Credit Derivatives

CFTC Proposes Amendments to Recordkeeping Requirements

 

On January 12, the Commodity Futures Trading Commission (“CFTC”) unanimously approved the proposal of numerous amendments to CFTC Regulation 1.31, the regulation that sets forth the recordkeeping requirements for records required to be kept under the U.S. Commodity Exchange Act (the “Act”) and the CFTC’s regulations, including with respect to swaps.[1]  The proposed amendments are largely intended to modernize and make technology-neutral the form and manner in which regulatory records are kept.[2]

The last major revision of Regulation 1.31 was made in 1999, when records were largely kept in paper form and before the prevalence of advanced electronic information systems. [3]  Through the proposed amendments, the CFTC intends to update, reorganize and, effectively, re-write Regulation 1.31, while maintaining its ability to examine and inspect required records.[4] READ MORE

CFTC Delays Reduction in Swap Dealer De Minimis Exception Threshold

 

On October 13, 2016, the Commodity Futures Trading Commission (the “CFTC”) approved an Order delaying for one year the reduction of the threshold for determining whether an entity constitutes a “swap dealer” for purposes of the U.S. Commodity Exchange Act.[1]  Currently, persons are not considered to be swap dealers unless their swap dealing activity in aggregate gross notional amount measured over the prior 12-month period exceeds a de minimis threshold of $8 billion.  This threshold had been scheduled to automatically decline to $3 billion on December 31, 2017, but the Order extended that date to December 31, 2018, absent further action from the CFTC. READ MORE

CFTC Expands Swap Clearing Requirement

 

On September 28, 2016, the Commodity Futures Trading Commission (the “CFTC”) unanimously approved the expansion of currencies of interest rate swaps subject to mandatory clearing under the U.S. Commodity Exchange Act (the “Act”).[1]  Subjecting standardized swaps to central clearing is intended to decrease risk in the financial system and has been a primary goal of global regulators for several years.

Section 2(h) of the Act makes it unlawful for any person to engage in a swap that is required to be centrally cleared unless that swap is submitted to a derivatives clearing organization (a “DCO”) that is either registered under the Act or exempt from registration under the Act.[2]  This same section of the Act sets forth the process through which the CFTC is to make determinations of whether a swap, or group, category, type or class of swaps should be subject to mandatory clearing.[3] READ MORE

An Overview of Proposed Regulation AT

Orrick attorneys authored an overview of Regulation Automated Trading (known as “Regulation AT”) proposed by the Commodity Futures Trading Commission (“CFTC”) in the May/June 2016 issue of the Journal of Taxation and Regulation of Financial Institutions.  The “overarching goal” of proposed Regulation AT is to update the CFTC’s rules in response to the development and prevalence of electronic trading.  The article is titled “Regulation Automated Trading in Derivatives: An Overview of the CFTC’s Proposed Regulation AT” and is available here.

SEC Amends Rules on Security-Based Swap Reporting

On July 13, 2016, the Securities Exchange Commission (“SEC”) approved certain amendments and guidance to the rules governing the reporting and public dissemination of security-based swaps (“SBS”), known as “Regulation SBSR,”[1] which were adopted in February 2015.  The amendments and guidance are intended to increase transparency in the SBS market.

Generally, Regulation SBSR provides for the reporting of SBS information to registered security-based swap data repositories (“SBSDRs”), as well as the public dissemination of SBS transaction data. The amendments and guidance address certain open issues in the Regulation SBSR adopting release, and also clarify how Regulation SBSR would apply to SBS activity engaged in by non-U.S. persons within the United States. READ MORE

Novo Banco and CDS – A Post-Mortem

In 2014, the International Swaps and Derivatives Association, Inc. (“ISDA”), published the 2014 ISDA Credit Derivatives Definitions (the “Definitions”), which updated the 2003 ISDA Credit Derivatives Definitions.[1]

One of the most significant changes in the Definitions was the inclusion of a new credit event for “Governmental Intervention.”[2]  This credit event was intended to address concerns expressed in the market that the credit event for “Restructuring” may not cover certain measures actually taken by governments to support struggling entities, especially banks.  Governmental Intervention[3] is generally defined to include actions or announcements by a “Governmental Authority”[4] that result in, inter alia, the reduction in the rate or amount of interest payable by a reference entity, an expropriation or other event which mandatorily changes the beneficial holder of the relevant obligation, or a mandatory cancellation, conversion or exchange.  This event is similar to Restructuring in certain respects (for example, the reduction in the rate or amount of interest of an obligation may trigger both events).  However, unlike Restructuring, deterioration in creditworthiness is not required to trigger a Governmental Intervention.

It did not take long for this new credit event to be probed and tested by a set of straightforward, but unusual, facts that apparently were not specifically considered by the drafters. In August 2014, Banco de Portugal, the central bank of Portugal, applied resolution measures to Banco Espírito Santo, S.A. (“BES”), a bank organized in Portugal that was experiencing distress.  These measures included a €4.9 billion rescue package for BES, and the transfer of numerous assets, liabilities and deposit-taking operations from BES to a new “good bank,” Novo Banco, S.A. (“Novo Banco”).  However, on December 29, 2015, Banco de Portugal announced the re-transfer of five senior Euro-denominated bonds (having almost €2 billion in principal) from Novo Banco back to BES.[5]  This re-transfer resulted in significant losses to bondholders, up to 90% in secondary market trading.

It was clear that Banco de Portugal constituted a “Governmental Authority” and that it had taken a binding action pursuant to its resolution law. However, irrespective of the undeniable losses suffered by creditors,[6] there was an issue as to whether the re-transfer of the bonds at issue from BES to Novo Banco affected creditors’ rights in one of the ways specified in Section 4.8(a) of the Definitions.

In accordance with the standard practice in the credit default swap (“CDS”) market, purchasers of protection asked the relevant 15-member Determinations Committee (the “Committee”) to determine whether the central bank’s actions amounted to a Governmental Intervention, hence triggering protection payments under CDS contracts.  Under the relevant rules, an 80% supermajority (12 of 15 members) is required for a Committee to decide whether or not a credit event has occurred.[7]   The Committee fell just short of the required percentage, with 11 members voting that there was no Governmental Intervention.  Although the Governmental Intervention event was generally intended to protect investors from governmental actions negatively affecting the value of obligations, the majority of the Committee concluded that the transfer of debt to another institution did not constitute a “mandatory cancellation, conversion or exchange” and did not have “an analogous effect” to the events specifically enumerated in the definition of Governmental Intervention.

Nevertheless, without the required supermajority, pursuant to the relevant rules governing Committees, the matter was referred for “external review.”[8]  External reviews of Committee decisions are quite rare and entail at least three “experts” nominated by Committee members deciding the issue.  A unanimous decision is needed to override the Committee’s original “No” vote where, as here, over 60% of Committee members voted against the occurrence of a credit event.  On February 15, 2016, the external review panel released a unanimous decision to uphold the negative determination.  In short, the panel decided that the central bank’s transfer did not constitute a mandatory cancellation, conversion or exchange of the obligations, and was not analogous to those types of event.[9]  On the latter point, the panel stated that taking a broader review of the word “analogous” would result in this clause “dominat[ing] the whole of the definition, which is inconsistent with [the] careful and detailed drafting” of the definition.[10]

In addition to seeking a determination that a Governmental Intervention had occurred, protection buyers pursued one more potential avenue for payout under the Definitions: seeking a determination that a “successor” event had occurred with respect to CDS naming Novo Banco as reference entity. A successor event occurs under the Definitions if, generally, more than 25% of the relevant obligations of a reference entity are transferred to another entity and more than 25% of the relevant obligations of the reference entity remain with the reference entity.[11]  The Committee sought additional information from Banco de Portugal and Novo Banco to determine whether this threshold had been exceeded.  After receiving this additional information, the Committee unanimously decided on March 3, 2016 that a successor event did not occur.[12]

Many industry participants believed that the Governmental Intervention was designed to protect against precisely the type of result that precipitated from Banco de Portugal’s actions.  Nevertheless, the Committee concluded, and the external review panel agreed, that the actions of Banco de Portugal did not align with the requirements of the Definitions.  Thus, one lesson from this situation is that Determinations Committees may take a formalistic view of requirements under the Definitions, regardless of the scope of losses incurred by creditors or the spirit or purpose of the language in the Definitions.  CDS purchasers should take note and not overlook the precise words of the Definitions.


[1] The implementation date for the updated Definitions was September 22, 2014.

[2] For a more complete description of the changes to ISDA Credit Derivatives Definitions, click here.

[3] “Governmental Intervention” is defined in full, as follows:

(a) “Governmental Intervention” means that, with respect to one or more Obligations and in relation to an aggregate amount of not less than the Default Requirement, any one or more of the following events occurs as a result of an action taken or an announcement made by a Governmental Authority pursuant to, or by means of, a restructuring and resolution law or regulation (or any other similar law or regulation), in each case, applicable to the Reference Entity in a form which is binding, irrespective of whether such event is expressly provided for under the terms of such Obligation:

(i) any event which would affect creditors’ rights so as to cause:

(A) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals (including by way of redenomination);

(B) a reduction in the amount of principal or premium payable at redemption (including by way of redenomination);

(C) a postponement or other deferral of a date or dates for either (I) the payment or accrual of interest, or (II) the payment of principal or premium; or

(D) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation;

(ii) an expropriation, transfer or other event which mandatorily changes the beneficial holder of the Obligation;

(iii) a mandatory cancellation, conversion or exchange; or

(iv) any event which has an analogous effect to any of the events specified in Sections 4.8(a)(i) to (iii).

Definitions, §4.8(a) (emphasis added).

[4] The term “Governmental Authority” includes, inter alia, any de facto or de jure government (or agency, instrumentality, ministry or department thereof), any court, tribunal administrative or other governmental, inter-governmental or supranational body and any authority or other entity designated as a resolution authority or charged with the regulation or supervision of the financial markets of the “reference entity” or some or all of its obligations.  Definitions, §4.9(b).

[5] It appears from Banco de Portugal’s announcement of the measure that it specifically selected these bonds because they were “intended for institutional investors.” See Banco de Portugal, Banco de Portugal approves decisions that complete the resolution measure applied to BES (December 29, 2015) (available at: https://www.bportugal.pt/en-US/OBancoeoEurosistema/ComunicadoseNotasdeInformacao/Pages/combp20151229-2.aspx). Among other things, the central bank stated that “[t]he selection of the above-mentioned bonds was based on public interest and aimed to safeguard financial stability and ensure compliance with the purposes of the resolution measure applied to Banco Espírito Santo, S.A. This measure protects all depositors of Novo Banco, the creditors for services provided and other categories of unsecured creditors.” Id.

[6] Some US$430 million in net protection payments would be triggered if it was determined that a credit event had occurred.

[7] ISDA supported a decision of a Governmental Intervention having occurred, arguing that the re-transfer of the bonds at issue constituted a “conversion or exchange” or had “an analogous effect” to an exchange, and that a negative determination “would lead to an illogical outcome.” See ISDA Determinations Committee Request, Has a Governmental Intervention Credit Event occurred with respect to Novo Banco, S.A.? (December 30, 2015) (available at http://dc.isda.org/documents/2016/01/novo-banco-pai-3.pdf). Specifically, ISDA argued as follows:

A decision that a Governmental Intervention has not occurred would lead to an illogical outcome where holders of the Transferred Bonds suffer a near complete economic loss for the arbitrary reason that they are institutional investors, but this loss is not mitigated by their CDS protection despite paying a higher premium for protections against the risk of governmental interventions.  This outcome will further diminish CDS’s efficacy as a tool to hedge credit risk and further erode confidence in the product. . . .  This action is taken under the “bail in” regime that the European banking regulators seek to implement, and is precisely the type of governmental intervention risk that the Definitions were designed to cover.

[8] Specifically, Section 4.1(a) of the 2014 ISDA Credit Derivatives Determinations Committees Rules (available at http://www.isda.org/credit/docs/ICM-2319997111-v10-DC_Rules_2014.pdf) provides that “[a]ny DC Question relating to DC Resolutions to be made by Supermajority under . . . 3.1(c) (Credit Event Resolution) . . . shall be referred to the external review process described in this Section 4 (External Review) . . . if a Convened DC . . . holds a binding vote on, but is unable to Resolve by a Supermajority, such DC Question.”

[9] Among other things, the panel pointed to the use of the word “transfer” elsewhere in the Definitions and concluded that “it would seem . . . that the draftsman has deliberately decided not to include the expression of ‘transfer’ as an event within the definition of a [Governmental Intervention].”  Novo Banco External Review; Decision and Analysis of the External Review Panel of the ISDA EMEA Determinations Committee with respect to DC issue Number 2015123002 pursuant to Section 4 of the 2016 ISDA Credit Derivatives Determination Committees Rules, at 4 (February 15, 2016) (available at http://dc.isda.org/documents/2016/02/nb-er-decision.pdf).

[10] Id. at 6.

[11] Definitions, at §2.2(a). More specifically, in this case, if the Committee concluded that BES succeeded to more than 25% of Novo Banco’s relevant obligations but more than 25% of relevant obligations remained with Novo Banco, then the CDS would be divided accordingly into new CDS transactions with each of BES and Novo Banco, respectively, as the reference entity. See id. at §2.2(a)(iv) and 2.2(n).

[12] See ISDA EMEA Credit Derivatives Determinations Committee, Statement (March 3, 2016) (available at: http://dc.isda.org/documents/2016/03/emea-dc-meeting-statement-3-march-2016.pdf). It appears that, in addition to Novo Banco’s €7.35 billion of outstanding senior debt, the European Central Bank had provided Novo Banco with some €7 billion in loans. Therefore, €2 billion of re-transferred bonds constituted less than 25% of Novo Banco’s aggregate obligations at the time.

Publication of 2014 ISDA Credit Derivatives Definitions

On February 21, the International Swaps and Derivatives Association, Inc. (“ISDA”) announced the publication of the 2014 ISDA Credit Derivatives Definitions (the “2014 CD Definitions”), which amend several terms that existed in the 2003 version of the definitions, and introduce several new terms based on “lessons learned.”

The most important new terms in the 2014 CD Definitions are in response to events affecting financial institutions and sovereign entities that have occurred since the introduction of the 2003 version of definitions, including governmental interventions in bank debt.  These new terms include an entirely new credit event known as “Governmental Intervention,”[1] which is intended to be triggered upon a government-initiated “bail-in”[2] or debt restructuring, as well as a provision for delivery of instruments resulting from a government-initiated debt exchange.

In recent years, concerns have been expressed that the credit event for “Restructuring” may not cover certain measures actually taken by governments to support struggling entities, especially banks.  For example, there was uncertainty as to whether a Restructuring had been triggered by the February 2013 nationalization of SNS Bank NV, the fourth largest bank in the Netherlands, by the Dutch government and the expropriation of all of its subordinated bonds.[3]  This uncertainty was caused primarily because “expropriation” was not expressly included as a triggering event in the 2003 definition of Restructuring.

The Governmental Intervention credit event is intended to fill this gap in protection.  Governmental Intervention is defined to include actions or announcements by a “Governmental Authority”[4] that result in, inter alia, the reduction in the rate or amount of interest payable by a reference entity, an expropriation or other event which mandatorily changes the beneficial holder of the relevant obligation, or a mandatory cancellation, conversion or exchange.  This event is similar to Restructuring in certain respects (for example, the reduction in the rate or amount of interest of an obligation may trigger both events).  However, unlike Restructuring, deterioration in creditworthiness is not required to trigger the Governmental Intervention credit event.

In addition to the new credit event, the 2014 CD Definitions also introduce the ability to settle certain credit events by delivery of assets into which debt is converted.  This change was prompted, at least in part, by Greece’s 2012 debt restructuring, in which the Greek government used a “collective action clause” under domestic law to exchange certain debt before an auction to settle credit default swaps could be held.  A final settlement price for contracts is typically determined by holding an auction for the defaulted bonds.  The result of the debt exchange was that there were fewer bonds constituting “deliverable obligations” for purposes of the auction.  As we have previously highlighted, credit protection buyers were spared serious losses in connection with the credit event caused by the Greek debt restructuring because the price for the new bonds delivered at the auction closely approximated the level of loss sustained by private investors on the old bonds.[5]  Nevertheless, the Greek debt exchange highlighted the need to address a potential disconnect in prices under similar circumstances in the future.

In response, the 2014 CD Definitions provide for new “Asset Package Delivery” provisions.  These provisions generally apply upon the occurrence of an “Asset Package Delivery Event,” which is defined to include events such as a Restructuring with respect to a sovereign entity.  Under the new provisions if, for example, a sovereign Restructuring credit event occurs, the assets that will be deliverable into an auction will be based on “Package Deliverable Bonds,” which are obligations that qualified as deliverable obligations at the time the Asset Package Delivery Event became effective and that are selected by ISDA based on certain specified criteria and published on its (or a third party designee’s) website.

ISDA has stated that it expects market participants to begin confirming transactions using the 2014 CD Definitions starting in September 2014.  A protocol will also be established to allow parties to utilize the 2014 CD Definitions for existing transactions.


[1] This new credit event, is defined as follows:

“(a) ‘Governmental Intervention’ means that, with respect to one or more Obligations and in relation to an aggregate amount of not less than the Default Requirement, any one or more of the following events occurs as a result of an action taken or an announcement made by a Governmental Authority pursuant to, or by means of, a restructuring and resolution law or regulation (or any other similar law or regulation), in each case, applicable to the Reference Entity in a form which is binding, irrespective of whether such event is expressly provided for under the terms of such Obligation:

(i) any event which would affect creditors’ rights so as to cause:

(A) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals (including by way of redenomination);

(B) a reduction in the amount of principal or premium payable at redemption (including by way of redenomination);

(C) a postponement or other deferral of a date or dates for either (I) the payment or accrual of interest, or (II) the payment of principal or premium; or

(D) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation;

(ii) an expropriation, transfer or other event which mandatorily changes the beneficial holder of the Obligation;

(iii) a mandatory cancellation, conversion or exchange; or

(iv) any event which has an analogous effect to any of the events specified in Sections 4.8(a)(i) to (iii).”

[2] A “bail-in” is when a borrower’s creditors are forced to partially bear some of the burden of assistance through a write-off (in contrast, a “bail-out” is when a government or external investors rescue a borrower, whether by infusing cash or assisting in the servicing of debt).  See What is a bail-in?, The Economist (April 7, 2013).

[3] See generally Letter of Minister of Finance Dijsselbloem to Parliament (English translation), dated February 1, 2013 (stating that “[i]t has been decided to expropriate the securities and other assets not only of SNS Bank but also SNS REAAL (the holding company). . . . the expropriation extends to both shares and subordinated creditors.”).  After deferring a decision on two separate occasions, the relevant ISDA determinations committee ultimately decided by a vote of 14 to 1 that a Restructuring had occurred.

[4] “Governmental Authority” is defined in Section 4.9(b) of the 2014 CD Definitions to include the following:

“(i) any de facto or de jure government (or any agency, instrumentality, ministry or department thereof);

(ii) any court, tribunal, administrative or other governmental, inter-governmental or supranational body;

(iii) any authority or any other entity (public or private) either designated as a resolution authority or charged with the regulation or supervision of the financial markets (including a central bank) of the Reference entity or some or all of its obligations; or

(iv) any other authority which is analogous to any of the entities specified in Sections 4.9(b)(i) to (iii).”

[5] See [DIR May 7, 2012].

Greece Triggers Credit Event and Raises Questions for Sovereign CDS

On March 9th, the ISDA Determinations Committee for Europe unanimously concluded that The Hellenic Republic (Greece) had triggered a restructuring “credit event” under credit default swap (“CDS”) contracts in connection with the exchange of its debt with private creditors.  The committee’s determination was based in large part on the imposition and use by Greece of retroactive “collective action clauses” (“CACs”) on bonds governed by Greek law which bound all holders of such debt to the decisions of a supermajority.  In accordance with the 2003 ISDA Credit Derivatives Definitions, a restructuring credit event (whether due to a reduction of coupon, extension of maturity or other specified change) is not triggered unless the restructuring “occurs in a form that binds all holders.”

When it was first announced in October 2011, the Greek debt exchange appeared to be carefully structured to avoid a credit event by making the exchange with private investors voluntary.  However, as Greece’s economic situation deteriorated (or became more apparent) in the months that followed, private investors became more reluctant to participate, which precipitated the imposition of the CACs.  The final debt exchange deal with private investors, which is intended to help reduce the Greek debt load from 165 percent of GDP in 2011 to below 120 percent by 2020, resulted in a real loss of some 74% on bond holdings.[1]  On March 19th, ISDA held an auction for the Greek bonds and established a recovery rate of 21.5%, resulting in net payouts of some €2.89 billion (i.e., 78.5% of the approximately €3.7 billion net notional amount of protection out of some €80 billion in gross CDS notional).

Despite many commentators’ concerns, the settlement of CDS contracts in the wake of the determination of a Greek credit event did not lead to broader market turmoil and has been widely viewed as a success.[2]   Nevertheless, the CDS market’s experience in connection with Greece’s credit event, and other developments, have generated substantial apprehension and raised several questions regarding the future of the sovereign CDS market.  One of these questions is whether the sovereign CDS product, as it currently exists, can be too easily circumvented.  Specifically, many market participants expressed dissatisfaction when it became apparent that the Greek debt exchange, as it was originally proposed, would not trigger a credit event due to its “voluntary” nature, arguing that such a comprehensive restructuring should trigger protection payments under CDS contracts.  Although a credit event was eventually triggered, the confusion regarding the circumstances under which a credit event would occur in the case of a sovereign debt restructuring has led to calls to modify the relevant ISDA definitions to deal with similar situations in the future.[3]

Another concern has been voiced regarding the bonds deliverable in the ISDA settlement auction itself.  Specifically, auction bidders were primarily able to bid only on the new Greek law governed bonds issued in the Greek debt exchange, because the old bonds (other than international law governed bonds) generally had been retired and no longer existed at the time of the auction.  There was concern that the price of these new bonds, which necessarily looked to Greece’s risk profile after the extinguishment of debt through the bond exchange, would be higher than the price of the original bonds which, in turn, would lead to a lower CDS recovery rate.  Fortunately, and somewhat fortuitously, the price for the new bonds closely approximated the level of loss sustained by private sector investors.

Another concern is the potential impact of the European Union’s recent ban on “naked” sovereign CDS, which came into effect on March 25th, but will apply beginning November 1, 2012.  The ban, which includes certain exemptions, will be overseen by the European Securities and Markets Authority (“ESMA”).  However, the draft guidance published by ESMA[4] regarding the ban raises questions regarding how determinations of violations will be made.  For example, it appears that the ban could cover “cross border” situations where a market participant seeks to hedge exposure in a sector of one sovereign (e.g., Italian banks) by purchasing protection against the default of another sovereign (e.g., Cyprus).  The existence of the ban itself, and any confusion caused by the breadth of its potential enforcement, may lead some market participants to exit the sovereign CDS market.

 


[1] On April 25th, the Greek finance ministry announced that 96.9% of debt held by private bondholders (some €199 billion out of a total €205.5 billion) had been exchanged.

[2] Indeed, it remains to be seen whether the potential settlement of CDS contracts for a sovereign for which there are far larger volumes would lead to market panic and present systemic risk.  The approximately €3.7 billion net notional amount of CDS contracts on Greece at the time of its credit event is dwarfed by the current net notional amount of CDS contracts on other sovereigns, including approximately €22 billion on France and between €18-20 billion on each of Italy, Germany and Brazil.

[3] On a related note, the future involvement of clearinghouses in making determinations regarding CDS contracts (including whether credit events have occurred) has also become a recent topic of market discussion.

[4] ESMA’s draft technical advice on possible Delegated Acts concerning the regulation on short selling and certain aspects of credit default swaps (EC) No XX/2012) (15 Feb 2012).