• The Continuing Evolution of Credit Derivatives: ISDA Publishes 2009 Supplement and Protocol
  • April 15, 2009 | Authors: Kenneth A. Kopelman; Stephen C. Tirrell; Christine L. Ayotte-Brennan
  • Law Firms: Bingham McCutchen LLP - New York Office; Bingham McCutchen LLP - Boston Office
  • Overview

    Credit default swaps and other credit derivative transactions (“CDS”) have been at the center of discussions involving the recent credit crisis and a central topic in discussions of regulatory reform. Partly as a result of recent events and to address the ongoing concerns discussed below, the International Swaps and Derivatives Association, Inc. (“ISDA”) has published the 2009 Credit Derivatives Determinations Committees and Auction Settlement Supplement to the 2003 ISDA Credit Derivatives Definitions (the “2009 Supplement”) and the related 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement CDS Protocol (the “Protocol”).

    From its inception in the early 1990’s, the CDS market grew very quickly and its accelerated growth has led to and revealed certain risks and issues. These include documentation risk, operational risk, settlement risk, legal uncertainty and counterparty credit risk. Led by ISDA and strongly encouraged by the Federal Reserve Bank of New York, the CDS dealer community, along with various buy-side market participants, has been addressing these risks over the last few years. Notable successes include the clearing of large backlogs of undocumented transactions, the streamlining of documentation forms and the imposition of market discipline on the process for assigning (novating) transactions. Work is also in process to increase transparency in the market through the publication of market data, and central clearing facilities are commencing operations, which should help address counterparty credit issues. None of these efforts is likely to be sufficient to forestall more regulation of this over-the-counter derivatives market.

    Two fundamental issues are addressed by the 2009 Supplement:

    • Settlement Issues. CDS were designed as a physically-settled product. Following a Credit Event (as defined in the 2003 ISDA Credit Derivatives Definitions), the protection buyer is obligated to deliver a conforming debt instrument to the protection seller in exchange for par. Over the last few years, the high volume of CDS created the potential for market destabilizing shortages of physical instruments to deliver, which in turn could have led to price distortions and settlement failures. In response, ISDA developed protocols that permitted a clearing price to be determined through an auction process, thus avoiding the need for physical settlement for protocol adherents. To date auction protocols have generally worked well, but participation has been wholly elective. The 2009 Supplement and Protocol will standardize the auction settlement process and will have market participants agree in advance to participate in the auction process for all classes of CDS, save a few that are specifically excluded.
    • Uncertainty as to Questions of Interpretation. CDS confirmations contain critical terms that are subject, from time to time, to differing interpretations. The most critical of these is the determination of whether a Credit Event or a Succession Event (defined below) has occurred, and whether certain instruments or obligations are eligible for delivery to a seller of protection following a Credit Event, or are eligible for inclusion in an auction. Uncertainty regarding these determinations has led to much heated discussion but has not yet led to significant financial dislocation or litigation. We think that may just be fortuitous and that eventually serious interpretive disagreements might lead to significant market problems. The 2009 Supplement creates regional Credit Derivatives Determination Committees that will determine these matters and such determinations will be binding on all parties to transactions that incorporate the 2009 Supplement.

    A summary of the 2009 Supplement and the Protocol follows.

    The 2009 Supplement

    The 2009 Supplement makes three major modifications to the 2003 ISDA Credit Definitions that will govern both new transactions and outstanding Protocol Covered Transactions (as defined in the Protocol):

    • “hard-wiring” auction settlement 
    • establishing five regional Credit Derivatives Determinations Committees to make determinations relating to Credit Events and other CDS-related matters
    • introducing a “backstop date” for Credit Events and Succession Events

    Auction Settlement

    The 2009 Supplement may be incorporated into the confirmations of new CDS transactions and will amend the terms of each outstanding Protocol Covered Transaction entered into by parties signing on to the Protocol (“Adhering Parties”). The 2009 Supplement provides for auction settlement to apply to each such transaction upon the occurrence of a Credit Event. In the event that an auction fails, the 2009 Supplement also provides for a “fallback” settlement of the transaction by way of physical or cash settlement (as specified in the original confirmation that governs the transaction). Certain types of transactions are excluded from the auction settlement mechanism.

    The auction methodology set forth in the 2009 Supplement is similar to recent auctions sponsored by ISDA over the last few years, although specific auction terms will be published following the determination by the relevant Determinations Committee that a Credit Event has occurred. The “hard-wiring” of the auction settlement mechanism is designed to standardize the auction procedures and ensure the efficient settlement of CDS without the need for market participants to agree to a new protocol each time a Credit Event occurs.

    Credit Derivatives Determinations Committees

    The 2009 Supplement also provides for the formation of five different regional committees of rotating ISDA members (each, a “Determinations Committee” and collectively, the “Determinations Committees”) to make determinations regarding the details of each Credit Event. The five regions for which a Determinations Committee will be formed are: (1) the Americas; (2) EMEA (Europe); (3) Australia-New Zealand; (4) Asia, excluding Japan; and (5) Japan.

    Each Determinations Committee will be comprised of eight global dealers, two regional dealers, five buy-side members, two non-voting dealers (one global, one regional) and one non-voting buy-side member. Criteria for dealers to be included on a Determinations Committee will be based on trading volume. Non-dealer members that wish to be considered for inclusion in the pool of members in the non-dealer committee (the “Non-dealer Committee”) from which buy-side members of the Determinations Committee are randomly chosen must have (i) at least $1 billion in assets under management and (ii) notional single-name CDS trade exposure of at least $1 billion. Non-dealer members of the Determinations Committees will serve staggered one-year terms.

    The Determinations Committees will, in effect, supersede the role of the Calculation Agent for many material issues that can arise in a CDS. The Determinations Committee will be responsible for determining, among other things:

    • the effective date for, and type of, Credit Event
    • the date on which the requirement to deliver a notice of publicly available information with respect to a Credit Event is satisfied
    • the date of receipt of a Credit Event notice
    • what obligations of the relevant reference entity will constitute obligations that may be delivered to a counterparty in satisfaction of a buyer’s obligations upon the occurrence of a specified Credit Event
    • whether to hold one or more auctions with respect to a Credit Event and reference entity, and the details surrounding each auction

    In order for the decisions of a Determinations Committee to be binding, at least 80% of the members of the committee must vote in favor of that decision. In the event that an 80% supermajority is not achieved on any question, a panel of external reviewers (the “External Review Panel”) will be convened to review the question and potentially overturn the decision of the Determinations Committee. In order for the External Review Panel to overturn the decision of a Determinations Committee, (i) 2 out of 3 of the members of the panel must vote in the affirmative if the original vote of the Determinations Committee did not exceed 60%, or (ii) all three members of the panel must vote in the affirmative if the original vote of the Determinations Committee was between 61% and 79%. The External Review Panel will be chosen from a pool that is made of industry experts nominated by ISDA members. The members of each External Review Panel will be chosen with the unanimous approval of the applicable Determinations Committee or by ISDA (which serves as the secretary to each Determinations Committee). Market participants may present arguments to make their case with respect to each question presented to the External Review Panel.

    Market participants can petition the Determinations Committees to consider whether an event constitutes a Credit Event and, if so, the date of the occurrence of the event. In order to convene a Determinations Committee for any question, a market participant must provide notice to ISDA and the basis on which the request is made. Any determinations made by a Determinations Committee will be binding on all parties with respect to transactions that are subject to the 2009 Supplement.

    Backstop Dates for Credit Events and Succession Events

    The 2009 Supplement also includes a provision that the Determinations Committees must determine whether a Credit Event or a Succession Event (each as defined in the 2003 Credit Definitions) has occurred within a specific number of days of the date that a notice of such event is provided to the Determinations Committees (each, a “backstop date”). The backstop dates for Credit Events and Succession Events, for all transactions subject to the 2009 Supplement, will be 60 days and 90 days, respectively, from the date that a Determinations Committee receives notice of such event. Under the 2003 Credit Definitions, a Credit Event or a Succession Event can only occur with respect to a credit derivatives transaction if such event occurs after the effective date of the transaction but before the termination date. However, under the 2009 Supplement, a Credit Event or a Succession Event can be deemed to occur with respect to a transaction up to 60 or 90 days, respectively, prior to the effective date of the transaction. This effectively means that on any particular day during the term of a transaction a Credit Event or a Succession Event can be deemed to have occurred only if the relevant event occurred no more than 60 or 90 days, as applicable, prior to the date on which a request to the relevant Determinations Committee was determined to be effective.

    The Protocol

    The Protocol is the mechanism by which Adhering Parties can elect to incorporate the provisions of the 2009 Supplement into the terms of each “Protocol Covered Transaction.” It is open for adherence by all parties until April 7, 2009 and will take effect on April 8, 2009. The Protocol allows Adhering Parties to Protocol Covered Transactions to incorporate the terms of the 2009 Supplement into the terms of their existing trades as well as those trades that are entered into after April 7, 2009. Certain transactions specified in the Protocol such as “Loan Only Transactions,” “U.S. Muni Transactions,” “CDS on ABS Transactions” and “Excluded Index Transactions” are not covered by the Protocol. In addition, parties to a credit derivatives transaction may bilaterally agree to exclude any transaction from the provisions of the Protocol (and the 2009 Supplement).

    In order to be considered an Adhering Party, a party to a Protocol Covered Transaction must deliver to ISDA both a manually signed and conformed Adherence Letter in the form provided by ISDA by April 7, 2009, or such later date as ISDA subsequently determines and publishes (the “Cut-Off Date”). A party will not be an Adhering Party unless it has delivered both a manually signed and conformed copy of the Adherence Letter to ISDA on or prior to the Cut-Off Date.

    The agreement between Adhering Parties to make the amendments contemplated by the Protocol will be effective as of the date of delivery of the Adherence Letter to ISDA from the later of the Adhering Parties to adhere, and the amendments will be effective as of April 8, 2009 with respect to each Protocol Covered Transaction entered into between the parties prior to April 8, 2009. Separate rules apply for CDS transactions entered into or novated between Adhering Parties after April 8, 2009.

    Adhering Parties may agree by separate bilateral agreement that one or more CDS transactions entered into between them will not be amended in accordance with the Protocol. Accordingly, it is advisable for any party that wishes to become an Adhering Party but also wishes to exclude one or more CDS transactions from the Protocol to contact the relevant counterparty or counterparties to implement an agreement prior to delivering its Adherence Letter to ISDA.


    The Protocol and the Supplement provide a great amount of detail as to how CDS transactions will be conducted and interpreted. These changes will have a significant impact on specific CDS transactions and on the CDS market generally. The full consequences of these changes will be determined over time as they are tested in the changing market. It is important that institutions trading these products have an understanding of these changes and closely monitor their impact on existing and newly-established positions.