management support services’ from Citadel SPV — a somewhat mysterious entity not affiliated with Citadel Americas. Crucially, Isda said at the time it would no longer participate in the DC process, althought it would continue to publish documentation such as the credit derivatives definitions.

It was thus especially eye-opening when, in December last year, Isda intervened by commissioning Linklaters to conduct this independent review of the DCs. Simon Firth, a partner at the law firm, has been charged with authoring the report.

"The DCs have continued to function effectively, and there’s nothing to suggest they won’t be able to do so in future,” said Isda CEO Scott O’Malia at the time. "Nonetheless, after nearly 15 years with more or less the same fundamental structure, we think it makes sense to kick the tyres to check if any potential changes could be made that would ensure the integrity of the DCs for the next 15 years.”

Confusing the matter the DCs, which have a closer association with A&O Shearman, quietly added a statement in January saying they could change their own rules, as and when they choose to do so. Unannounced and buried several layers deep in the DC website, this suggests they are ready to revolt if the Isda/Linklaters recommendations do not suit them. It is hard to gauge the DCs’ intentions here, as the Citadel SPV spokesperson has not responded to 9fin's requests for comment, but Isda affirmed the two reviews are entirely separate.

The DC's legalistic wording leaves open the possibility it may implement no changes at all. Yet members must be conscious there are problems that do need addressing — after all, the number of firms willing to participate on the DCs has fallen from 26 in 2009 to just 12 today. As well as reputational and legal risk in making decisions, dealers also have to pay to maintain the DCs.

“The current system is not good for those market participants that are not part of the DC but it also puts a huge burden and risk on DC members,” says Carlos Pardo, an independent CDS specialist who advises on credit event matters. “It is preventing the volumes from recovering but the need for the product is there.”

And it may not be just the DCs who are revolting. In a recent podcast, Linklaters associate Ashley Rowlands said that while Isda will publish its report soon it has not given a view on timing for the wider public consultation or implementation. This may indicate Isda expects market resistance or regulators' interference.

At Isda's AGM, it became clear Linklaters has not concluded the DCs yet need to be disbanded — although Firth did consider an independent DC proposal and this idea remains an option for the future. But likely changes in the published proposals are that buysiders should help pay for the DCs and that these could include an independent chair as well as two independent members “with appropriate experience and status”. Retired commercial court judges would be ideal candidates, Firth added.

Firth also announced that one recommendation is to refer tougher decisions to an external panel. Pardo had suggested this in a submission to the review, as it would alleviate conflict of interest and antitrust concerns for DC members.

"It is better for the industry to create a functioning external panel voluntarily than to have it imposed on us by regulators", said Pardo, who added that "it is surprising that the existing External Review Panel is not even being published for all regions and reviewed annually by the DC as per its own rules". 

Giving an idea of how the DCs may take exception, A&O Shearman partner David Lucking countered on the AGM panel that conflicts of interest are already dealt with by the supermajority rule and that the proposed changes would be costly. It would also be hard to find sufficiently independent panellists, since retired law firm partners have their own skew while retired judges are busy acting as expert witnesses and speaking at conferences.

Pardo, on the contrary, thinks the current supermajority system only shows there is consensus among all the big industry players by volume but fails to even consider the position, or opinion, of end users and smaller players.  

Credit where credit's due — the author's take

I probably should have stated from the outset I am biased toward preserving CDS. I haven't agreed with industry commentators repeatedly labelling the product as ‘murky’, ‘arcane’ or ’toxic’ — or referred to DCs as being some kind of ‘cabal’. Over the years I have in fact been more in favour of arguing the positives of the DC process

Case in point, the Ukraine repudiation/moratorium credit event in September 2015 was one example where speedy resolution was required before the sovereign bonds disappeared through a tender. The European DC delivered its verdict on a very tight turnaround of just five few days. That’s not to say another mechanism could not have undertaken the same feat, but it was a moment when the European DC came into its own. It's hard to imagine a more bureaucratic process (say a legal one) achieving a satisfactory outcome in that same time frame.

More broadly, the CDS market has proved responsive and adaptable over time as new challenges and criticisms arise. Measures have been taken — with Isda playing a strong role — on improving the language, such as in the 2014 credit derivatives protocol, and deterring manufactured credit events (ie when a borrower is incentivised to wilfully trigger its own CDS). Likewise the market has found ways to thwart activist investors from forcing a credit event on an otherwise viable company, by introducing features such as net-short language in loan and bond documentation.

The DCs' problem is largely one of perception. There are bound to be occasions where the dwindling member firms face an ostensible conflict of interest in positions their traders hold. And even if the individuals involved are able to act above such considerations, the suggestion will always be there, as well as the threat of legal action.

Biases may even out, broadly speaking, but neutrality would be unlikely in each particular credit event question. It would be rare even on the toss of a coin per member to end up with a perfectly split panel, and a supermajority requirement only goes so far to eliminate bias. The problem becomes more acute as members drop out — and is compounded by dealers running the ensuing auction when they declare a credit event.

This is also a problem of bad comms. The DCs' website is not very friendly to navigate, and you can’t even locate the page address easily with a Google search. Rules transparency could be greatly improved, with clearer guidelines on pertinent sections of the Isda docs and how to trigger a credit event.

Serious consideration should be given to whether this could all be handled by an external panel, and what that would look like. There is also often no explanation when a credit event question is rejected without consideration — only when it reaches the threshold of being considered and voted on.

In the case of Casino Guichard-Perrachon last year there were some causes for complaint among market participants in how that was handled. There was a delay in publishing a failure to pay decision and the second bankruptcy question was likewise allowed to lapse beyond the expiry of some CDS contracts. The European DC cited a need for public info — meaning, press reports — which jarred with rating agency S&P having already declared a selective default on Casino (which everyone in the market knew about).

Solutions would include a separate (or replacement) panel that is independent. Credit event questions could be automatically sent to external review, perhaps in tandem with the DCs. Or how about use AI to sort it out, based on the DC rules and recourse to precedents. This could be a great opportunity to showcase machine learning.

The best way of getting checks and balances would likely be to have a House and Senate type of set up to oversee decisions. At the moment it looks more like a politburo.

The media also has a charge to answer here. Too often my peers like to play up how things are arcane and incomprehensible, without taking the time to read through documentation, auction rules or the reasoning behind credit event decisions. And, since the financial crisis, there has been a lack of training for new journalists on how the process works, or what a CDS even is.

We have to take some responsibility. In any credit event decision or credit auction result it is easy to find a buysider who was on the wrong side of the trade. That makes it easy to bate someone to accuse the dealers of conspiring on the result, but it doesn't make it true.

The Europcar auction in January 2021 was loudly lambasted in the press (lapping up the outrage of unnamed sources) for returning a 100% recovery price. It turned out the reason this came unstuck was because so many opportunists piled into shorting the name, once the credit event question had been raised, that orders outstripped available bonds. Those who had been short before on a genuine credit conviction had long since cashed out, before the auction operated exactly as its rules dictated.

And of course with the current DC rules — which do need an overhaul — there are perks for a journalist in being central to the filing of a credit event question. At my previous employer I was thrilled and bemused to find our report on Russia was cited in a question to the DC that caused the sovereign CDS to trigger.

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