dcg credit event terminology

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Sapient is a global firm supporting capital market participants who use derivatives. Derivatives Consulting Group (DCG) is a wholly owned subsidiary of Sapient and specialises in derivatives and capital markets operations support, consulting and outsourcing. All DCG resources are trained through the DCG Academy.

The DCG Academy is a unique three year training program focusing on product knowledge, business processes and professional skills. The Academy ensures that our staff have an unrivalled level of skill to support our clients.

This glossary represents a quick reference guide for our clients who may currently or in the future be exposed to any credit event.

The DCG quick reference guide to credit event terminology

Standard CDS Physical Settlement Timeline

DCG SUBJECT MATTER EXPERTS

www.sapient.com/trm

Boston Ed Dragon [email protected] +1.617.963.1576

India Prakash Kini [email protected] +91.805.1047094

London Anna McAndrew [email protected] +44.207.653.1470

New York Pat O toole [email protected] +1.212.488.4210

Singapore Steve Payne [email protected] +65.6622.5813

Prior to or on the Scheduled

Termination Date

Up to 14 calendar days after

Scheduled Termination Date

Event

Determination

Date

Physical

Settlement

Date

Cut Off Date

Europe & Asia: 30 business days

US: No longer than 30 business daysA further 5 business days

Up to 30 Calendar

days after EDD

Physical

Settlement Period

A further 5 business daysEurope & Asia: 60 Business day cap

US: No cut off date

CREDIT

EVENT

CEN PAI

NOPSProtection

Seller Buy-in

Process

Protection

Buyer can

deliver

Alternating 5 day cycle

Settlement Fall Back Period

DerivativesConsultingGroup

A DCG Training Academy Publication. Edited by Jonathan Davies and Anna McAndrew


Adherence

The process by which market participants sign up to an ISDA credit event protocol.

Adherence Period

The period between the date of publication of an ISDA credit event protocol and the cut off date. Parties can adhere to a protocol as a participant or a participating bidder. Participants agree to cash settle their covered transactions with other participants at the final price. Participating bidders submit quotes into the auction process in accordance with the auction terms.

Adjustment Amount

A penalty amount paid to ISDA for the submission of off-market bids into a credit event auction. If the open interest is to sell, high bids are penalised. If the open interest is to buy, low offers are penalised.

Administration

A UK bankruptcy provision in which a company will appoint a third party administrator to conduct an orderly wind-down of the business.

Auction Date

The date on which a credit event auction takes place.

Auction Party

A credit derivative market participant who has adhered to a credit event protocol as participant or participating bidder for a specific credit event.

Auction-Settled Transaction

A credit derivative transaction which is cash settled with reference to the final price as determined in the credit event auction.

Bankruptcy

One of three market standard credit events applicable in the majority of credit default swaps where the reference entity is a corporate (bankruptcy does not apply to sovereign names). Bankruptcy events include the reference entity being dissolved, becoming insolvent, making an arrangement for the benefit of its creditors, being wound up or having a judgment of insolvency made against it.

Bid Price

The price at which a trader or market maker is willing to purchase a contract.

Borrowed Money

A category of debt obligation. Typically a CDS will reference the senior unsecured debt of the reference entity. Borrowed money is a broader category of debt relating to any funds that have been borrowed by the reference entity.

Buy In Procedure

A back-up physical settlement process which can be exercised if a buyer of protection fails to deliver a deliverable obligation to the seller within the physical settlement period. The right to settle the contract reverts to the seller of protection who can source an appropriate deliverable in the market in order to settle the contract.

A DCG Training Academy Publication. Edited by Jonathan Davies and Anna McAndrew www.sapient.com/trm

Cash Settlement

Settlement of a credit derivative contract under which a credit event has occurred by a payment from protection seller to protection buyer. The payment is equal to the difference in the notional of the contract and the final price of an agreed reference obligation, as determined by cash settlement valuation mechanics or in a credit derivative auction.

Chapter 07

A bankruptcy proceeding under US law where a company ceases trading. A trustee is appointed to liquidate the assets of the company in order to meet the claims of creditors.

Chapter 11

A form of US bankruptcy that involves the reorganisation of the business affairs, assets and debts of a bankrupt company. Otherwise known as bankruptcy protection, it is generally filed by corporations who may be able to restructure their business and emerge later as a going concern.

Chapter 15

A US bankruptcy proceeding catering for cross border bankruptcies.

Cheapest to Deliver

An optionality that exists after technical or soft credit events when not all deliverable obligations are trading at the same price, equal to the expected recovery rate. Buyers of protection have an option to source the cheapest obligations in the market to deliver under physical settlement, often creating a short squeeze.

Close Out

The process following a termination event under an ISDA master agreement through which all outstanding OTC transactions under the master are terminated. The net exposure between the defaulting and non-defaulting parties are then calculated in order for claims against either party to be made.

Conditionally Transferable

A conditionally transferable obligation is only transferable between parties under certain circumstances. For example, the consent of the debt issuer may be required before ownership can be transferred.

Covered Transaction

A transaction that can be cash settled under an ISDA credit event protocol and associated auction. Covered transactions include single name CDS, tranched or untranched transactions referencing a credit index, constant maturity swap transactions (both portfolio and single name), principal only and interest only transactions, first to default and nth to default transactions, recovery lock transactions, swaptions (both single name and portfolio). Covered transactions include those documented under either the 1999 or 2003 definitions.

Credit Default Swap (CDS)

The simplest credit derivative contract designed to isolate credit risk and allow it to be transferred between parties. In a single name CDS, the credit risk of a reference entity is transferred from protection buyer to protection seller. In return, the protection buyer pays the seller a fixed rate premium over the life of the transaction, or until a credit event occurs, in which case there is a compensatory payment from seller to buyer.



Credit Event

An event linked to the deteriorating creditworthiness of an underlying reference entity in a credit derivative transaction. The occurrence of a credit event triggers full or partial termination of the contract and a compensatory payment from protection seller to protection buyer, through either physical or cash settlement. The market standard credit events are bankruptcy, failure to pay and restructuring. However some contracts also include obligation acceleration, obligation default and repudiation/moratorium.

Credit Event Auction

An independently administered synthetic auction process on a set of defined deliverable obligations that sets a reference final price that can be used to facilitate cash settlement of all covered transactions following a credit event.

Credit Event Notice (CEN)

One of the notices required to be delivered to trigger a credit derivative transaction when a notifying party believes a credit event has occurred. A CEN must contain a description in reasonable detail of the facts relevant to the determination that a credit event has occurred. It should be noted that the delivery of the notice is a process to facilitate settlement and that delivery of the notice does not override fact or law.

Credit Support Annex (CSA)

An annex to an ISDA master detailing the terms of the collateral agreement between the parties.

Default Date

The date on which a credit event is deemed to have occurred.

Deliverable Obligation

Debt obligations of a reference entity that has suffered a credit event that are eligible to be delivered under physical settlement of any relevant credit derivative contracts.

DTCC Credit Event Processing

A service offered by DTCC Deriv/SERV to cash settle final payments and fixed rate stubs following a credit event through the Warehouse.

Event Determination Date (EDD)

The date on which the credit event notice and notice of publicly available information are delivered by the notifying party in order to trigger a credit derivative transaction.

Event of Default

A termination event under an ISDA Master agreement.

Excluded Transactions

A transaction that cannot be settled under an ISDA credit event protocol and associated auction. Excluded transactions include reference obligation only transactions, loan only transactions, preferred CDS, fixed recovery transactions and OTC hedge transactions for credit linked notes (or other securitised Credit Linked instruments).



Expected Recovery Rate (ERR)

The recovery rate expected by the market at the point of bankruptcy. In efficient markets, defaulted bonds will trade at the ERR.

Failure to Pay (FTP)

A credit event that is triggered if a reference entity fails to make interest or principal payments due under the terms of one or more of their debt obligations. FTP is usually subject to a minimum payment requirement and grace period.

Final Price

A reference final price determined in a credit event auction or through a bilateral cash settlement valuation methodology. The final price is used to cash settle transactions after a credit event.

Fixed Rate Payer

The buyer of protection under a credit derivative contract.

Fixed Rate Premium

The fixed rate payable from protection buyer to protection seller under a CDS contract.

Floating Rate Payer

The seller of protection under a credit derivative contract.

Floating Rate Payer Calculation Amount

The notional of the relevant credit derivative transaction.

Fully Transferable

An obligation that is fully transferable is freely tradeable with no restrictions. For example, no consent of the borrower is required to transfer ownership of the asset.

Grace Period

A period, usually of 30 days, after which a potential failure to pay becomes an actual failure to pay and hence a credit event.

Grace Period Extension Applicable

If grace period extension is applicable, protection is deemed to be valid under a credit derivative contract if a potential failure to pay occurs before the scheduled termination date, but the actual failure to pay occurs afterwards (i.e. after the grace period has expired).

Hard Credit Event

A credit event in which all debt obligations of the reference entity have become due and payable immediately, resulting in them all trading at the same value equal, in efficient markets, to the expected recovery rate.

Initial Bidding Period

The first stage of a credit event auction which culminates in the calculation and publication of the inside market mid point and the size and direction of the open interest.

Inside Market Mid Point (IMM)

The first stage in the setting of a final price in a credit event auction is the setting of an IMM. The Inside Market Mid-Point is a hypothetical representative mid-market price for reference obligations of the affected Reference Entity named



in the relevant Protocol. It is calculated through a bespoke credit event auction process that is similar to familiar dealer-poll type methodology in other OTC transactions.

ISDA Credit Event Protocol

An agreement published by ISDA following each credit event. The protocol requires adhering parties to agree to amend the terms of covered transactions between themselves and other adhering parties such that they become cash settled with reference to a final price as determined by the associated auction methodology. Each protocol will define a default date and an expected cash settlement date.

ISDA Physical Settlement Matrix

Parties to a physically settled CDS may incorporate the terms contained in a matrix published by ISDA which sets out the standard market terms for different transaction types.

ISDA Risk Reduction Trading Session

A special out of hours trading session organised for credit derivative dealers to allow them to hedge market risk due to an impending bankruptcy filing of another dealer.

ISDA Uniform Settlement Agreement (USA)

An agreement published by ISDA following a credit event that allows adhering parties to agree that a CEN and PAI are deemed to have been delivered correctly and timely on the notice date without requiring the actual delivery of such notices. The decision to sign up to the USA is separate and independent of the decision to sign up to any associated protocol.

Limit Order

Bid or offer inputs into the second stage of a credit event auction. Limit orders differ from physical settlement requests in that they have a firm price associated with them, in addition to a size and buy/sell direction. Limit orders represent a firm commitment by participating bidders to either deliver or receive deliverable obligations at the price and in the amount stated in the order.

Market Position

The aggregate amount of deliverable obligations a participating bidder in a credit event auction would have to sell or buy in order to obtain an identical risk profile with respect to both covered transactions and auction-linked cash settled transactions with counterparties also adhering to the protocol.

Markit RED

A reference Entity Database citing legally ‘scrubbed’ reference entity names and associated reference obligations in RED ‘pairs’.

Modified Modified Restructuring

Normally traded on European reference entities and reflecting the deeper loan market there, modified modified restructuring restricts deliverable obligations to ‘conditionally transferable’ obligations with a maximum maturity of 60 months after the legally effective restructuring date. The multiple holder obligation is also applicable, apart from loan only obligations.

Modified Restructuring

Normally traded on North America and Australian reference entities, modified restructuring restricts



deliverable obligations to ‘fully transferable’ obligations with a maximum maturity of 30 months after the legally effective restructuring date. The multiple holder obligation is also applicable under modified restructuring (deliverable obligations must have at least four owners).

Multiple Credit Event Notices

A process in the 2003 ISDA credit derivative definitions that allows for the delivery of a number of credit event notices, and the associated partial unwind of a credit derivative transaction where the buyer of protection is the notifying party.

Multiple Holder Obligation Applicable

A restriction under modified and modified modified restructuring which stipulates that an eligible deliverable obligation must have at least four holders.

Notice of Intended Physical Settlement (NIPS)

A NIPS is the equivalent of a NOPS under the 1999 definitions. It differs from a NOPS in that a NIPS sets out that it is the intention of the buyer to physically settle a credit derivative. It is not an irrevocable notice that the buyer will do so.

Notice of Physical Settlement (NOPS)

The NOPS is an irrevocable confirmation that the buyer of protection will physically settle a CDS contract. The NOPS must be delivered within 30 calendar days of the EDD and must contain a detailed description of the intended deliverable obligation. The buyer may change the intended deliverable obligation, up to and including the physical settlement date, by the issuance of another NOPS. However, the settlement period is calculated from the day

on which the first NOPS was delivered. The NOPS replaced the Notice of Intended Physical Settlement (NIPS) from the 1999 definitions.

Notice of Publicly Available Information (PAI)

The second notice required to be delivered to trigger a credit derivative transaction when a notifying party believes a credit event has occurred. A PAI cites the publicly available information that reasonably confirms a credit event has occurred. It is market convention to cite two sources of publicly available information from ‘internationally recognised’ news sources.

Notification Time

The time by which a CEN and PAI must be delivered by the notifying party, usually 4pm London time, else the event determination date is deemed to be the next good business day.

Notifying Party

The party triggering a credit derivative after a credit event by the delivery of the CEN and PAI.

Obligation Acceleration / Default

Obligation acceleration is a technical credit event where the obligations of a reference entity have become declared due and payable before they would otherwise have been. Obligation default is where the obligations of a reference entity have become capable of being declared due and payable before they would otherwise have been (due to an event of default by the Reference Entity).



Open Interest

The open interest is the net sum of all physical settlement requests submitted by participating bidders into a credit derivative auction.

Participant

A signatory to a credit event protocol and participant in the auction but not as a participating bidder.

Participating Bidder

Participants in a credit event auction who submit inputs into the auction and must represent in writing that:

They regularly trade in securities ‘of the type’ as those defined as deliverable obligations in the protocol and / or;

They regularly trade CDS on the reference entity and;

They are in a position to deliver or accept delivery of the deliverable obligations and;

They agree to abide by the terms of the auction methodology.

Physical Settlement

Settlement of a credit derivative contract under which a credit event has occurred by delivery of a deliverable obligation of the reference entity from protection buyer to protection seller. Under physical settlement the seller also pays the buyer the notional cash amount of the contract.

Physical Settlement Date

The date of delivery of the deliverable obligation.

Physical Settlement Period

The timeframe after the delivery of a NOPS in which the buyer must deliver an eligible deliverable obligation to the seller.

Physical Settlement Request

A representation from a participating bidder in a credit event auction. Each participating bidder in a credit derivative auction must submit a physical settlement request. Such requests represent, either for their own account or on behalf of a customer, the price at which they would buy / sell the deliverable obligation in an amount equal to their net open market position (and in the same direction).

Recovery Rate

The percent of a creditor’s claim that is actually recovered through liquidation of the assets of a company following bankruptcy.

Reference Obligation

A debt obligation of a reference entity that determines the minimum seniority of an eligible deliverable obligation under a credit derivative. A deliverable obligation must not be subordinated to the reference obligation. It should be noted there is no obligation to deliver the reference obligation.

Representative Auction Settled Transaction

A representative auction settled transaction is a standardised CDS contract referencing the defaulted entity following a credit event and used as an input into the auction process.

Repudiation / Moratorium

A credit event applicable to sovereign and some Asian names which occurs when there is both a statement by an authorized government officer that repudiates or rejects the validity of one or more of their debt obligations, followed by a failure to pay on or restructuring of one or more of such obligations.



Restructuring

A credit event that occurs when a reference entity restructures the terms of some or all of its’ debt obligations in agreement with its’ creditors. Common restructuring events include debt for equity swaps, extensions in maturity or reductions in principal or interest payable.

Scheduled Termination Date

The maturity date of a credit derivative contract. A credit event has to occur on or before the scheduled termination date for protection to be valid.

Short Squeeze

A market phenomenon created as the result of the physical settlement mechanics of CDS. In order to settle the CDS, buyers of protection who do not have an underlying physical position in a deliverable obligation have to go and buy them in the market. The price of the underlying physical instrument moves artificially higher, driven by increased demand and distorting the value of CDS protection.

Soft Credit Event

A credit event in which not all debt obligations have become due and payable immediately. In this situation, not all deliverable obligations will have the same value, resulting in a cheapest to deliver option and a potential for a short squeeze.

Successor Event

An event such as a merger, demerger, amalgamation or transfer that changes the legal structure of a reference entity under a credit derivative transaction. A succession event is distinct from a restructuring event which refers to the restructuring of the debt obligations of a reference entity.

Tear Up

The process by which derivative transactions are terminated on a bilateral basis whilst maintaining the predefined tolerances of an institution for changes in counterparty credit risk, market risk and cash payments.

Technical Credit Event

An event where a company is not bankrupt and has not ceased trading, but where a credit event is nevertheless deemed to have occurred. An example is the appointment of the US government as conservator of Fannie Mae and Freddie Mac.

Termination Event

An event under an ISDA master that allows a non-defaulting party to close out all ISDA documented transactions with a defaulted counterparty.



dcg credit event terminology

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