credit default swaps after the global banking crisis - cadwalader

derivatives, financial restructuring, collateraliseddebt obligations (cash and synthetic) and funds.Marco earned his LLM from New York UniversitySchool of Law and JD, magna cum laude, fromthe University of Turin. He is admitted to practicein England, the State of New York and Italy.

ABSTRACT

The role of credit default swaps (CDS) in thefinancial crisis has been hotly debated amongregulators, market participants and academicssince early 2008. The purpose of this article is:(i) to outline the current debate for furtherregulation of CDS (both in the US and theUK) and (ii) to describe the various industry-led initiatives designed to address the lack oftransparency and the counterparty risk as-sociated with CDS.

Keywords: credit default swaps, ISDAinitiatives, central clearing, collateral

INTRODUCTIONIn the past nine years, the CDS markethas grown into a multi-trillion dollarnotional market with participants fromnearly every sector of the financial world.1

The first CDS products were relativelysimple transactions in which a protectionbuyer would make payments to a protec-tion seller in exchange for the right to

Nick Shiren is a partner in the FinancialServices Group of the London Office ofCadwalader, Wickersham & Taft LLP. Hispractice focuses on complex financing transac-tions involving a wide variety of asset classes. Inparticular, Nick has extensive experience inderivative products (including credit defaultswaps, total return swaps, repos and othercomplex derivative instruments), structuredcredit transactions and securitisation transac-tions. He represents leading investment banks,arrangers, issuers and collateral managers intransactions throughout the UK, Europe andAustralia.

Assia Damianova is Special Counsel in theFinancial Services Group of the London officeof Cadwalader, Wickersham & Taft LLP. Shehas advised investment banks, hedge funds,portfolio managers, arrangers and originators oncredit and equity derivative transactions and amultitude of synthetic structures. Assia has beenclosely involved in the closing out of derivativesand prime brokerage agreements and positionsof several major funds upon Lehman’s insol-vency and has worked on the return of clients’trust property assets.

Marco Crosignani is an Associate in the Finan-cial Services Group of the London office ofCadwalader, Wickersham & Taft LLP. He con-centrates on capital markets and structuredfinance transactions, including credit and equity

Credit default swaps after the globalbanking crisis: Regulatory responses andindustry initiatives

Nick Shiren*, Assia Damianova and Marco CrosignaniReceived: 25th June, 2009*Cadwalader, Wickersham & Taft LLP, 265 Strand, London, WC2R 1BH, UK;Tel: �44 (0)20 7170 8700; Fax: �44 (0) 20 7170 8600;E-mail: [email protected]

Journal of Securities Law, Regulation & Compliance Volume 2 Number 3

91

Journal of Securities Law,Regulation & ComplianceVol. 2 No. 3, pp. 191–204Henry Stewart Publications,1758-0013

receive a payment upon the occurrence ofcertain credit events with respect to aspecified corporate, the transaction beingakin to insurance against credit risk. Thesesimple trades later evolved to the myriadof ‘basket’, ‘Nth to default’, ‘index’,‘contingent’, ‘recovery lock’ and ‘constantmaturity’ CDS; CDS on mortgage-backed securities, syndicated secured loansand asset-backed securities. The volumeof CDS trades and the growth in theircomplexity rapidly increased over the pastfew years.

The recent financial crisis has focusedthe world’s attention on CDS transactions.In particular, as part of the re-assessmentof risk in the credit markets, concernshave been expressed about the CDSmarket’s largely unregulated environ-ment and opaqueness. In the midst ofthe turmoil in the financial markets,regulators2 have become increasingly con-cerned with systemic and counterpartyrisk and also with the perceived lackof transparency, liquidity and efficiencyin the CDS market. To tackle theseproblems, the US Treasury, the UKTreasury, the Financial Services Authorityand other European regulators and entities(including the European Central Bank)have promised a thorough regulatoryoverhaul of the CDS markets in theirrespective jurisdictions.

REGULATION OF CDS

The US Regulatory LandscapeCDS have been lightly regulated in theUS, but numerous regulatory proposals in2009 will change the status quo. As longas over-the-counter (OTC) derivatives areindividually negotiated and are not a partof a fungible class of securities, they arenot generally considered ‘securities’ forpurposes of US securities law (subject tosome exceptions). Hence, they are not

subject to detailed US federal regulation,or the supervision of the SecuritiesExchange Commission (SEC). Deriva-tives did not have to be cleared ortraded on regulated exchanges, giventhe specific exemptions provided for inthe US Securities Act of 1933 (the‘Securities Act’) and the US SecuritiesExchange Act of 1934 (the ‘ExchangeAct’). Derivatives traded OTC between‘eligible swap participants’ and subject toother requirements were also excludedfrom the supervision of the CommodityFutures Trading Commission (CFTC)under the Commodity Exchange Act (the‘CEA’).3 Nor were they considered asinsurance contracts by the state insuranceregulators.

Things are changing quickly. In March2009, US Treasury Secretary TimothyGeithner described to Congress theTreasury’s Framework for RegulatoryReform, which addresses, among otherthings:

1. regulation and supervision of dealers inOTC derivative markets, and

2. clearing of standardised CDS (every-thing except bespoke) through centralcounterparties (CCPs) and exchanges.

It also subjects non-standardised CDS tohigher standards of documentation andpractice. CCPs will be required topublicly disclose aggregate data of tradingvolumes and positions for CDS and passindividual counterparty information tofederal regulators on a confidential basis.On 13th May, 2009 the Treasury issued apress release, broadening the scope ofproposed reform to regulate not justCDS but all OTC derivatives markets.4

The International Swaps and DerivativesAssociation (ISDA) has welcomed thisproposal as ‘an important step towardmuch-needed reform of financial industryregulation’.

Credit default swaps after the global banking crisis

Page 192

ing house will have to keep records ofCDS trading for at least five years.12

To fight market manipulation, the SECwould have rule-making power in respectof ‘fraudulent, deceptive or manipula-tive acts or practices in connection withcredit-default swaps’.13

On 17th June, 2009 the Obamaadministration released its white paper onits proposed regulatory reform of the USfinancial industry.14 Along the same linesas the US Treasury’s Framework forRegulatory Reform published in March2009, the white paper covers many areasof financial regulation including OTCderivatives and CDS. In particular, OTCmarkets (including CDS) will be subjectto comprehensive regulation aimed at (i)preventing activities in those marketsfrom posing risk to the financial system,(ii) promoting the transparency and ef-ficiency of those markets, (iii) preventingmarket manipulation, fraud, and othermarket abuses and (iv) preventing OTCderivatives from being marketed in-appropriately to unsophisticated parties.These goals will be reached throughcomprehensive regulation requiring (i)standardised OTC derivatives (includingCDS) to be centrally cleared and executedon exchanges and other transparent trad-ing venues, (ii) transparency for all OTCderivative trades and positions throughrecordkeeping and reporting require-ments, (iii) conservative regulation of allOTC derivative dealers and all othermajor participants in the OTC derivativesmarkets and (iv) higher capital charges forcustomised OTC derivatives.

Although the New York State Depart-ment of Insurance has delayed indefinitelyits initial plans to regulate CDS asinsurance,15 the states of Missouri andVirginia have proposed initiatives in thisregard,16 and the National Conference ofInsurance Regulators has announced itsintention to publish model legislation that

At the same time, three bills have beenintroduced into Congress that may pavethe way for further CDS regulation.5

The Derivatives Trading Integrity Act of2009 (DTIA), would end the exemptionfor trading of derivatives (including CDS)under the CEA and require such tradingto occur on registered exchanges.6

The Derivatives Markets Transparencyand Accountability Act of 2009 (theDMTAA), would require all derivatives(including CDS) to be settled or clearedthrough a Derivatives Clearing Organisa-tion regulated by the CFTC or througha SEC-regulated clearing entity.7 As analternative to central clearing, counter-parties could report derivatives transac-tions to the CFTC (subject to showingtheir own financial stability/integrity aswell as that of the relevant transaction).8

The DMTAA would grant the CFTCextensive power to supervise OTCtransactions;9 including the power:

1. to impose limits on positions in OTCderivatives if it determines that tradingin the OTC market has a potentialto ‘disrupt the liquidity or price dis-covery function on a registered entity’or ‘cause a severe market disturbance inthe underlying cash or futures market’,and

2. to suspend CDS trading if ‘the publicinterest and the protection of investorsso require’, subject to the US Presi-dent’s consent.10

The Financial System Stabilization andReform Act of 2009 (FSSRA) aims at amore general overhaul of the US financialsystem, and includes specific requirementsfor all CDS regardless of complexity,though it does not address all derivatives.It would require all CDS to be tradedthrough a clearing house regulated by theCFTC with adequate capital.11 Any per-son dealing with CDS through a clear-

Shiren, Damianova and Crosignani

Page 193

will give insurance regulators authorityover CDS.17

At present, none of these initiativeshas been implemented, but the focus ofpolicy-makers and legislators on OTCderivatives generally and CDS particularlyforecasts sweeping regulatory changes inthe US derivatives market in the nearfuture.The UK Regulatory LandscapeIt cannot be said that CDS are currently‘unregulated’ in the UK. The Finan-cial Services Authority (the FSA) is ap-pointed under the Financial Services andMarkets Act 2000 (FSMA) to regulateprescribed ‘regulated activities’. No per-son may carry on or purport to carry ona regulated activity in the UK unless heis an authorised person or an exemptperson18 — this is known as the ‘generalprohibition’. An activity is a regulatedactivity for these purposes if it is anactivity of a specified kind, which iscarried on by way of business and relatesto an investment of a specified kind.19

Activities that are so specified includedealing in investments, arranging deals ininvestments and managing investments.Investments that are so specified includealmost all CDS.20

CDS can also be susceptible to theFSA’s powers under the market abuseregime (which includes insider deal-ing offences). CDS are not traded onprescribed markets, which is the usualprerequisite for susceptibility to commit-ting an offence set out within the marketabuse canon of offences. However, thelegislation also covers behaviours affect-ing ‘related instruments’ or investments‘whose price or value depends on theprice or value of the qualifying invest-ment’,21 which definition may in turncapture CDS. Dealing in relevant CDSthat amounts to abusive behaviour wouldtherefore be the subject of FSA enforce-ment action.

However, until recently, the FSA hasbeen reluctant to develop a specific andcomprehensive regulatory regime forCDS. The regulatory philosophy hasbeen based on the assumption thatproduct regulation would stifle innova-tion and is not necessary because firmsthat are subject to prudential regula-tion will not develop excessively riskyproducts and customers will be wellinformed of risks associated with par-ticular products as such firms would alsobe subject to conduct of businessregulation. In the wholesale structuredproducts market, it has also been assumedthat customers are by definition sophisti-cated and do not need a high level ofregulatory protection. Recently, theseassumptions have been subject to scrutinyand there has been a call for regulationof those products that have beenidentified as having contributed to thecurrent economic instability.

Following the banking crisis, theChancellor of the Exchequer asked LordTurner (Chairman of the FSA) to reviewand make recommendations for reform-ing the UK and international approachto the way banks are regulated. TheFSA published its review (the ‘TurnerReview’)22 and a discussion paper (the‘FSA Discussion Paper’)23 in March 2009.The Turner Review considered whetherthe CDS market in the UK should besubject to product regulation and sum-marised the arguments for regulation asfollows:24

• The existence of significant investorswith an interest in a company run-ning into trouble, when combined withthe potential for short-selling, creates aheightened risk of abusive market be-haviour.

• CDS prices systematically understate therisk in the upswing and overstate itin the downswing, thus making the


Page 194

reduce the opportunities for marketparticipants to use CDS transactions as aneffective tool for risk management. Inaddition, the market may lose the benefitsof price discovery that many industryparticipants believe facilitates capitalraising. While there are somecommentators who find these advantagesof CDS transactions to be doubtful,29

there are many who don’t believe theirdisappearance is a desirable end.30 Anumber of writers31 have pointed out thatCDS should not be considered the onlycause of the current financial crisis andhave warned against a regulatoryover-kill.

The Turner Review has been seenby most commentators as a measuredresponse — inviting further debate beforeany product regulation of CDS may beintroduced. It draws no conclusions onthe strength of the arguments in favour oragainst the regulation of CDS. How-ever, it does conclude that regulatorsshould leave open the possibility for di-rect product regulation and suggests thata distinction between different types ofCDS — complex bespoke CDS, on theone hand, and more ‘vanilla’ CDS, on theother — might be useful, while notingthat CDS contracts do play an importantrole in hedging risk exposures.

Various industry groups are currentlyconsidering their response to the TurnerReview: for example, ISDA has recentlypublished its response (‘ISDA’s InitialResponse’) to the Turner Review.32 Inarguing the case against direct productregulation of CDS, ISDA’s InitialResponse notes that abusive behaviour inCDS linked to publicy traded securities isthe subject of existing regulation.Although recognising that systematic riskneeds to be monitored, ISDA cautionsthat the distinction between vanilla CDSand complex synthetic derivatives instu-ments may not be useful, as complexity of

extensive use of CDS prices to as-sess the fair value of illiquid underly-ing bonds potentially pro-cyclical andmaking overall CDS spreads poor in-dicators of risk.25

• Unrestricted CDS trading can introducesignificant volatility into the price ofcredit, bringing about the very defaultevents that CDS insure against.

• Such effects have the potential to beparticularly harmful to banks, where thecombination of CDS shorting andequity short-selling can generate afailure of confidence and rising fundingcosts, creating an incentive for harmfulposition-taking which can achieve aself-fulfilling effect.

The Turner Review26 also notes thatarrangements that related the level ofcollateral posted in CDS to the creditratings of counterparties and VAR-basedmeasures of price volatility created pro-cyclical market behaviour and practices.27

For example, CDS and other OTCderivative contracts entered into by AIGrequired it to post more collateral if itsown credit rating fell — creating adownward spiral of increased liquiditystress and falling perceived credit worthi-ness. The Turner Review suggests thatconsideration be given to setting min-imum levels of haircuts in OTC deriva-tives contracts to reduce the extent towhich increases in haircuts in periods ofrising volatility contribute to deflationarypressures.

Conversely, there are marketparticipants28 that are of the view thatincreasing regulation will not necessarilyhelp recovery as more regulation mayincrease transactional costs and drivemarket efficiency down, with marketinnovation being hampered. One possibleresult of increased regulation is acontraction in the size and scope of theCDS market. A smaller market may


Page 195

the latter relates to the underlying risk,not the CDS instrument.

THE CLEARING HOUSE PROPOSAL

IntroductionThe size and complexity of the CDSmarket has created the concern that thefailure of one counterparty could producemarket disruption. If one counterpartydefaults on its CDS, this may have a‘domino’ effect on all the other CDSentered into by such counterparty, whichin turn will affect the parties facing thedefaulting party and their respectivecounterparties and so on. The TurnerReview concluded that a reduction inthe net position outstanding could begreatly assisted by the development ofclearing systems with central counter-parties (CCPs), allowing multilateral net-ting and reducing economic exposuresto those outstanding versus the centralcounterparty.33

A CCP operates by being ‘a buyer forevery seller and a seller for every buyer’34

by putting itself in between counterpartiesof each CDS cleared. If a counterpartywere to default under a CDS, the CCPwill perform such counterparty’s obliga-tions under such CDS as if no defaultoccurred and the loss borne by the CCPwill be shared between the CCP’s mem-bers. Contracts will still be negotiatedbetween the original counterparties35 andthen submitted to the clearing house forvalidation and clearing.

There are a number of entities currentlyproviding clearing services for CDS in-cluding:

1. Euronext Liffe (the derivatives busi-ness owned by NYSE Euronext) andits subsidiary LCH.Clearnet Limited(LCH);

2. Intercontinental Exchange (ICE);

3. Chicago Mercantile Exchange (CME);and

4. Eurex.36

Systemic and counterparty riskAs buyer and seller will not face eachother any longer, but the CCP instead,it is argued that the use of a CCPwill reduce systemic and counterpartyrisks.37 This argument is based on theassumption that the CCP’s credit riskis preferable to counterparty risk. How-ever, some commentators38 have arguedthat the large dealers (that trade billionsof US$ of CDS annually) have bet-ter capacity to sustain counterparty losseswhen compared with the existing CCPs.The strength of these arguments willultimately depend on the profile of themembers of the CCP, the operating rulesof the CCP,39 whether or not the CCP isadequately capitalised,40 and how easy itwould be for the CCP to raise new capitalfrom its members if need be.

Membership requirements will, there-fore, be a key factor for the efficientfunctioning of a CCP. The lower thecriteria, the higher the number of mem-bers and, in a pre-default scenario, themore efficient the clearing will become asthere will be more trading and nettingopportunities in a larger pool of counter-parties available. However, lower criteriawould lead to higher counterparty riskand ultimately higher systemic risk asCCP members will bear higher losses.41

Netting efficienciesIt has also been argued that the use ofa CCP will increase netting efficiencyacross positions between counterpartiesthereby reducing both the amount ofcollateral required to be posted and theregulatory capital that banks must holdagainst such positions. A counterparty willbe able to net its obligations to postcollateral on the basis of its global ex-


Page 196

when compared with an OTC counter-party and that large dealers are more aptand have better resources than CCPs todetermine collateral requirements whenassessing risk. This may lead to mis-pricing of risk, driving market efficiencydown and ultimately increasing systemicrisk.

Following the recent experience ofmany market participants in relation tothe administration of Lehman BrothersInternational (Europe) where there is stilluncertainty as to the fate of the claims toproprietary assets held by the Lehmanentities on behalf of their clients,45 ofconcern will be the way in whichcollateral will be held by the CCP and inparticular whether collateral posted by amember will be segregated from thatposted by others.46

Transparency and pricing efficienciesOne of the perceived benefits of the CCPapproach is increased transparency and liq-uidity — trades cleared through a CCPwill be publicly disclosed. Indeed the UKTreasury has recommended that the FSAtakes steps to encourage trading throughclearing houses and where appropriate ex-changes to avoid the lack of transparencyinherent in OTC trading.47 With greatertransparency, the expectation is that priceswill go down and market efficiency willimprove. However, there is much uncer-tainty on the level of disclosure that will berequired (whether or not information relat-ing to pricing and volumes will be disclosedis still unclear).48 Balancing the interests ofcounterparties not wanting to disclose pric-ing information in an illiquid market withregulatory concerns on market abuse andtransparency may prove to be difficult.

A solution for all CDS?Although the apparent benefits of a CCPapproach to CDS are seen by mostregulators to be desirable, perhaps those

posure to the CCP by taking into accountall such counterparty’s CDS positions,without limitation to the positions heldwith one particular dealer. For example,if counterparty A has to post collateralworth 100 under a CDS with counter-party B, but has to receive collateral for70 from counterparty C, it may be re-quired to only post the difference of 30with the CCP, while without a CCP, itwould have to post or receive, as the casemay be, the full collateral for each CDSposition and hold capital against that.

However, other commentators42 haveargued that netting across different assetclasses of derivatives (not limited to CDS)between two counterparties is likely tobe more efficient than netting betweenmultiple counterparties across CDS only.For example, if counterparty A owes100 to counterparty B under a CDS,and counterparty B owes counterpartyA 60 under a FX swap, in an OTCenvironment, counterparty A’s total ex-posure to counterparty B will be 40 (andthe collateral posted will be calculated onthat basis). However, if CDS are clearedthrough a CCP but FX swaps are not, inthis example, counterparty A’s collateralobligations in respect of the CDS will becalculated on a gross basis without net-ting opportunities across the other assetclasses (in this example, the FX swap).This argument supports the view that theCCP proposal should extend to all OTCproducts so as to capture all netting ef-ficiencies.

CollateralA related issue that will need consider-ation for the efficient functioning of aCCP is the way in which collateral iscalculated,43 posted and held. In the caseof determining collateral requirements, ithas been argued44 that CCPs will be lesslikely to have the required skills, timeand information to price CDS accurately


Page 197

benefits should not be overstated. Not allCDS products are suitable for clearing.49

The Turner Review notes that clearingand central counterparty systems will onlybe feasible for roughly 50–75 per cent ofthe CDS that is accounted for bystandardised contracts — a large volumeof bespoke contracts will continue to betraded in an OTC fashion. Bespoke CDSperform an important role in meetingthe different and often complex needsof customers and counterparties.50 Thecounterparty risk for those products thatremain outside the CCP will continue tobe managed on a bilateral basis. Indeed, ifa CCP approach to CDS is to be imposedby regulation, one significant issue thatneeds to be considered by the regulatorsis which CDS will be required to becleared.

Location of CCP and RegulatoryArbitrageEuropean regulators (including amongothers, the French Central Bank and theEuropean Commission) have put con-siderable pressure on banks to find aEuro-based solution in relation to CDSclearing51 arguing that the location of theCCP should correspond to the locationof the market.52 However, the TurnerReview considers that the proposals thateuro-denominated CDS must be clearedwithin the Euro zone are unnecessary forfinancial stability reasons.53 In any event,some of the ‘biggest operators’ in theCDS market have been reported to agreein principle to a Euro-based clearinghouse for Euro-based CDS.54

A number of market observers andparticipants have expressed concerns55 thatusing both a European CCP and a USCCP (rather than a global CCP) wouldbe more costly for dealers as they wouldhave to run two collateral pools, one inthe US CCP and one in the EuropeanCCP. It has also been argued that a

national-based solution would introduceunnecessary complexity,56 may constituteprotectionism57 and would be out of stepwith the international drive to improvecross-border regulatory cooperation anddevelop shared standards and regulatoryinputs.58 Indeed, with a national basedCCP approach, where each CCP issubject to different regulatory over-sight and treatment, there is a risk ofregulatory arbitrage, whereby market par-ticipants seek out jurisdictions with lowerregulatory burdens in an attempt to cutcosts and increase their competitivenessin relation to those competitors thatremain subject to more onerous oversight.Regulatory arbitrage also creates competi-tion among jurisdictions, which in turnencourages regulators who wish to retainregulated activities in their jurisdiction todecrease their scrutiny. On 20th February,2009, the Federal Reserve Bank ofNew York released a statement claimingregulators in the US, UK and Europewere working toward an information-sharing agreement and consistent cross-border standards for CDS clearing.59

Many market participants and dealerswould prefer a global solution to centralclearing,60 which benefits from lowertransaction costs, single counterparty risk,better CCP capitalisation with a largernumber of members, better infrastructureand netting opportunities. Striking abalance between national regulatory con-trol and the global dimension of the CDSmarket will not be an easy task.

INDUSTRY SPONSORED INITIATIVES

IntroductionMany market participants have arguedthat the derivatives industry has, in fact,demonstrated a remarkable ability todevise industry solutions and to gain veryhigh levels of consensus for those without


Page 198

Bang Protocol opened on 12th March,2009 and closed on 7th April, 2009. Allthe provisions of the Auction TermsSupplement became effective on 8thApril, 2009 except the provisions relatingto the ‘look-back’ periods which cameinto effect on 20th June, 2009.)

Pursuant to those amendments:

1. a determination committee will be setup to decide most of the key issues inrespect of the covered CDS transac-tions, such as Credit Events (type, dateand occurrence), Auctions, DeliverableObligations, Succession Events andSubstitute Reference Obligations;

2. a relatively short window for creditevents and successor determinations(60- and 90-day look-back periods,respectively) shall apply, and

3. where ISDA holds an auction forcovered transactions, market participantswill be able to easily avail themselves ofthe auction settlement mechanism.

The structural framework through whichthe changes will be implemented is asfollows:

1. an ISDA protocol will facilitate theamendment of existing CDS transac-tions to incorporate the auction-relatedterms,

2. a Supplement to the ISDA CreditDerivatives Definitions (the ‘Defini-tions’) will incorporate the CDS auc-tion settlement mechanism into theDefinitions; and

3. future trades will incorporate thatSupplement when incorporating theDefinitions (unless otherwise speci-fied).

Change in the trading convention forNorth American corporate CDSAnother recent ISDA initiative aimed atstandardisation has been the change of the

the need of externally imposed rules. Therecent market initiatives of the Inter-national Swaps and Derivatives Associa-tion, Inc. (ISDA) are a good example ofthe CDS industry acting to strengthen theinfrastructure of market transactions. Therecent projects undertaken by ISDA willstandardise many CDS trades, which inturn will expedite the industry goal ofclearing CDS through a CCP.

The CDS AuctionsOne example of the derivatives industryreacting to perceived settlement risks inthe market is the CDS auction process,designed to counteract the problemsposed by the physical settlement of CDStransactions, where bonds or loans have tobe delivered by one party to another,possibly at a time of market stress. Theauction route, designed and tested overa significant number of credit eventsinvolves an agreement of ‘adhering’market participants (through a stand-ardised protocol) to establish a fairmarket price for the bonds and loans ofthe defaulted entity through an auctionprocess, which price is then used for thecash settlement of the relevant CDStrades. It is worth noting that adherenceto the auction route has been voluntary,ie, it was not devised or imposed bythe regulators, yet this mechanism hasachieved a very high level of uniformityacross the market.

The Big Bang ProtocolPerhaps the most notable among therecent ISDA initiatives has been theamendment to the CDS documentation,which aims to standardise the determina-tions relevant to the CDS market andto facilitate settlement following creditevents. ISDA’s Auction Terms Supple-ment, Big Bang Protocol and Determina-tion Committee Rules were published on12th March, 2009. (Adherence to the Big


Page 199

trading convention for North Americancorporate CDS by providing a standardfixed rate (of 1 per cent for single-name investment grade transactions and 5per cent for high-yield ones) and afull initial fixed-rate payer calculationperiod (regardless of whether the actualtrade date occurs at the start of thatperiod). The updated Matrix introducingthe Standard North American CorporateTransaction Type and the related form ofconfirmation were published by ISDAon 8th April, 2009. That standardisedtemplate also introduced common accrualperiods: regardless of the effective date ofthe transaction, accruals would begin on20th March, 20th June, 20th Septemberand 20th December (each, a ‘quarterlydate’) and the scheduled termination datewill also be a quarterly date. All thesechanges are designed to make the CDStrades more fungible.

Margin call dispute protocolISDA is currently working on a setof protocols (for dealers and for buy-side) to be used when facing mar-gin call disputes. A draft of the 2009ISDA Protocol for Resolution of Dis-puted Margin Calls is expected to bereleased this month for comments. Theaim would be to facilitate valuations(especially in the current environmentwhen positions may be hard to mark-to-market) and to standardise electronicmessages on margin calls.

CONCLUSIONThe recent ISDA initiatives shouldstrengthen the infrastructure of the CDSmarket and enhance the liquidity andtransparency of the market of standardisedCDS. In turn, the standardisation of thoseelements will expedite the industry goalof clearing CDS through a CCP.

Despite the industry’s proven track

record of adapting to changes, it seemsthat the general trend is towardsmeasured regulation of the CDS marketwith the view of improving transparencyand counterparty risk. A successful CCPshould reduce counterparty risk for‘vanilla’ CDS, increasing netting ef-ficiency and easing capital requirements,even though the right balance betweenthe desire for national regulatory controland the global nature of the CDS willbe difficult to establish.

The regulatory response cannotprovide an instant fix for the perceivedrisks in the CDS market. As suggestedby the Turner Review, the argumentsboth in favour and against theunrestricted regulation of the CDSshould be debated. Any regulatoryrestrictions might have to drawa distinction between the differentcategories of the credit derivatives market(the growth of complex synthetic creditderivatives instruments raising moreconcerns than ‘vanilla’ CDS).

� Cadwalader, Wickersham & Taft LLP,2009.

References(1) See data released by the Bank of

International Settlements quoted byAline van Duyn, Henny Sender andFrancesco Guerrera, ‘Shining a lightinto the world of derivatives’, FinancialTimes (‘FT’), 13th May, 2009 availableat www.ft.com.

(2) See inter alia, in the UK, ‘The TurnerReview: A regulatory response to theglobal credit crisis’, published by theUK Financial Services Authority inMarch 2009, Chapter 1, available atwww.fsa.gov.uk; House of Commons,Treasury Committee, ‘Banking Crisis:dealing with the failure of the UKBanks’, 1st May, 2009, 97 et seq.available at www.parliament.uk. In the


Page 200

(16) Missouri proposal available at:http://www.insurance.mo.gov/Contribute%20Documents/InsuranceBulletin08-12.pdf. ; Virginia proposalavailable at http://leg1.state.va.us/cgi-bin/legp504.exe?091+ful+HB2320.

(17) http://www.ncoil.org/HomePage/2009/0492009CDSCallPressRelease.pdf.

(18) Section 19(1) FSMA.(19) Section 22 and Schedule 2 of FSMA

and the Financial Services and MarketsAct 2000 (Regulated Activities) Order2001.

(20) Article 85(1) of the Financial Servicesand Markets Act 2000 (RegulatedActivities) Order 2001 includes‘contracts for differences’ as ‘specifiedinvestments’. Within contracts fordifferences are ‘any other contract thepurpose or pretended purpose of whichis to secure a profit or avoid a loss byreference to fluctuations in: (i) thevalue or price of property of anydescription; or (ii) an index or otherfactor designated for that purpose in thecontract’.

(21) Section 130A(3) FSMA.(22) See The Turner Review, ref. 2 above.(23) See DP09/2: A regulatory response to

the global banking crisis, published bythe FSA and available at:www.fsa.gov.uk.

(24) See The Turner Review, ref. 2 above,section 3.1(ii).

(25) See The Turner Review, ref. 2 above,section 1.4(iv).

(26) See The Turner Review, ref. 2 above,section 1.1(v).

(27) See The Turner Review, ref. 2 above,exhibit 1.14.

(28) See Helen Wray, Divide and Conquer,ISR, April 2009, 23 et seq.

(29) See John Dizard, Put the Credit DefaultSwaps Market out of its Misery, FT, 9thDecember, 2008, available at:www.ft.com.

(30) Darrell Duffie, an economist at StanfordUniversity, believes CDS are a usefultool and should not be done away withentirely (see Darrell Duffie and

US, see, inter alia, US Department ofTreasury, ‘US Treasury Framework forRegulatory Reform’, 26th March, 2009and ‘Regulatory ReformOver-The-Counter (OTC) Derivatives’,13th May, 2009 both available atwww.treas.gov. For a more generaloverview of systemic risk, seeCounterparty Risk Management PolicyGroup Third Report, ‘ContainingSystemic Risk: The Road to Reform’,6th August, 2008, 102 et seq. availableat: www.crmpolicygroup.org.

(3) Title IV of the Commodities FuturesModernization Act of 2000.

(4) See http://www.treas.gov/press/releases/tg129.htm.

(5) These are (i) the Derivatives TradingIntegrity Act of 2009 (S. 272)introduced 15th January, 2009 bySenator Harkin of the SenateAgriculture Committee, (ii) theDerivatives Markets Transparency andAccountability Act of 2009 (H.R.977), introduced 11th February, 2009by Rep. Collin Peterson of the HouseAgriculture Committee and (iii) theFinancial System Stabilization andReform Act of 2009 (S. 664 and H.R.1764), all available at:www.govtrack.us.

(6) See DTIA section 3(h)(2).(7) See DMTAA, section 13.(8) Ibid.(9) Ibid, section 11.

(10) Ibid, section 16.(11) See FSSRA, section 120.(12) Ibid, section 118.(13) Ibid, section 120.(14) ‘Financial Regulatory Reform, A New

Foundation: Rebuilding FinancialSupervision and Regulation’, USDepartment of Treasury, 17th June2009, available at: http://www.ustreas.gov/initiatives/regulatoryreform.

(15) Initial proposal available athttp://www.ins.state.ny.us/circltr/2008/cl08_19.pdf. Suspension announcementavailable at http://www.ins.state.ny.us/circltr/2008/cl08_19s1.pdf.


Page 201

Haoxiang Zhu, ‘Does a CentralClearing Counterparty ReduceCounterparty Risk?’, available at:http://www.stanford.edu/~duffie/DuffieZhu.pdf). See Matthew Philips,‘The Monster That Ate Wall Street’,Newsweek, 27th September, 2008,available at: http://www.newsweek.com/id/161199/page/1.Derivatives trader Terri Duhon believesthat the vilification of CDS is likeblaming the gun when someone getsshot. See also David Stevenson, ‘Allyou Need to Know about CreditDefault Swaps’, Moneyweek, 10thOctober, 2008, available at:http://www.moneyweek.com/news-and-charts/economics/all-you-need-to-know-about-credit-default-swaps-13792.aspx. ISDA CEO Robert Pickelclaims that CDS have had blame placedon them unfairly in connection withthe financial crisis; Aaron Pan, ‘DefaultSwaps’ Role in Global Turmoil‘‘Exaggerated’’’, 15th October, 2008,available at: http://www.bloomberg.com/apps/news?pid=20601087&sid=a966RcwJ.aik&refer=home.

(31) See Lynton Jones, Bourse Consult,‘Current Issues Affecting the OTCDerivatives Market and its Importanceto London’, April 2009, 7 et seq. Theauthor argues that there is littleevidence to suggest that CDScontributed in any significant way tothe crisis and that the efficient way inwhich they were closed out during theLehman default suggests that they arecapable of being transacted safely andsecurely.

(32) See the letter dated 18th June, 2009 onISDA’s website available at:htp://www.isda.org/uploadfiles/_docs/ISDA_response_to_Turner_Review_and_DP_09_2_06.18.09.pdf.

(33) See The Turner Review, ref. 2 above,section 2.5(iii).

(34) Craig Pirrong, ‘The Clearing HouseCure’, in Regulation, Winter 2008–2009,45.

(35) As pointed out by AnthonyBelchambers, chief executive at theFutures & Options Association, ‘firmswill still have to carry out theirfront-end due diligence duties oncounterparties as the CCP will not doit for you’ (see Divide and Conquer, ref.28 above, 24).

(36) In the US, the activity of clearingsecurities requires registration by therelevant clearing house or exchangewith the SEC or, alternatively,obtaining a temporary exemption fromregistration from the SEC. On 24thDecember, 2008 LCH was the first toreceive a temporary exemption(expiring in September 2009) from suchregistration requirements as a ‘clearingagency’ in respect of ‘Cleared IndexCDS’ under section 38(a) of theExchange Act. On 6th March, 2009,the SEC granted a similar exemption(due to expire late 2009) to ICE USTrust, a limited purpose trust bankregulated by the Federal Reserve Bankof New York and the New York StateBanking Department and a subsidiary ofICE. ICE Trust has large support fromthe dealer community (includingJPMorgan, Citi, Credit Suisse andGoldman Sachs) and has during its firstmonth of operations cleared in excessof US$70bn of notional value of CDS.ICE Trust intends to expand itsoperations in Europe through a separateentity (ICE Clear Europe) and tradesingle name CDS later this year. Liffehas similar ambitions — it intends tolaunch clearing services managed out ofParis by December 2009 (see PressRelease by LCH.Clearnet, 13thFebruary, 2009, available athttp://www.euronext.com). CME (inpartnership with the hedge fund CitadelInvestments) recently received approvalfrom the SEC and is consideringclearing a variety of CDS (includingsingle-name products). Eurex,controlled by Deutsche Borse, isplanning to start clearing CDS by mid


Page 202

have certain financial, operational andregulatory qualifications, contribute to aguaranty fund based on the individualmember’s risk profile and post dailycollateral based on marked-to-marketvaluations of the positions held.Additionally, members of LCH must belocated in a jurisdiction with satisfactoryregulatory supervision, cooperation withthe FSA and must meet capitaladequacy standards. Ibid.

(42) See ‘Does a Central ClearingCounterparty Reduce CounterpartyRisk?’, ref. 30. above.

(43) For Liffe and ICE Trust, collateral callswill be calculated on a daily,mark-to-market basis based (at least forICE Trust) on an auction-stylecalculation of the value of the positionsheld.

(44) See ‘The Clearing House Cure’, ref. 34above, 47 et seq.

(45) See application by PWC to the HighCourt seeking directions on the clientmoney held by Lehman BrothersInternational (Europe) (inadministration) available at:www.pwc.co.uk/eng/issues/lehman_client_money_update_court_application_010509.html; Global Trader EuropeLtd (In Liquidation), Re ChanceryDivision, 24th March, 2009.

(46) See ‘Margin Segregation May Snag ICEClearing Effort’ in Derivatives Week, vol.XVIII, no. 10, 16th March, 2009, 1

(47) See ‘Banking Crisis: dealing with thefailure of the UK banks’, ref. 2 above,ibid.

(48) See ‘A Safer, clearer route for OTC’,ref. 40 above, 1.

(49) See ‘DP09/2: A regulatory response tothe global banking crisis’, ref. 23 above,section 10.70.

(50) See ‘Current Issues Affecting the OTCDerivatives Market and its Importanceto London’, ref. 31 above, 1 et seq.

(51) See Jeremy Grant, ‘France calls forEurozone CDS clearing house’, FT,18th February, 2009. Charles McGreevy,the EU Internal Market Commissioner

2009 but has not received anyregulatory approval yet.

(37) See Containing Systemic Risk: The Roadto Reform, ref. 2 above, ibid.

(38) See The Clearing House Cure, ref. 32above, 34 et seq.

(39) Both LCH (operating through itsderivatives processing service BClear)and ICE Trust had to represent to theSEC that they will meet the standardsset by the FSA and IOSCO for CCPs(see Committee on Payment andSettlement Systems and TechnicalCommittee of the InternationalOrganisation of Securities Commissions(IOSCO), ‘Recommendations forCentral Counterparties’, November2004, available at:http://www.bis.org/publ/cpss64.htm)and pledged transparency on pricinginformation, clearance and settlements,capital adequacy standards for clearingmembers, the publication of their ownfinancial statements on a regular basisand at least five-year record keeping.

(40) Capitalisation issues have had to beaddressed by both LCH and ICE Trust.A default fund will be established withLCH. Similarly, a guaranty fund will beset up and administered by ICE Trust;each ICE Trust member will berequired to make a minimumcontribution and maintain an adequatebuffer on the basis of its risk profilewhich will be assessed on at least aquarterly basis. See Liffe, ‘A Safer,clearer route for OTC’ and the otherinformation available at:http://www.euronext.com/editorial/wide/editorial-4587-EN.html; ICETrust, ‘Clearing house for CreditDefault Swaps, CDS ClearingOverview’ and the other informationavailable at: https://www.theice.com/ice_trust.jhtml. See Adsatis,‘Comparison of CDS ClearingProposals for ISDA’, available at:http://www.adsatis.com/page.aspx?p=xxHiddenPagexx.

(41) Members of ICE Trust and LCH must


Page 203

has been campaigning towards this goaland considered that ‘central clearing [. . .]is particularly urgent to restore marketconfidence’ (as reported by Nikki Tait,‘Agreement reached over EuropeanCDS clearance’, FT, 19th February,2009). Pervenche Beres (Chairman ofthe Economics and Monetary AffairsCommittee in the European Parliament)had early this year called for anamendment to the Capital RequirementsDirective to require banks to hold morecapital against CDS that are not centrallycleared (on the assumption that a centralclearing solution was soon to be found).This proposal was eventually voteddown by the European Parliament inMarch 2009 (see Mark Pengelly, ‘CDScapital charge voted down’, in Risk,April 2009, vol. 22, no. 4).

(52) Corinna Freund of the ECB has alsopointed out that ‘location of coremarket infrastructures [ie CCPs] shouldcorrespond to the location of themarket’ as Europe represents asignificant share in the CDS marketwith around 40 per cent of CDS indexproducts being based on Europeanentities, 39 per cent of CDS beingdenominated in Euro and Europeandealers accounting for a large share ofthe dealers calculating the iTraxxEurope and CDX indices. Aside frommarket data and dealing power, aEuropean solution for Euro-basedproducts would be beneficial as ‘[it]would offer significant congruencebenefits between the location of themarket and the scope of the legal andregulatory framework and fiscalresponsibility’, she suggested. Whatever‘congruence benefits’ means in theECB’s parlance, we are assured thatthey will include ‘central bankresponsibility and tools for monetarypolicy, financial stability and paymentsystems’. See ‘The role of Europe in

the global CDS market’ at www.ecb.int.(53) See The Turner Review, ref. 2 above,

section 2.5(iii).(54) Nine dealers have written to the

European Commission and havecommitted to clearing CDS onEuropean reference entities via aEuropean CCP by the end of July2009. See Nikki Tait and Jeremy Grant,‘Agreement reached over EuropeanCDS clearance’, FT, 19th February,2009; Simon Boughey, ‘High noon forCDS clearing’, Credit, March 2009, 32et seq.

(55) See Divide and Conquer, ref. 28 above,25.

(56) Complexity can evolve at regulatorylevel: by way of example, a CDSentered into between a Japanese bankand an Australian hedge fund andwritten on a European borrower inAustralian dollars is likely to entail abundle of misaligned regulatory interestsbetween different regulators: supervisionof the Japanese bank in Japan,supervision of the Australian hedgefund in Australia, protection of theEuropean borrower in Europe.

(57) See High Noon for CDS clearing, ref. 54above, 34.

(58) See Divide and Conquer, ref. 28 above,23 et seq.

(59) See Jacob Bunge, ‘Regulators SeekCoordinated Oversight of CDSClearing houses’, Wall St. Journal, 20thFebruary, 2009.

(60) See Nikki Tait, ‘New Move for CDSClearer in Europe’, FT, 12thFebruary, 2009; Jeremy Grant andNikki Tait, ‘European CDS ClearingHits Hurdle’, FT, 13th January, 2009,both available at: www.ft.com. Incontrast to the European Commission,European dealer banks would preferto clear CDS trades through a singleglobally functioning CCP, regardless ofits location, ibid.


Page 204