The credit derivatives industry faced a challenge with Germany’s 2018 passage of a law reclassifying the seniority of German banks’ outstanding unsecured bonds to comply with a European Union (EU) directive on loss-absorbing capital levels. The change in banks’ bond seniorities produced a knock-on effect in the default protection contracts counterparties held on these bonds, necessitating a massive documentation revision affecting tens of thousands of credit derivatives contracts.
Making these changes could have been a massive headache for affected counterparties, but thanks to a combination of factors -- the International Swaps and Derivatives Association’s (ISDA’s) 2019 German Bank CDS Protocol, changes to IHSMarkitSERV’s operating procedures, and the processing infrastructure of DTCC’s Trade Information Warehouse (TIW) -- contract records were updated seamlessly, with no disruption to the industry.
TIW, an offering of DTCC’s Repository and Derivatives Services (RDS), plays a central role in the global credit default swap (CDS) market by automating the record keeping, lifecycle event processing, and payment management for these contracts. Implementing industry protocol changes like those for German bank CDS is part of its mission.
What is TIW
After collaborating with major dealers in 2003 to introduce a CDS payment reconciliation service, DTCC in 2006 established TIW, the industry’s first infrastructure for record retention and asset servicing of credit default swaps worldwide.
Although its activities are now generally considered business as usual, TIW has had a tremendous impact on the CDS market. Ever since the global financial crisis in 2008 and 2009, TIW has been an important source of information on the size and depth of this market. TIW is also responsible for processing corporate mergers and defaults for the outstanding CDS positions on those underlying entities, including the Sears Roebuck bankruptcy processed by TIW in January 2019. Dozens of such credit events occurred during the 2008-2009 crisis, 50 of them in 2009 alone.
“But TIW does more than routine lifecycle processing,” said Val Wotton, DTCC Managing Director, Product Development and Strategy, Derivatives and Collateral Management. ”It helps the industry implement protocol changes that occur from time to time and require absolute precision.”
Protocols are issued by industry body ISDA to multilaterally amend the language or terms of ISDA standard contracts, often in response to regulatory or legislative developments. With its track record of seamless processing and the trust it has earned from market participants, TIW is the entity the industry relies on to carry out large-scale records modifications necessitated by ISDA protocols. ISDA’s German Bank CDS Protocol, issued in February 2019, is just the latest to be implemented by TIW.
Amending contracts in bulk
As explained by an August 2018 comment published by Moody’s, the EU’s Bank Recovery and Resolution Directive (BRRD) aims to shift the cost of a bank’s failure from taxpayers to bank creditors, by requiring EU banks to “hold minimum volumes of loss-absorbing capital and debt.” The law passed by the German parliament in July 2018 brings the country’s banks into alignment with those in other EU nations. Among its provisions, the legislation reclassifies – i.e., downgrades – the seniority of banks’ subordinated unsecured debt outstanding at the time of the law’s passage, putting these bonds first in the queue to take losses in the event of a bank failure.
Because this sweeping reclassification triggered a wholesale revision of the documentation for all outstanding credit default swaps on German bank debt, DTCC began working with ISDA and the industry following release of the ISDA protocol to determine which transactions and fields needed updating to match the redefined subordination of each affected debt obligation. Once the relevant transactions and fields were identified, TIW processed the updates to the contracts it holds, thereby maintaining their “golden” status. The updates covered cleared and uncleared contracts.
“Essentially, we amended outstanding trades to reflect the new credit hierarchy,” said Marcus Denne, DTCC Executive Director and TIW Product Lead. “Our updates represented a massive risk mitigant to the market by alleviating doubt about the level of insurance parties had purchased.”
TIW’s work also minimized operational risks to market participants. If counterparties had needed to implement the protocol changes on their own, they would have faced enormous difficulties. A firm buying or selling protection on a bond issued by a German bank would first have had to seek agreement with all the institution’s dealer and buy-side counterparties on that bond’s position in the new seniority hierarchy and on whether a bankruptcy would prompt a default on the bond, Denne explained. Such agreement, if secured, would have had to be documented and amendments added to hundreds or thousands of contracts.
“If the burden had rested on counterparties to revise all their contracts and documentation on German bank CDS, the level of confusion and uncertainty around who was covered in a case of default and who would pay who would have been immense,” Denne said. “TIW removed a huge amount of cost and risk from the process.”
While counterparties can opt out of TIW’s processing of protocol-driven contract changes, they rarely do so because of the substantial benefits TIW delivers in minimizing firms’ operational risks.
Protocol processing results
After several weeks of preparation, TIW processed the protocol changes on May 2019. In total, nearly 144,000 positions were affected by the changes.
“This latest protocol implementation is another example of how TIW facilitates the smooth functioning of the CDS market and significantly reduces its risks, to the benefit of all market participants,” said Wotton.