Forthcoming CDS Convention Changes

Transcription

1 Forthcoming CDS Convention Changes September 14th, 2009

2 Contents Executive Summary... 3 Convention Changes... 5 Fixed Coupons... 5 Trading with a Full Coupon... 5 Restructuring Clause Conventions... 6 Payment Frequency... 6 Roll/Maturity Dates... 6 Quoting Conventions... 7 Markit CDS Converter and ISDA CDS Standard Model... 7 Migration of Old Contracts to New Contracts/Conventions... 9 Portfolio Recouponing... 9 Conclusion

3 Executive Summary Why is the CDS Market Changing? The industry continues to extend contract standardization to other areas of the CDS markets. This report outlines the convention changes for several classes of CDS transactions. The transactions include corporate and sovereign CDS for Australia, New Zealand, Emerging Markets, Japan, and Asia ex-japan, Australia, & New Zealand (Asia ex-jan). Emerging Markets here includes Eastern and Central Europe, Latin America, and the Middle East. The motivations for these convention changes are facilitate central clearing, gain efficiencies in trade and operational processing, and reduce the gross notional amount outstanding in the market the same motivations behind CDS Big Bang and CDS Small Bang. Global Contract Changes Our previous reports on the CDS Big Bang and Small Bang provide extensive detail on global contract changes to CDS contracts to date. Both reports are available at Unlike Big Bang and Small Bang, the changes discussed in this report consist of only convention changes there are no new contract changes at this time. The contract changes from Big Bang and Small Bang, at their time of implementation, did apply to these classes of CDS transactions as well. Convention Changes As the changes discussed here consist only of convention changes, not contract changes, there will not be any protocols to modify the terms of existing trades or supplements to amend the 2003 ISDA Credit Derivative Definitions. There will however be new confirmation templates and product matrices similar to what accompanied the convention changes in North America and Europe earlier this year. The convention changes are: Quoting Conventions and Coupons Starting September 21 st, 2009 there will be 100 and 500 fixed strikes for corporate and sovereign CDS for Australia, New Zealand, and Emerging Markets similar to the convention of North American corporates following CDS Big Bang. While standard recovery rate assumptions for single name corporate and sovereign CDS is typically 40% for senior and 20% for subordinated, which is the case for Australian and New Zealand CDS as well, the recovery rate assumption for Emerging Markets transactions is 25% for both senior and subordinated trades. Japan is expected to adopt standard coupon strikes of 25, 100, and 500 basis points starting December 21 st, Recovery rate assumptions of 35% for senior and 15% for subordinated are expected. The 25 strike would be used for particularly tight credits. Asia ex-jan is likely to follow Japanese conventions closely. Convention changes for Japan and Asia ex-jan are awaiting industry approval at the time of writing and could ultimately change. Restructuring For clarity, there will be no changes to the restructuring clause conventions for Australian, New Zealand, Emerging Markets, Japanese, or Asia ex-jan CDS whether corporate or sovereign. The restructuring convention continues to be Modified Restructuring (Mod R) for Australian and New Zealand CDS, Restructuring (Old R) for Emerging Markets, Japanese, and Asia ex-jan CDS. Full First Coupon Similar to the SNAC contract, there will be no more short stubs or long stubs dependent on the trade date for Australian, New Zealand, and Emerging Markets CDS. The protection buyer will pay the seller the full period accrual even if the trade is entered mid-period. The cash settlement amount due at settlement date includes a rebate payment from the 3

4 seller for the accumulated accrued coupon. For Japanese and Asia ex-jan CDS, this change will be implemented in December. For Australian, New Zealand, and Emerging Market CDS, this will be implemented on September 21 st, Payment Dates Traditionally Emerging Markets CDS paid their coupons semi-annually, not quarterly like most other CDS. Payments for Emerging Markets CDS will occur quarterly going forward from September 21 st, 2009 for new trades. Australian, New Zealand, Japanese, and Asia ex-jan CDS coupon payments continue to pay quarterly, no change. Roll/Maturity Dates Emerging Markets CDS used to roll or have maturity dates for each month of traded tenors. As of June 22 nd, 2009, the roll dates were standardized to the quarterly IMM dates (March 20 th, June 20 th, September 20 th, and December 20 th ) similar to other single name CDS. There are no changes regarding roll dates for Australian, New Zealand, Japanese, or Asia ex-jan CDS. How Will This Change Existing CDS Positions? Legacy CDS positions under the existing trading conventions may become relatively illiquid. Consequently, investors may elect to roll into new standardized contracts, work on a bilateral basis with their counterparties to modify their positions, or utilize a portfolio recouponing service to rebook their existing positions into new positions reflecting the new coupon strikes. 4

5 Convention Changes The changes for Australian, New Zealand, Emerging Markets, Japanese, and Asia ex-jan CDS consist entirely of convention changes which is a significant difference from the changes around the Big and Small Bangs, which also included significant contract changes. However, a lot of the benefits in reduced operational and systemic risk come in the form of convention changes as these deal with the commercial terms of individual CDS contracts. Fixed Coupons Corporate and sovereign CDS for Australia, New Zealand, and Emerging Markets will trade with standard fixed coupons of 100 and 500 basis points similar to North American corporates. Japanese and Asia ex-jan CDS are likely to feature 100 and 500 strikes although Japanese CDS is expected to see a 25 basis points strike as well these have yet to be fully confirmed. The concept of fixed coupons is not new and has been employed in the trading of CDS indices and distressed names historically. The CDS Big Bang brought fixed coupon trading to single names more fully by extending the practice to investment grade credits in North America with 100 basis points coupons and also 500 basis points coupons to high yield credits. Europe followed in June 2009 with their own set of standard fixed coupons: 25, 100, 500, and 1000 basis points. Readers who are unfamiliar with the concept of fixed coupons should read our previous report Understanding the CDS Big Bang: Global Contract Changes and North American Convention Changes found at Standardized Coupons for Single Names Globally 1 The table to the right displays the standard coupons (basis points) for CDS instruments that are expected following the implementation of convention changes for Australian, New Zealand, Emerging Market, Japanese, and Asia ex-jan CDS. Source: Markit Trading with a Full Coupon Prior to CDS Big Bang, whether a protection buyer paid a coupon on the first coupon or IMM date for a North American CDS trade depended on when the trade occurred. IMM dates are the chosen termination dates for CDS contracts: March 20th, June 20th, September 20th, and December 20th for any given year. If the trade date fell before 30 days prior to the first coupon date, the accrual was due on the first coupon date for the number of days of effective protection during the period. This was known as a short stub period. If the trade date was within 30 days before the first coupon date, there was a long stub period. No accrual of premium would be paid on this first IMM coupon date, rather the long stub would be paid on the following coupon date. That payment would include the portion of premium owed for protection in the first period plus the full premium for the second period. Clearly this is suboptimal for contract standardization. Australian, New Zealand, Emerging Market, Japanese, and Asia ex-jan corporate and sovereign CDS are expected to adopt the full coupon convention similarly to the way the convention now works for North America as a result of CDS Big Bang. The first trading day with this convention is expected to be September 21 st, 2009 for these instruments with the 1 Some dealers also utilize strikes of 300 and 750 basis points for European Corporate CDS occasionally. 5

6 exception of Japanese and Asia ex-jan CDS, whose convention changes are expected to first trade in the December roll (December 21 st, 2009). For a more detailed treatment of the full coupon convention, readers are encouraged to read our previous report Understanding the CDS Big Bang: Global Contract Changes and North American Convention Changes. Restructuring Clause Conventions For clarity, there are no changes to the restructuring clause conventions for the corporate and sovereign CDS of Australia, New Zealand, Emerging Markets, Japan, and Asia ex-jan. It is still Mod R for Australia and New Zealand, Old R for Emerging Markets, Japan, and Asia ex-jan. Payment Frequency This convention change applies only to Emerging Markets CDS. Traditionally Emerging Markets CDS paid their coupons semi-annually, not quarterly like most other CDS. Payments for Emerging Markets CDS will occur quarterly going forward from September 21 st, 2009 for new trades. Legacy trades will not adjust and will maintain semi-annual payments. Australia, New Zealand, Japanese, and Asia ex-jan already pay on a quarterly basis. Roll/Maturity Dates For the Emerging Markets CDS, there is a convention change for maturity dates. Emerging Markets CDS used to roll or have maturity dates for each month of traded tenors. As of June 22 nd, 2009, the roll dates were standardized to the quarterly IMM dates (March 20 th, June 20 th, September 20 th, and December 20 th ) similar to other single name CDS. This change does not apply for the other CDS contracts discussed here as they already have quarterly IMM dates as standard maturities. 6

7 Quoting Conventions In North America, the predominant quoting conventions are to quote 100 strikes in quoted spreads and 500 strikes in points upfront with the idea that only the more distressed credits, would see the 500 strike + points upfront convention. This followed closely the conventions from before CDS Big Bang where most names were quoted in par spreads and the more distressed credits in points upfront with a 500 basis point fixed strike. While we have yet to see new dealer runs for these transaction types, we expect the quoting conventions going forward from their implementation date to resemble the practice in North America. Markit CDS Converter and ISDA CDS Standard Model Historically, one of the most common causes for trade breaks with Markit CDS indices has been a disagreement surrounding the upfront amount payable to one counterparty from another. As the trading conventions began to go to a fixed coupon with an upfront payment for single name trades, it was critical that trades would not break due to disagreements on the upfront payment due. This was a particular concern for entities that trade with a 100 basis points fixed coupon as dealer runs for those credits displayed a conventional spread and not the upfront payment. Thus a universally available calculator that utilized standard inputs was needed. At the urging of CDS participants, Markit created the Markit CDS Converter. The Markit CDS Converter was designed with the input of key CDS dealers and utilizes the ISDA CDS Standard Model code as well as the standardized inputs for the code. The converter allows for easy translation between the conventional spread found in dealer runs for investment grade reference entities to the required upfront payment. In support of the forthcoming convention changes, Markit is adding four additional currencies for use in the Converter: Australian Dollar (AUD), New Zealand Dollar (NZD), Hong Kong Dollar (HKD), and Singapore Dollar (SGD). In addition, the recovery rate field will become free-form to allow a full range of recovery rates. While the standard recovery rate for most corporate single names remains 40% for senior and 20% for subordinated, the convention for emerging market credits is 25%. Japan is expected to adopt 35% and 15% standard recoveries for senior and subordinated, respectively. This change also allows for flexibility for certain unwind transactions. The flexibility could also extend to municipal CDS and loan CDS transactions, if and when, those products trade under a standardized recovery rate assumption. Standard Recovery Rate Conventions (Single Names) The table here illustrates the current standard recovery rate conventions for single name corporate and sovereign CDS. Because of the range of recoveries currently and the anticipation of other instruments adopting standard recovery conventions, also with different recovery rates, the Markit CDS Converter will change the Recovery field to be a free-form text field. Source: Markit The Markit Converter can be found at It is made freely available to investors. The Converter is an implementation of the ISDA Standard Model which is maintained by Markit. More information about the model, including any updates, can be found at 7

8 Changes to Markit CDS Converter The following changes will be made to the Markit CDS Converter in order to accommodate the changes to Emerging Market, Australian, New Zealand, Japanese, and Asia ex-jan CDS conventions: 1. The Recovery Rate field will be changed from a dropdown selection of just 40% and 20% to be a freeform text field to incorporate a greater number of recovery rates. 2. Additional currency choices will be added. 3. The interest rate curves used in the Converter calculations vary with the selection of currency (not explicitly illustrated in the diagram to the left). Note: Diagram provided as an illustration only, not an actual calculation. The changes discussed here have not been implemented at time of writing. Source: Markit Standard Recovery Rate Conventions (Indices) The table here illustrates the current standard recovery rate conventions for most credit indices traded in the market. It is possible that some of these standard recovery rate conventions may change over time in response to changing market 1. conditions. If they do, we expect these standard recovery rate conventions to be updated at Because of this and the range of recoveries currently, the Markit CDS Converter will change the Recovery field to be a free-form text field. Source: Markit 8

9 Migration of Old Contracts to New Contracts/Conventions There are no new global contract changes for Australian, New Zealand, Emerging Markets, Japanese, and Asia ex-jan CDS at this time. Consequently, investors will not be asked to adhere to any protocols to amend the terms of legacy trades nor will there be any supplements to the 2003 ISDA Credit Derivative Definitions both were features of the CDS Big and Small Bang as part of the contract changes. Convention changes do not require documentation changes in order to conduct a transaction per se, but there will be updated confirmation documents to facilitate accurate capture of trade details and efficient trade settlement. Portfolio Recouponing As these convention changes include fixed coupon strikes that are different from the par spreads that pre-existing trades were struck, investors may want to consider recouponing their legacy positions. Recall from the CDS Big Bang that the idea behind recouponing is to rebook your existing trade that was done at a par spread, into new trades using the fixed coupons of 100 and 500 basis points. The new trades were subject to the condition that you replicated the same risk profile from your original trade. Stated another way, you should not have to change the economics of your existing position such that you would profit or lose from this adjustment. This is relatively easy to do where there are only two strikes and the trades are done as No Restructuring or Old Restructuring. Recall the recouponing example we used in our Big Bang Report: Source: Barclays Capital Assume an investor bought protection with a $100 million notional legacy position and a coupon at 50 basis points requiring an annual premium of $500,000 per year. In order to yield the same cash flows using the standard combination of the 100 and 500 fixed coupons, the resulting position would be $112.5 million notional long at 100 basis points fixed and $12.5 million notional short at 500 fixed. This is fine as long as the trade is done as No R (or Old R even). However if done, under Mod R or Mod Mod R, the resulting positions one leg long protection and one leg short protection results in an asymmetric risk profile. The motivation for recouponing would be to avoid possible liquidity risk in liquidating legacy positions which will be nonstandard after the adoption of new trading conventions. At this time it is hard to say whether or not recouponing will be a significant factor for the CDS markets discussed here simply due to the smaller amount of notional outstanding in these markets. It is possible that additional, wider strikes might be used to facilitate recouponing efforts for Australian and New Zealand CDS as they trade under Mod R conventions, but coupons other than 100 and 500 are not expected to trade as standard. 9

10 Conclusion While the convention changes for the CDS products enumerated here seem relatively minor compared to their cousins, Big Bang and Small Bang, standardizing the CDS product globally is an important industry priority. These upcoming changes push product standardization more broadly into additional corners of the world. While efforts at establishing central clearing houses in the Asia Pacific region are still at an early stage, the industry continues to innovate. Additional standardization changes are expected. Even if clearing houses are not established for some countries or geographical regions, efforts at greater standardization of CDS are not wasted. In fact, a global proliferation of CDS clearing houses makes product standardization even more important. Regardless, the trading of CDS contracts is a global phenomenon and greater standardization by itself promotes greater operational efficiency and reduced systemic risk. 10

11 Contact For further information, please contact: Tom Price Managing Director Otis Casey Vice President Or please visit 11

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