Decoding Derivatives - Q4 2019

Thomas Cook Takeaways

For credit default swap (CDS) protection buyers with protection on Thomas Cook Group Plc,  a U.K. scheme of arrangement paving the way for a £1.6 billion debt-to-equity exchange imposed on all debt holders coupled with a Chapter 15 filing in the U.S. was insufficient to constitute a bankruptcy credit event. However, an automatic acceleration provision in an indenture triggered just before the roll date saved the day. Allaying some of the concerns following determination in Windstream in 2017, the DC engaged in an analysis of the automatic acceleration provision and made an interpretation of the indenture based on settled principles of contractual interpretation. Thomas Cook therefore not only adds to the ever-filling vault of complicated credit events, but also reiterates that the DC will engage in some reasonable amount of debt documentation interpretation.

Net-Short Lender Activism

Following the case of Windstream, the credit markets have been adapting to the risk of net-short lenders taking adverse actions against a borrower/issuer to favor their short positions. Windstream, however, appears to be a unique case study and, as has been highlighted by some market experts, the perception of “creditor sabotage” is misplaced and largely a consequence of partisan hyperbole. Nonetheless, credit documentation addressing net-short lenders has made it to market in a number of forms. Such rapid adoption of updated documentation indicates that credit markets can be very reactive to perceived threats and, predictably, there are evident flaws in the provisions that have found their way to market thus far.

Credit Derivatives Definitions Updated

In order to address the proliferation of so-called narrowly-tailored credit events, ISDA has issued updates to the 2014 Credit Derivatives Definitions. The new credit deterioration requirement injects significant subjectivity into a previously objective determinations process and will likely have some value implications for outstanding CDS trades and the possible liquidity implications of non-adherence. Nevertheless, the changes have been widely adopted with 1,298 parties adhering to the protocol; however, a short additional adherence period is expected to be opened immediately prior to the effective date to sweep up non-adhering parties. The changes become effective on Jan. 27, 2020.

CDS Is Critical for Cash Market Liquidity

As opportunistic CDS strategies have proliferated over the past few years, many have taken aim at the CDS market. Some commentators view the market as a casino, with few market participants, each equally incentivized to be the smartest person in the room. However, what many fail to realize is that the CDS market is far larger, far more diverse and far more critical to a liquid debt market than it is given credit for. Moreover, participation in the CDS market has been relatively stable, notwithstanding recent developments. As ISDA has noted in its market study, CDS trade volume has ticked up since multiyear lows in the first part of 2018 and, as a similar CFTC market study noted, the reduction in notional amounts over time is also concentrated in the interdealer market, and thus not reflecting a diminution in the amount of CDS being traded by end users.

Given its flexibility and utility as a hedge, the CDS product is critical to liquid cash credit markets and is a vital tool for not only private funds, but also mutual funds and bank lending desks alike. As a recent Bank of England study noted, there is empirical evidence that the presence of CDS increases liquidity in the corporate bond markets. The CDS market is, though, not without liquidity issues. As the CFTC study also highlights, despite a migration to clearing, which should bolster liquidity, the number and size of single-name CDS contracts with high levels of liquidity has decreased. That said, the stable end-user volume shows that CDS continues to serve an important purpose despite this reduction in liquidity in certain names. It would have been interesting had the CFTC study identified who the players in the CDS market are, an information the CFTC has access to.

In any event, whatever one may think of CDSs, it is clear that they serve a critical role in our financial markets and investors continue to see CDS as a useful product. Following market changes, recent events and activism by regulators, the question for the credit markets is how can we promote continued stability and ultimately growth and enhanced liquidity in the CDS product going forward? As we have advocated, a forum of buy-side and sell-side market participants to identify issues and fixes would be very helpful in that respect.

Kramer Levin Hosts CDS Symposium

Kramer Levin hosted a panel discussion on the upcoming NTCE updates. This was the inaugural event in Kramer Levin’s CDS Symposium series, continuing in 2020, addressing the most pressing issues in the CDS market. The panel was moderated by Kramer Levin partner Fabien Carruzzo and included Nick Van Dusen (Goldman Sachs), David Hong (King Street Capital Management), Steven Sparling (Kramer Levin) and Daniel King (Kramer Levin). The discussion centered on the application of the changes to real-world scenarios and the value implications of adhering to the ISDA protocol. The panel and audience engaged in though-provoking discussions of hypothetical fact-patterns and how they should be viewed under the updated Credit Derivatives Definitions.