On 21 August, ISDA published the ISDA 2014 Credit Derivatives Definitions Protocol (the "Protocol"). The deadline for adhering to the Protocol is 12 September 2014 and, if the conditions to implementation are satisfied, the Protocol will become effective between adhering parties on 22 September 2014 (the "Implementation Date").
What is the Protocol?
The Protocol is designed to enable market participants to apply the 2014 ISDA Credit Derivatives Definitions to certain existing credit derivative transactions. The 2014 Credit Derivatives Definitions are the most wide-ranging update to the standard form documentation for privately negotiated (or over-the-counter) credit derivative transactions since the 2003 Credit Derivatives Definitions were published. Like many other protocols published by ISDA, the Protocol also applies to certain transactions entered into in the year following the Implementation Date, to allow parties to continue using their existing documentation as updated by the Protocol while they adjust their systems and templates.
How is the Protocol different to other protocols published by ISDA?
While the broad effect of the Protocol is similar to other protocols published by ISDA (it amends existing documentation on a multilateral basis and, like certain other protocols, amends future documentation), there are a few new features that market participants should be aware of:
- Excluded Reference Entities
While the Protocol is expected to apply to the significant majority of credit derivative transactions, it was considered necessary to exclude transactions referencing certain reference entities from the scope of the Protocol. Accordingly, ISDA has published on its website a list of Excluded Reference Entities which will not be covered by the Protocol. See also "Why was the Excluded Reference Entity list changed at the last minute?" below.
To encourage market participants who are considering adhering to the Protocol to do so at the earliest opportunity, they are given a limited right to revoke any adherence letter that they have previously given. This is designed to discourage participants from adopting a "wait and see" approach as regards the extent of industry adoption of the Protocol, and therefore mitigate the risks of either everyone leaving it to the last minute before adhering or taking a "you first" approach. There is now little advantage in adhering at the last opportunity, since a party who adheres early can look to use the revocation procedure if they do not consider there to be sufficient market adoption.
- Conditional implementation
Similarly, to give comfort to market participants that they would not end up having a Protocol that is effective as between themselves and only a limited number of other adhering parties, ISDA has introduced a "Protocol Effectiveness Condition". In essence, the Protocol will only become effective if at least seven of the first eight Eligible Global Dealers on the Global Dealer Trading Volume List (as defined in the rules applicable to the Credit Derivatives Determinations Committees) have adhered. The rationale for this condition is that adherence by at least seven leading dealers in the credit derivatives markets indicates significant market adoption of the Protocol.
Why was the Excluded Reference Entity list changed at the last minute?
As noted above, transactions in respect of which the reference entities are on the Excluded Reference Entity list are not subject to the Protocol. The way in which certain types of reference entity are excluded from the scope of the Protocol was, however, amended at the eleventh hour. To understand the nature of those changes, it is first necessary to consider the background as to why those types of reference entity were proposed to be excluded.
While almost every section of the 2003 Credit Derivatives Definitions has been amended or replaced in the 2014 Credit Derivatives Definitions, two of the most significant changes represented by the new definitions are (a) the introduction of the new Governmental Intervention Credit Event for financial reference entities and (b) the introduction of "asset package delivery" for financial and sovereign reference entities.
Because of the material economic impact of these changes (and asset package delivery in particular) in respect of sovereign and financial reference entities, it was initially proposed that sovereign and financial reference entities would be excluded from the scope of the Protocol (there was a concern that net protection sellers might be reluctant to adhere to the Protocol given the degree of additional benefit that these provisions afford to protection buyers). The consequence would have been that existing trades on these reference entities would not have moved across to the 2014 Credit Derivatives Definitions, while new transactions would be entered into utilising the new definitions.
Market feedback, however, indicated that there was some concern with this approach, primarily in relation to reference entities in certain emerging market regions. First, a concern was that the transactions would not benefit from the many other amendments and improvements contained in the 2014 Credit Derivatives Definitions. Secondly, some market participants were concerned that there would be a liquidity cost in having existing transactions and new transactions on the same reference entity being governed by different sets of definitions.
As a result, for certain emerging market regions, a different approach has been adopted. Instead of excluding sovereign and financial reference entities in those regions from the scope of the Protocol, transactions on those reference entities will be included within the scope of the Protocol, except that (i) asset package delivery will not apply to those sovereigns or financial entities, and (ii) Governmental Intervention Credit Event will not apply to those financial entities. Similarly, new transactions on sovereign and financial reference entities in those regions will be expected to be entered into on the basis of the 2014 Credit Derivatives Definitions, but again without asset package delivery or the Governmental Intervention Credit Event. As such, transactions in those regions will continue to benefit from the majority of the amendments in the 2014 Credit Derivatives Definitions, but without those provisions that were considered to be most price sensitive and without creating mismatch between existing and new transactions.
What should I do now?
The Protocol operates as an amendment to the documentation in respect of existing transactions, and also a forward-looking amendment to transactions entered into in the year following implementation. Market participants should therefore consider the impact of the amendments on their existing and future transactions before considering whether to adhere. As well as considering the substantive amendments made by the Protocol (and use of the new definitions), market participants should consider the likelihood of the new definitions being adopted for future transactions, and any resulting basis risk associated with not using the Protocol to amend existing transactions.
Asset managers and other agents considering adhering to the Protocol on behalf of their clients should also ensure that they are duly authorised to do so. The adherence process contains specific options for asset managers, reflecting the fact that they may wish to adhere on behalf of only some of their underlying clients and may wish to do so on an unnamed basis, and so they should carefully consider whether (and if so, how) they wish to adhere.
If I adhere to the Protocol, is that it?
While adhering to the Protocol will deal with a significant portion of the work associated with moving across to the 2014 Credit Derivatives Definitions, it does not end there. Parties will also have to:
- update their systems to reflect the changes to existing transactions and new transactions
- update their template documentation to ensure that they incorporate the new definitions going forward
- consider whether (and, if so, how) to amend existing transactions / template documentation for new transactions where those transactions are not covered by the Protocol.
Those participants who are, or will be, involved in credit-linked products, such as credit-linked notes, should also consider the broader implications of the 2014 Credit Derivatives Definitions and the Protocol on their products, particularly bearing in mind the potential basis risk associated with hedging activities being conducted using the new definitions. In particular, they should:
- consider whether existing credit-linked products permit one of the parties to amend the terms of the documentation to reflect the new definitions, or to incorporate or pass on the economic effect of the new definitions when making determinations and payments (and, if so, whether / when / how to notify investors of those changes and/or obtain trustee consent)
- in the absence of such provisions, consider negotiating amendments to update existing credit-linked products to the new definitions
- consider updating programme or template documentation to reflect the new definitions for future issuances.
If you have any questions about the 2014 Credit Derivatives Definitions or the Protocol, please contact a member of Fieldfisher's Derivatives & Structured Finance group.