Forthcoming CDS Convention Changes for Japan and Asia

Transcription

1 Forthcoming CDS Convention Changes for Japan and Asia December 10th, 2009

2 Contents Executive Summary... 3 Why is the CDS Market Changing?... 3 Global Contract Changes... 3 Convention Changes... 3 Convention Changes... 5 Fixed Coupons... 5 Trading with a Full Coupon... 5 Restructuring Clause Conventions... 6 Quoting Conventions... 7 Markit CDS Converter and ISDA CDS Standard Model... 7 Migration of Old Contracts to New Contracts/Conventions... 9 Portfolio Recouponing... 9 Conclusion

3 Executive Summary Why is the CDS Market Changing? The industry made many changes to the way CDS contracts are traded this past year and continues to extend these efforts for the December roll. This report outlines the convention changes for corporate and sovereign CDS in Japan and Asia. The motivations for these convention changes are to facilitate central clearing, gain efficiencies in trade and operational processing, and the reduction of the gross notional amount outstanding in the market the same motivations behind CDS Big Bang, CDS Small Bang, and other convention changes made this year. Global Contract Changes Our previous reports on the CDS Big Bang and Small Bang provide extensive detail on global contract changes to CDS contracts to date. Both reports are available at Unlike Big Bang and Small Bang, the changes discussed in this report consist of only convention changes there are no new contract changes at this time. The contract changes from Big Bang and Small Bang, at their time of implementation, applied to these classes of CDS transactions as well. Convention Changes As the changes discussed here consist only of convention changes rather than contract changes, there will not be any protocols to modify the terms of existing trades or supplements amending the 2003 ISDA Credit Derivative Definitions. There will however be new confirmation templates and product matrices similar to what accompanied the convention changes for other regions. The convention changes are: Quoting Conventions and Coupons Starting December 21, 2009 there will be 25, 100 and 500 basis points fixed strikes for corporate and sovereign Japanese CDS. For corporate and sovereign Asian CDS, the standard strikes will be 100 and 500 basis points. The standard recovery rate assumptions for single name corporate and sovereign Asian CDS will be 40% for senior and 20% for subordinated, which is similar to the conventions for most other single names. The standard recovery rate assumptions for single name corporate and sovereign Japanese CDS will be 35% for senior and 15% for subordinated, similar to the convention for the Markit itraxx Japan index. Restructuring For clarity, there will be no changes to the restructuring clause conventions for Japanese and Asian CDS, whether corporate or sovereign. The restructuring convention will continue to be Restructuring (Old R). Full First Coupon Similar to the Standard North American Corporate contract, there will be no more short stubs or long stubs dependent on the trade date for Japanese and Asian CDS. The protection buyer will pay the seller the full period accrual even if the trade is entered mid-period. The cash settlement amount due at settlement date includes a rebate payment from the seller for the accumulated accrued coupon. Like the other convention changes discussed in this report, this will be implemented on December 21, Payment Dates Japanese and Asia CDS coupon payments continue to pay quarterly. There are no changes in the payment date conventions. 3

4 Roll/Maturity Dates There are no changes regarding roll dates for Japanese or Asian CDS. These continue to correspond to the IMM dates (Mar, Jun, Sep and Dec 20). How Will This Change Existing CDS Positions? Legacy CDS positions under the existing trading conventions may become relatively illiquid. Consequently, investors likely will elect to roll into new standardized contracts, work on a bilateral basis with their counterparties to modify their positions, or utilize a portfolio recouponing service to rebook their existing positions into new positions reflecting the new coupon strikes. Markit CDS Converter In order to calculate upfront fees for CDS contracts trading under the new standardized Japanese and Asian conventions, Markit provides an upfront fee calculator: the Markit CDS Converter. The Markit CDS Converter uses the new conventions and references the Tokyo holiday calendar published on when calculating the upfront fee for all contracts trading under the Japanese conventions. 4

5 Convention Changes The changes for Japanese and Asian CDS consist entirely of convention changes. This represents a significant difference from the Big and Small Bang changes, which also included significant contract changes. However, much of the benefit from reduced operational and systemic risk stems from convention changes, as these deal with the commercial terms of individual CDS contracts. Fixed Coupons Corporate and sovereign CDS for Asia will trade with standard fixed coupons of 100 and 500 basis points, similar to North American corporates. Japanese CDS will have a 25 basis points strike as well as 100 and 500. This allows for some of the tighter credits in Japan to trade with a smaller amount upfront. The concept of fixed coupons is not new and has historically been employed in the trading of CDS indices and distressed names. The CDS Big Bang brought fixed coupon trading to single names more fully by extending the practice to investment grade credits in North America with 100 basis points coupons and 500 basis points coupons to high yield credits. Europe followed in June 2009 with their own set of standard fixed coupons: 25, 100, 500, and 1000 basis points. For a fuller discussion on fixed coupons, please see our previous report Understanding the CDS Big Bang: Global Contract Changes and North American Convention Changes at Standardized Coupons for Single Names Globally 1 The table to the right displays the standard coupons (basis points) for CDS instruments that are expected following the implementation of convention changes for Japanese and Asian CDS. Trading with a Full Coupon Source: Markit Prior to CDS Big Bang, whether a protection buyer paid a coupon on the first coupon or IMM date for a North American CDS trade depended on when the trade occurred. IMM dates are the chosen termination dates for CDS contracts: March 20th, June 20th, September 20th, and December 20th for any given year. If the trade date fell before 30 days prior to the first coupon date, the accrual was due on the first coupon date for the number of days of effective protection during the period. This was known as a short stub period. If the trade date was within 30 days before the first coupon date, there was a long stub period. No accrual of premium would be paid on this first IMM coupon date, rather the long stub would be paid on the following coupon date. That payment would include the portion of premium owed for protection in the first period plus the full premium for the second period. Clearly this is suboptimal for contract standardization. Japanese and Asian corporate and sovereign CDS will adopt the full coupon convention similar to the way the convention now works for North America as a result of CDS Big Bang. The first trading day with this convention will be December 21, For a more detailed treatment of the full coupon convention, readers are encouraged to read our previous report Understanding the CDS Big Bang: Global Contract Changes and North American Convention Changes. 1 Some dealers also quote strikes of 300 and 750 basis points for European Corporate CDS occasionally but these are not considered standard. 5

6 Restructuring Clause Conventions For clarity, there are no changes to the restructuring clause conventions for the corporate and sovereign CDS of Japan and Asia; it is Restructuring (Old R). In the post-small Bang world, this is an important distinction. As there are no maturity limitation restrictions for Old R, multiple auctions by maturity buckets would not be required. Stated another way, a single auction would set the recovery rate for a single reference entity and tier of debt. 6

7 Quoting Conventions In North America, the predominant quoting conventions are to quote 100 strikes in quoted spreads and 500 strikes in points upfront with the idea that only the more distressed credits, would see the 500 strike + points upfront convention. This followed closely the conventions from before CDS Big Bang where most names were quoted in par spreads and the more distressed credits in points upfront with a 500 basis point fixed strike. While we have yet to see new dealer runs for these transaction types, we expect the quoting conventions going forward from their implementation date to resemble the practice in North America. Explicitly stated, Asian CDS would be quoted in quoted spreads for 100 strikes and in points upfront for 500 strikes. Likewise Japanese CDS would be quoted following these same conventions with the added point that the 25 basis points strike would also be quoted in quoted spreads. Markit CDS Converter and ISDA CDS Standard Model Historically, one of the most common causes for trade breaks with Markit CDS indices has been a disagreement surrounding the upfront amount payable. As the trading conventions began to go to a fixed coupon with an upfront payment for single name trades, it was critical that trades would not break due to disagreements on the upfront payment due. This was a particular concern for entities that trade with a 100 basis points fixed coupon as dealer runs for those credits displayed a conventional spread and not the upfront payment. Thus a universally available calculator that utilized standard inputs was needed. At the urging of CDS participants, Markit created the Markit CDS Converter. The Markit CDS Converter was designed with the input of key CDS dealers and utilizes the ISDA CDS Standard Model code as well as the standardized inputs for the code. The converter allows for easy translation between the conventional spread found in dealer runs for investment grade reference entities to the required upfront payment. The upfront fee calculated includes the accrued amount. In order to determine the accrued amount for Japanese CDS transactions, the upfront fee must account for certain Japanese holidays that occur around some IMM days (September and March). The Markit CDS converter therefore incorporates a Tokyo holiday calendar that is published on for transactions under the new Japanese conventions The Markit CDS Converter can fully support the forthcoming convention changes for Asian and Japanese CDS. It supports the following currencies: Australian Dollar (AUD), Canadian Dollar (CAD), Swiss Franc (CHF), Euro (EUR), British Pound (GBP), Hong Kong Dollar (HKD), Japanese Yen (JPY), New Zealand Dollar (NZD), Singapore Dollar (SGD) and US Dollar (USD). In addition, the recovery rate field is free-form to allow a full range of recovery rates the required flexibility needed when Emerging Markets CDS conventions were added. This flexibility could also extend to municipal CDS and loan CDS transactions, if and when those products trade under a standardized recovery rate assumption. Standard Recovery Rate Conventions (Single Names) The table here illustrates the standard recovery rate conventions for single name corporate and sovereign CDS. Note that for Japanese corporate and sovereign CDS the standard recoveries are 35% and 15% for senior and subordinated, respectively. Asian corporate and sovereign CDS utilize 40% and 20% recovery rates. Source: Markit 7

8 The Markit Converter can be found at It is made freely available to investors. The Converter is an implementation of the ISDA Standard Model which is administered by Markit. More information about the model, including any updates, can be found at Markit CDS Converter The Markit CDS Converter can be found at and is instrumental in helping market participants determine the proper upfront amount required to settle a standard CDS trade. Source: Markit Note: Diagram provided as an illustration only, not an actual calculation. The changes discussed here have not been implemented at time of writing. 1. 8

9 Migration of Old Contracts to New Contracts/Conventions There are no new global contract changes for Japanese and Asian CDS at this time. Consequently, investors will not be asked to adhere to any protocols to amend the terms of legacy trades nor will there be any supplements to the 2003 ISDA Credit Derivative Definitions both were features of the CDS Big and Small Bang as part of the contract changes. Convention changes do not require documentation changes in order to conduct a transaction per se, but there will be updated confirmation documents to facilitate accurate capture of trade details and efficient trade settlement. Specifically separate confirmation documents will exist for Japanese, Singaporean, and Asian (Asia excluding Japan and Singapore) CDS. Portfolio Recouponing As these convention changes include fixed coupon strikes that are different from the par spreads where pre-existing trades were struck, investors may consider recouponing their legacy positions. Recall from the CDS Big Bang that the idea behind recouponing is to rebook an existing trade that was done at a par spread, into new trades using the fixed coupons of 100 and 500 basis points. The new trades were subject to the condition that a party replicated the same risk profile from the original trade. Stated another way, the economics of an existing position should not change simply from recouponing. This is relatively easy to do where there are only two strikes and the trades are done as No Restructuring or Old Restructuring. Recall the recouponing example we used in our Big Bang Report: Source: Barclays Capital Assume an investor bought protection with a $100 million notional legacy position and a coupon at 50 basis points requiring an annual premium of $500,000 per year. In order to yield the same cash flows using the standard combination of the 100 and 500 fixed coupons, the resulting position would be $112.5 million notional long at 100 basis points fixed and $12.5 million notional short at 500 fixed. This is fine as long as the trade is done as No R (or Old R even). However if done, under Mod R or Mod Mod R, the resulting positions one leg long protection and one leg short protection results in an asymmetric risk profile (see our report on the CDS Small Bang for more details, found at The motivation for recouponing would be to avoid possible liquidity risk in liquidating legacy positions which will be nonstandard after the adoption of new trading conventions. At this time it is difficult to say whether or not recouponing will be a significant factor for the CDS markets, simply due to the smaller amount of notional outstanding in the markets discussed here. 9

10 Conclusion While the convention changes for the CDS products discussed here seem relatively minor compared to their cousins, Big Bang and Small Bang, standardizing the CDS product globally has been an important industry priority in The December roll sees the standardization changes reach the Japanese and Asian CDS markets. While efforts at establishing central clearing houses in the Asia Pacific region are still at an early stage, the industry continues to innovate and several parties in the Asia region are actively considering the option to become a clearing house for CDS. Further standardization changes are also expected. The industry continues to work on a solution to try to harmonize the impact on Markit itraxx index tranches as a result of the CDS Small Bang. Furthermore, the industry may re-examine and possibly revise some of the changes made in the CDS Small Bang due to the challenges presented by Restructuring Events. Wider spreads on many sovereign CDS makes the focus on contract standardization and risk reduction as timely as ever. The trading of CDS contracts is a global phenomenon and greater standardization promotes greater operational efficiency and reduced systemic risk. 10

11 Contact For further information, please contact: Otis Casey Vice President Or please visit 11

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