By Alex Adamis*
Once derided as an accelerant of the 2008 financial crisis, the credit default swap (CDS) market has returned to the center of controversy. CDS are financial derivatives in which a party agrees to assume the default risk of a debt issuer (the “reference entity”), in exchange for premiums based on that entity’s creditworthiness[i]. If a reference entity defaults, a protection seller must pay the buyer face value in exchange for a markedly less valuable security.[ii] While CDS resemble insurance, purchasers do not need to have an “insurable interest” in the reference entity’s debt instruments.[iii] This difference allows speculators to profit from their perspectives on the issuer’s creditworthiness without having any actual exposure to its financial condition. Recently, opportunistic traders have attempted to influence the reference entity to benefit their CDS positions. These transactions, known as “narrowly tailored credit events,” or NTCEs, test the outer ethical and legal limits of financial innovation. Further, these transactions call into question the ability of the International Swaps and Derivatives Association (IDSA), a private trade association that regulates CDS transactions, to police cunning financial innovators. While NTCEs are problematic, the Securities and Exchange Commission (SEC) and other government regulators should take a “wait-and-see” approach toward ISDA’s new reforms before taking more aggressive steps.
NTCEs are not uniform. Their composition depends on a speculator’s position on the reference entity. Practical examples best illustrate how these transactions work. In 2013, GSO Capital Partners LP, the credit unit of alternative asset manager Blackstone, bought credit protection on Codere, a Spanish betting parlor operator, meaning the fund would profit if the company defaulted.[iv] Unable to access traditional financing, GSO offered Codere a solution: a debt package conditional on defaulting on certain obligations.[v] This event would trigger the CDS contracts and provide the Blackstone unit a massive profit. Another NTCE began with GSO selling credit protection on Norske Skog, a distressed Norwegian paper company hurt by digitization.[vi] Had Norske Skog defaulted, GSO was liable to pay face value for securities of diminished value. However, GSO provided the paper mill operator with enough financing to keep the company alive long enough until the CDS contracts expired.[vii] NTCEs, while elegant to financial academics, present massive problems to market efficiency. Market participants are frequently unaware of NTCE traders’ positions, leading to an incorrect perception of the reference entity’s actual creditworthiness.[viii]
In June 2019, the SEC, along with the Commodity Futures Trading Commission (CFTC) and the United Kingdom Financial Conduct Authority (FCA), announced an inquiry into NTCEs, stating that, “these opportunistic strategies raise various issues under securities, derivatives, conduct and antifraud laws.”[ix] Since this announcement, ISDA has taken action independent of public securities regulators to combat NTCEs.
ISDA’s regulatory power over NTCEs stems from its Master Agreement, a document most dealers require their counterparties to execute before engaging in swap trades.[x] The Master Agreement provides market participants a standardized legal infrastructure dealing with major issues that arise in derivatives trading. Section 5 provides ISDA its most direct path to deal with NTCEs. This Section defines the circumstances under which reference entities are deemed in default, triggering payouts on CDS contracts.[xi] The categorization of a default event falls on ISDA’s regional Determinations Committees.[xii] In response to the proliferation of NTCEs, ISDA published new guidelines on how its Determinations Committees ought to analyze potential defaults, stating that the failure of a company to pay its obligations would not be a default event unless it related to “a deterioration in the creditworthiness or financial condition of the Reference Entity.”[xiii]
A wait-and-see approach would allow public securities regulators to take advantage of ISDA’s unique benefits, while reserving the right to engage in future action. As a private entity, ISDA is not subject to the same procedural and legal hurdles as federal agencies are, such as public notice and comment periods, meaning it can take faster action. This is crucial, since sophisticated financial players move at a rapid pace. Further, ISDA’s jurisdiction is trans-national, as Master Agreement signatories span the entire global reach of the CDS market. As the GSO transactions demonstrate, NTCEs can involve reference entities and CDS players from multiple countries, requiring coordinated regulatory action under different legal regimes.[xiv] Independent national agency action may create larger regional variations in CDS regulation, increasing compliance costs and diluting the benefits of standardization provided by the Master Agreement.
Some commentators have argued that ISDA’s response is insufficient and that the best way to combat NTCEs is to move swiftly to classify them as market manipulation under federal securities laws.[xv] The concern is that the reforms only target “manufactured defaults” similar to the Codere transaction, while ignoring other methods available to influence reference entities.[xvi] However, in these other transactions, the mere threat of future regulatory action may be enough to deter opportunistic CDS traders. The most common of these alternatives is represented by the Norske Skog deal. Financing arrangements to keep companies alive are necessarily longer-term transactions. To save Norske Skog, GSO and its partner extended the maturity of certain bonds by nine years and even purchased an equity stake in the company.[xvii] Uncertainty over future legal penalties will likely make CDS traders think twice before tying up large amounts of investor capital in a longer-term trade.
The wait-and-see approach, combined with the threat of future regulation, provides an opportunity for ISDA to solve the NTCE problem in the least costly way possible. However, possible action provides a backstop in the event that ISDA fails and provides a powerful signal to market participants that NTCEs violate basic notions of market integrity.
*Alex Adamis is a Junior Editor on MJEAL. They can be reached via email at firstname.lastname@example.org.
The views and opinions expressed in this blog are those of the authors only and do not reflect the official policy or position of the Michigan Journal of Environmental and Administrative Law or the University of Michigan.
[i] Justin Kuepper, Credit Default Swaps (CDS) Definition, Investopedia, https://www.investopedia.com/terms/c/creditdefaultswap.asp.
[iii] Stacy-Marie Ishmael, Repeat After Me: CDS are not insurance, The Financial Times, (Mar. 9, 2010), https://ftalphaville.ft.com/2010/03/09/169811/repeat-after-me-cds-are-not-insurance/.
[iv] Matt Levine, Blackstone Made Money on Credit-Default Swaps With This One Weird Trick, Bloomberg, LP, (Dec. 5, 2013), https://www.bloomberg.com/opinion/articles/2013-12-05/blackstone-made-money-on-credit-default-swaps-with-this-one-weird-trick.
[vi] Miles Johnson and Robert Smith, The mystery trader who roiled Wall Street, The Financial Times (Jun. 4, 2018), https://www.ft.com/content/5e23e516-5cdc-11e8-ad91-e01af256df68.
[viii] Henry T.C. Hu, Corporate Distress, Credit Default Swaps, and Defaults: Information and Traditional, Contingent, and Empty Creditors, 13 Brook. J. Corp. Fin. & Com. L. 5, 21 (2018).
[ix] U.S. Securities and Exchange Commission, Joint Statement on Opportunistic Strategies in the Credit Derivatives Market, (2019).
[x] International Swaps and Derivatives Association, Inc., 2002 Master Agreement, 5 (2002).
[xi] International Swaps and Derivatives Association, Inc., 2002 Master Agreement, 5 (2002).
[xii] International Swaps and Derivatives Association, Inc., 2018 Credit Derivatives Determinations Committees Rules, 4 (2018).
[xiii] International Swaps and Derivatives Association, Inc., 2019 Narrowly Tailored Credit Event Supplement to the 2014 ISDA Credit Derivatives Definitions, 2 (2019).
[xiv] International Swaps and Derivatives Association, Inc., Membership, https://www.isda.org/membership/.
[xv] Gina-Gail S. Fletcher, Engineered Credit Default Swaps: Innovative or Manipulative?, 94 N.Y.U. L. Rev. 102, 156 (forthcoming 2019).
[xvi] Id. at 158
[xvii] David Wigan and Robert Smith, GSO’s win-win on Norske Skog CDS, Reuters, (Apr. 28, 2016), https://www.reuters.com/article/norske-skog-cds/refile-gsos-win-win-on-norske-skog-cds-idUSL5N17V5TX.