Reuters: Bankruptcy News: CDS revamp prompts fears of two-tier market

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CDS revamp prompts fears of two-tier market Jul 16th 2013, 15:14 Tue Jul 16, 2013 11:14am EDT * New credit definitions come into effect in March 2014 * Compromise on adoption could hamper liquidity * Insurance subordinated debt also on the radar By Christopher Whittall LONDON, July 16 (IFR) - Credit default swaps are about to undergo their biggest shake-up in more than a decade, but compromises over the implementation of the new legal framework for trading have raised fears of a two-tier market that could stifle liquidity in an already shrinking market. New credit definitions, released on Monday by the International Swaps and Derivatives Association (ISDA), kick in on March 20 next year, and seek to address flaws in the contract exposed by the financial crisis and a wave of new regulation. In the most high profile cases, buyers of protection feared that payouts on Greek CDS would not be sufficient to compensate for losses on bond positions, while bail-in of bank debt, such as in the case of SNS Reaal, has raised concerns about whether credit events would be triggered on old contracts. To address those issues, market participants from the buyside and sellside, under the auspices of ISDA's Credit Steering Committee, have hammered out changes to fix the contract and ensure its continued value as a hedging and trading instrument. The outcome, however, is far from ideal. The process has inevitably meant compromise over the implementation of the reforms as participants have sought to defend their different economic incentives. Net sellers of protection, for example, are unlikely to accept changes to existing contracts that will increase the likelihood of CDS triggering and them paying out. Only changes that aren't expected to have a "material economic impact on existing transactions" will be adopted universally, according to ISDA, while what are widely viewed as the most significant changes will only apply to new CDS trades. The latter camp includes the sovereign asset package - which will allow assets other than bonds to be delivered into CDS auctions to remove uncertainty around government debt restructurings - and the introduction of a new credit event included to capture bank bail-ins. TWO-TIER TROUBLES The CDS market has already halved to USD25trn at the end of last year from its peak of USD58trn at the height of the structured credit boom in 2007, according to the BIS. The practitioners warning against creating a two-tier CDS market say that the changes will only fragment liquidity further and open up a raft of arbitrage opportunities between the two types of contract. But others have downplayed the concerns, highlighting that liquidity quickly migrated to the new CDS after the 2003 credit definitions took hold, creating a natural incentive to abandon the old contract. The revamp includes many other alterations, of which the full impact is not yet clear. As well as amendments to sovereign and financial CDS, ISDA said it was discussing potential amendments to contracts on European insurers' subordinated debt, which has to meet new requirements under Solvency II. There are also a plethora of changes that will apply to existing trades that are not judged to alter the economics of these transactions, many of which are still under discussion at ISDA. Among other things, a standard reference obligation for frequently traded entities will be introduced - a new concept that looks to clarify exactly what entities are being referenced by the CDS. Succession events are also being amended to avoid other controversies that have occurred. It comes just weeks after ISDA, 13 dealers and Markit were accused of blocking exchanges from the CDS business between 2006 and 2009, and charged by the European Commission for breaching antitrust rules. (Reporting By Christopher Whittall, editing by Natalie Harrison and Julian Baker) Link this Share this Digg this Email Reprints

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