Quantum Mechanical CDS…

Credit Default Swaps (or CDS) have been around for over 20 years by now; and their use has waxed and waned over time. One of the arguments that has been used to assert their superiority over other credit risk mitigation or management techniques has been that the nature of their triggers and documentation (under various ISDA protocols) provides “certainty” of payment as long as the fee for protection has been paid.

The title of this blog is homage to an excellent post on the Dealbreaker website entitled “Schrödinger’s CDS”, which alluded to Heisenberg’s Uncertainty Principle and the famous thought experiment about whether, in the weird world of quantum mechanics, a cat could be both alive and dead at the same time; making the point that, in the world of CDS obligors there are supposed to be only 2 possible states- either “normal” or “defaulted”- i.e., no payment due, or payment due.

However, a recent controversy involving the ailing Noble Group has called into question the validity of this binary assertion about state. To sum up, when Noble Group extended loan payment terms on some of its debt parties who had bought protection on the company’s debt asserted that the action triggered payment on their CDS contracts. Given that there are apparently some USD 1.2BN of CDS contracts written on Noble Group’s debt, involving many different parties, the potential claims could be significant (with the FT quoting a figure of “up to USD 157MM”).

The question of whether a trigger had occurred was meant to be determined by the Industry Determinations Committee (IDC) mechanism managed by ISDA, in which 15 members (10 sell-side and 5 buy-side) vote on whether or not a “credit event” has occurred and, thus, payments triggered.

In the case of Noble Group, for reasons which have still not been properly explained (hence Dealbreaker’s mocking post) other than a statement that there was “insufficient information”, the relevant IDC was unable to make any determination at all. Naturally, this resulted in confusion, and no little amount of disbelief and frustration all round, as a mechanism that was supposed to end the practice of bilateral “flurries” of notices of claim and create certainty singularly failed to do so. ISDA has been at some pains to distance itself from the shambles, claiming that it is only the secretary and administers the process: “…we don’t have a vote and we don’t make decisions”.

The IDC then re-considered 2 formal questions posed to it by counterparts involved in the saga; and gave a narrow ruling that any attempts to trigger a payment had to be accompanied by “publicly available information” confirming the existence of particular language. It is unlikely that the CDS market’s major participants will be satisfied; and it has not gone unnoticed that the composition of the IDC creates inherent conflicts, rather than alignment of interests.

And in a further blow, the ICE (owner of the NYSE and LIFFE) has now stated that it will no longer oversee the administration of the DCs, because it cannot agree indemnification from the member banks and investment groups in the event of litigation, which puts ISDA itself as the Secretary of the IDC structure in the position of needing another third party to replace ICE.

At Awbury, our goal is to create and issue contracts which provide carefully-crafted, clear and unambiguous protection against a particular risk or risks, in ways which not only properly align interests, but provide certainty; because creating the potential for an ambiguous and disputed outcome such as occurred in the case of Noble Group’s CDS contracts helps no-one.

The Awbury Team


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