Credit Derivatives

Praccal Guidance

Credit Derivatives

A Practical Guidance

Practice Note by

Fabien Carruzzo and Daniel King, Kramer Levin Naftalis & Frankel LLP

Fabien Carruzzo

Kramer Levin Naalis & Frankel LLP

This practice note focuses on credit default swaps (CDS)

(both single-name and index) and provides a high-level

overview of their functioning, with a particular emphasis on

corporate CDS. Although the product may appear relatively

simple at first sight, it is governed by a complex set of

rules. Investors should seek to fully understand their terms

before they trade the product in an effort to avoid falling

into a trap for the unwary.

Credit derivatives are financial contracts enabling market

participants to take, reduce, or transfer credit exposure

on a sovereign or corporate entity (Reference Entities),

and typically reference bonds and/or loans (Reference

Obligations) of the underlying reference entity. The universe

of credit derivatives encompasses a variety of derivatives

and securitized products, including CDS, total return swaps,

and credit-linked notes.

Credit derivatives are primarily used by (1) banks and loan

portfolio managers to hedge the credit risk of their bond

and loan exposures, (2) hedge funds and other assets

managers to gain specific credit exposure to reference

entities or in connection with various credit trading or

relative value strategies, (3) insurance companies to

enhance asset portfolio returns, and (4) corporations to

manage credit exposure to third parties.

For further information relating to International Swaps and

Derivatives Association (ISDA) documents, see ISDA Master

Agreement: A Practical Guide. For regulation of swaps

by the Commodity Futures Trading Commission and the

Securities Exchange Commission, see Swaps and Security-

Based Swaps under Title VII of the Dodd-Frank Act: U.S.

Regulation and Swap Dealer and Major Swap Participant

External Business Conduct Rules. For cross-border

transactions, see Cross-Border Transactions Involving Swaps

and Security-Based Swaps: U.S. Regulation.

CDS Basics

A CDS contract is a derivative contract under which one

party buys, and the other party sells, credit protection on

a set of debt obligations of an underlying corporate or

sovereign reference entity (single-name CDS) or a basket

of reference entities (index CDS). Upon the occurrence of

certain events with respect to the reference entity (Credit

Events—see the section titled Credit Events below), the

CDS contract is triggered and the CDS protection seller

typically pays an amount to the CDS protection buyer in

order to cash settle the contract. This cash settlement

amount is typically determined by reference to the value

of the reference entity’s debt obligations set via an auction

process (discussed further in CDS Settlement below).

Credit Events are defined in the 2003 and 2014 Credit

Derivatives Definitions (Definitions), which are published

by ISDA. References to the Definitions and defined terms

in this practice note are to the 2014 Credit Derivatives

Definitions. The parties to the CDS contract specify

applicable Credit Events, generally by reference to the

ISDA Credit Derivatives Physical Settlement Matrix listing

applicable Credit Events based on market conventions in

the location of the reference entity. In the U.S. for example,

Credit Events applicable to a CDS referencing a corporate

entity are Failure to Pay and Bankruptcy.

Determinations as to whether a Credit Event has occurred

and other material issues impacting the CDS contract

or its settlement are usually made by a 15-member ISDA

Credit Derivatives Determinations Committee (DC). The

DC is comprised of the 10 largest CDS dealers (based on

CDS notional amount written) in the particular geographic

area and 5 buy-side member firms (which are the same in

all geographic areas). The DC decision-making framework

is based upon the DC Rules, which are also published by

ISDA. The DC typically follows the DC Rules but it does

have the flexibility to deviate from those rules in certain

instances if necessary.

When entering into a CDS contract as an end user,

a market participant will typically face a swap dealer

counterparty. Thus, for purposes of settlement and

performance, payments and/or deliveries will occur between

the market participant and its swap dealer counterparty.

The volume of CDS on a specific reference entity is publicly

available, but not the identity of trading counterparties. It is,

therefore, difficult to assess which market participants are

actively trading the CDS product on any given reference

entity and in which size.

Credit Events

Credit Event determinations are typically made by the DC

for the relevant region (North America, EMEA, and Asia).

Any CDS market participant may request the DC to make

such a determination. Credit Events must have occurred

within 60 calendar days preceding a request (accompanied

by the requisite information) to be taken into account. This

is referred to as a 60-day look-back period.

The Credit Events most commonly applicable in corporate

CDS contracts are as follows.

Failure to Pay

The Failure to Pay Credit Event is generally very clear on its

face. The low Payment Requirement ($1 million / €1 million)

is noteworthy because relatively benign payment failures

can potentially trigger settlement of the CDS contract.

In addition, the Definitions give effect to any applicable

grace periods in the underlying debt documentation or, if

no contractual grace period applies, the Definitions imply a

three-business day grace period. The definition is as follows:

“Failure to Pay” means, after the expiration of any

applicable Grace Period (after the satisfaction of any

conditions precedent to the commencement of such

Grace Period), the failure by the Reference Entity

to make, when and where due, any payments in

an aggregate amount of not less than the Payment

Requirement under one or more Obligations, in

accordance with the terms of such Obligations at the

time of such failure.

The term “Obligation” for the purposes of the Failure to Pay

definition is very broad. In the U.S. and Europe, obligations

include any form of “Borrowed Money,” which covers any

bond or loan obligation of the Reference Entity. That said,

CDS contracts are generally tied to the seniority of the

obligations they reference. As a result, a CDS contract

written on the senior obligations of a Reference Entity may

not be settled using subordinated obligations of the same

Reference Entity. “Subordination” refers to contractual

subordination, disregarding security and collateral

arrangements and the existence of preferred creditors

arising by operation of law.

Historically, Failure to Pay was perhaps the most clear-cut

Credit Event. However, the simplicity of the definition has

been taken advantage of in recent years in the context

of defaults engineered by market participants with the

cooperation of the reference entity (so-called narrowly

tailored Credit Event). In order to prevent misuse, narrowly

tailored Credit Event terms have been incorporated into

corporate CDS contracts and now require a payment failure

to result from or in a credit deterioration of the reference

entity in order for a Failure to Pay Credit Event to occur.

The relevant amendment became effective on January 27,

2020, for most CDS contracts. It specified that a failure

to pay will not be deemed a Failure to Pay Credit Event

if it doesn’t directly or indirectly result from (or in) the

deterioration of an entity’s creditworthiness or financial

condition, as long as the Confirmation includes a credit

deterioration requirement.

ISDA also published interpretive guidance setting out

certain factors that the relevant DC should take into

account when considering a Failure to Pay Credit Event.

These factors are only indicators of whether a deterioration

in creditworthiness is implicated (or not) and are not

intended to be exhaustive or conclusive.

This interpretative guidance introduces an element of

subjectivity (and, therefore, uncertainty) into the DC’s

determination for the Failure to Pay Credit Event. While the

added uncertainty is designed to serve as deterrent against

market participants’ misuse of the Definitions to their

economic advantage, it makes the product somewhat less

predictable and potentially more susceptible to inaccurate

determinations.

Bankruptcy

The Bankruptcy Credit Event is, in most circumstances, a

clear-cut event as it typically involves a bankruptcy or other

insolvency filing. That said, certain prongs of the definition,

such as those relating to proceedings seeking “similar

relief under any bankruptcy or insolvency law or other law

affecting creditors’ rights,” are relatively complex and their

resolution may require fair amount of analysis. Bankruptcy

is defined as follows:

“Bankruptcy” means the Reference Entity (a) is

dissolved (other than pursuant to a consolidation,

amalgamation or merger), (b) becomes insolvent

or is unable to pay its debts or fails or admits in

writing in a judicial, regulatory or administrative

proceeding or filing its inability generally to pay

its debts as they become due, (c) makes a general

assignment, arrangement, scheme or composition

with or for the benefit of its creditors generally, or

such a general assignment, arrangement, scheme or

composition becomes effective, (d) institutes or has

instituted against it a proceeding seeking a judgment

of insolvency or bankruptcy or any other similar relief

under any bankruptcy or insolvency law or other law

affecting creditors’ rights, or a petition is presented

for its winding-up or liquidation, and, in the case

of any such proceeding or petition instituted or

presented against it, such proceeding or petition (i)

results in a judgment of insolvency or bankruptcy or

the entry of an order for relief or the making of an

order for its winding-up or liquidation, or (ii) is not

dismissed, discharged, stayed or restrained in each

case within thirty calendar days of the institution or

presentation thereof, (e) has a resolution passed for

its winding-up or liquidation (other than pursuant

to a consolidation, amalgamation or merger), (f)

seeks or becomes subject to the appointment of

an administrator, provisional liquidator, conservator,

receiver, trustee, custodian or other similar official

for it or for all or substantially all its assets, (g) has a

secured party take possession of all or substantially

all its assets or has a distress, execution, attachment,

sequestration or other legal process levied, enforced

or sued on or against all or substantially all its assets

and such secured party maintains possession, or any

such process is not dismissed, discharged, stayed or

restrained, in each case within thirty calendar days

thereafter, or (h) causes or is subject to any event

with respect to it which, under the applicable laws

of any jurisdiction, has an analogous effect to any of

the events specified in Sections 4.2(a) to (g).

Restructuring

Restructuring is generally not specified as an applicable

Credit Event in North American corporate CDS contracts.

This is primarily due to the fact that corporate entities

typically restructure under Chapter 11 of the Bankruptcy

Code in the U.S., which would trigger a Bankruptcy Credit

Event. Restructuring is defined as follows:

(a) “Restructuring” means that, with respect to one

or more Obligations and in relation to an aggregate

amount of not less than the Default Requirement,

any one or more of the following events occurs in

a form that binds all holders of such Obligation,

is agreed between the Reference Entity or a

Governmental Authority and a sufficient number of

holders of such Obligation to bind all holders of the

Obligation or is announced (or otherwise decreed)

by the Reference Entity or a Governmental Authority

in a form that binds all holders of such Obligation

(including, in each case, in respect of Bonds only, by

way of an exchange), and such event is not expressly

provided for under the terms of such Obligation in

effect as of the later of the Credit Event Backstop

Date and the date as of which such Obligation is

issued or incurred:

(i) a reduction in the rate or amount of interest

payable or the amount of scheduled interest

accruals (including by way of redenomination);

(ii) a reduction in the amount of principal or

premium payable at redemption (including by way

of redenomination);

(iii) a postponement or other deferral of a date

or dates for either (A) the payment or accrual

of interest, or (B) the payment of principal or

premium;

(iv) a change in the ranking in priority of payment

of any Obligation, causing the Subordination of

such Obligation to any other Obligation; or

(v) any change in the currency of any payment

of interest, principal or premium to any currency

other than the lawful currency of Canada,

Japan, Switzerland, the United Kingdom and the

United States of America and the euro and any

successor currency to any of the aforementioned

currencies (which in the case of the euro, shall

mean the currency which succeeds to and

replaces the euro in whole).

(b) Notwithstanding the provisions of Section

4.7(a), none of the following shall constitute a

Restructuring:

(i) the payment in euros of interest, principal or

premium in relation to an Obligation denominated

in a currency of a Member State of the

European Union that adopts or has adopted

the single currency in accordance with the

Treaty establishing the European Community, as

amended by the Treaty on European Union;

(ii) the redenomination from euros into another

currency, if (A) the redenomination occurs as

a result of action taken by a Governmental

Authority of a Member State of the European

Union which is of general application in the

jurisdiction of such Governmental Authority and

(B) a freely available market rate of conversion

between euros and such other currency existed

at the time of such redenomination and there is

no reduction in the rate or amount of interest,

principal or premium payable, as determined by

reference to such freely available market rate of

conversion;

(iii) the occurrence of, agreement to or

announcement of any of the events described

in Section 4.7(a)(i) to (v) due to an administrative

adjustment, accounting adjustment or tax

adjustment or other technical adjustment

occurring in the ordinary course of business; and

(iv) the occurrence of, agreement to or

announcement of any of the events described

in Sections 4.7(a)(i) to (v) in circumstances where

such event does not directly or indirectly result

from a deterioration in the creditworthiness

or financial condition of the Reference Entity,

provided that in respect of Section 4.7(a)(v) only,

no such deterioration in the creditworthiness

or financial condition of the Reference Entity is

required where the redenomination is from euros

into another currency and occurs as a result of

action taken by a Governmental Authority of a

Member State of the European Union which is

of general application in the jurisdiction of such

Governmental Authority.

(Multiple Holder Obligation), the term Obligation

shall be deemed to include Underlying Obligations

for which the Reference Entity is acting as provider

of a Guarantee. In the case of a Guarantee and an

Underlying Obligation, references to the Reference

Entity in Section 4.7(a) shall be deemed to refer to

the Underlying Obligor and the reference to the

Reference Entity in Section 4.7(b) shall continue to

refer to the Reference Entity.

(d) If an exchange has occurred, the determination

as to whether one of the events described under

Sections 4.7(a)(i) to (v) has occurred will be based on

a comparison of the terms of the Bond immediately

prior to such exchange and the terms of the

resulting obligations immediately following such

exchange.

One key consideration in the restructuring definition

is that at least some creditors must be forced into a

restructuring in order to trigger a restructuring Credit Event.

In other words, if all creditors consent to the amendment(s)

contemplated by the definition of restructuring, a Credit

Event will not occur. This feature took a prominent role

during the restructuring of Greek (Hellenic Republic)

sovereign debt, which ultimately resulted in an amendment

to the debt documentation allowing for a drag-along of

dissenting creditors, which in turn enabled the CDS to get

triggered on that basis.

Another notable feature of the Restructuring Credit Event

is that it contains a Credit Deterioration Requirement.

Specifically, any restructuring of an obligation must arise

directly from a deterioration in the creditworthiness or

financial condition of the reference entity. In determining

whether such credit deterioration has occurred, the DC will

look for public information to that effect. This is designed

to distinguish a restructuring from a refinancing. This issue

took central stage in Cemex S.A.B. de C.V. a number of

years ago, where the determination was ultimately sent to

External Review.

A Restructuring Credit Event may also lead to a more

complex settlement process than for contracts triggered

by other Credit Events because certain CDS contracts will

limit the debt obligations that can be taken into account

to settle the CDS contract by reference to the maturity

of the CDS contract. Generally speaking, only obligations

with similar maturity to the CDS contract in question are

eligible to settle the CDS contract. This results in different

obligations being eligible to settle CDS contracts with

different maturities.

The Definitions provide for two procedures for establishing

the relevant maturity buckets, known as Mod-R and Mod-

Mod-R. Mod-Mod-R is typically applicable for European

corporate entities. The maturity buckets are calculated by

establishing set periods after the restructuring date and

including all CDS contracts maturing on or before the last

day in such period in the relevant bucket. The relevant

periods are as follows:

• 2.5 years (Mod-R only)

• 5 years

• 7.5 years

• 10 years

• 12.5 years

• 15 years

• 20 years

Under Mod-R and Mod-Mod-R, CDS contracts in each

bucket may be settled only by obligations maturing on

or before the end date of the applicable maturity bucket.

However, obligations not affected by the restructuring

event and maturing within 2.5 years of the restructuring

date or, for the purposes of Mod-Mod-R only, obligations

affected by the restructuring event and maturing within 5

years of the restructuring date are also eligible to settle any

CDS contract.

For each maturity bucket, the DC will determine whether

or not to hold an auction under its standard processes

(outlined in more detail below). If the DC resolves not to

hold an auction for any maturity bucket, both parties have

the right to move their CDS contract into another maturity

bucket for which an auction is being held. The so-called

“Movement Option,” if exercised by the buyer, results in the

CDS contract moving to the next shortest-dated bucket for

which there is an auction. If the seller exercises the option,

the CDS contract is moved to the longest-dated bucket for

which an auction is held. If both parties elect the option,

the buyer’s election prevails.

Governmental Intervention

The Government Intervention Credit Event applies to

non-U.S. financial Reference Entities and was added as

a new Credit Event in 2014 when the new 2104 Credit

Derivatives Definitions were published. The necessity

for the new Credit Event became obvious in early 2013

when the Dutch government nationalized SNS Bank and

expropriated all of its subordinated bonds. This action

created significant market uncertainty since government

bail-in was not expressly covered by the Restructuring

Credit Event under the 2003 Definitions. Government

Intervention is therefore a useful complement to

Restructuring and provides certainty to market participants

when governments take certain bail-in actions in respect

of financial institutions, especially since new European

legislation has facilitated those types of intervention.

The definition is as follows:

(a) “Governmental Intervention” means that, with

respect to one or more Obligations and in relation

to an aggregate amount of not less than the Default

Requirement, any one or more of the following

events occurs as a result of action taken or an

announcement made by a Governmental Authority

pursuant to, or by means of, a restructuring and

resolution law or regulation (or any other similar

law or regulation), in each case, applicable to

the Reference Entity in a form which is binding,

irrespective of whether such event is expressly

provided for under the terms of such Obligation:

(i) any event which would affect creditors’ rights

so as to cause:

(A) a reduction in the rate or amount of

interest payable or the amount of scheduled

interest accruals (including by way of

redenomination);

(B) a reduction in the amount of principal or

premium payable at redemption (including by

way of redenomination);

date or dates for either (I) the payment or

accrual of interest, or (II) the payment of

principal or premium; or

(D) a change in the ranking in priority of

payment of any Obligation, causing the

Subordination of such Obligation to any other

Obligation;

(ii) an expropriation, transfer or other event which

mandatorily changes the beneficial holder of the

Obligation;

(iii) a mandatory cancellation, conversion or

exchange; or

(iv) any event which has an analogous effect to

any of the events specified in Sections 4.8(a)(i) to

(iii).

(b) For purposes of Section 4.8(a), the term

Obligation shall be deemed to include Underlying

Obligations for which the Reference Entity is acting

as provider of a Guarantee.

Pursuant to the 2014 Credit Derivatives Definitions,

a Governmental Intervention Credit Event is triggered

when a government’s action or announcement results

in binding changes to certain Obligations of a Reference

Entity including a reduction or postponement of principal

or interest or further subordination of the Obligation, an

expropriation, transfer, or other event which mandatorily

changes the beneficial holder of the Obligation, or a

mandatory cancellation, conversion, or exchange of the

Reference Entity’s Obligations.

While Government Intervention and Restructuring overlap

to some extent, there are noteworthy differences between

the two Credit Events. Importantly, a Government

Intervention Credit Event can be triggered regardless

of whether there has been a deterioration in the

creditworthiness of the Reference Entity and even if the

government intervention event is expressly contemplated by

the terms of the Obligation.

Publicly Available Information

The occurrence of a Credit Event must be evidenced

by publicly available information. Any public information

released by the reference entity itself, a court, regulator,

agent, or trustee under a debt obligation generally qualifies.

Alternatively, two public sources such as financial press

articles are required. Naturally, this makes the content

of any press articles critical and can, on occasion, lead to

activism from CDS market participants seeking to push

information supporting their desired position into the

market.

CDS Settlement

If the DC finds that a Credit Event has occurred, the

DC will also decide whether an auction should be held

to determine the market value of certain qualifying

(deliverable) obligations of the reference entity.

Before the advent of auction settlement, CDS contracts

were in most instances physically settled. Under physical

settlement, the CDS protection buyer would deliver to

the CDS protection seller Deliverable Obligations of the

reference entity with a face amount equal to the notional

amount of the CDS contract, in exchange for a payment

generally equal to the notional amount (i.e., receiving par

for the Deliverable Obligations). Protection buyers had an

incentive to source and deliver the “cheapest” Deliverable

Obligation in the capital structure so as to maximize the

return on their CDS positions. However, in instances where

the net notional amount (volume) of CDS written on a

given reference entity vastly exceeded to the amount of

accessible Deliverable Obligations of that reference entity,

the need to source the Deliverable Obligations for purposes

of CDS settlement increased demand for the debt, thereby

driving up its price and reducing the economic benefits

of the CDS contracts to the protection buyers who were

forced to purchase the Deliverable Obligations at an

inflated price.

Starting in 2005, CDS market participants established a

mechanism to cash settle the CDS contracts on a number

of reference entities using an auction process to establish

the price at which the CDS contract would be settled for

all CDS market participants electing to participate in the

process (via a protocol published by ISDA). In 2009, auction

settlement was incorporated into the CDS contract via a

supplement published by ISDA and became the standard

settlement method for the vast majority of CDS contracts.

If an auction is not held to settle the contract, physical

settlement applies as a fallback.

Deliverable Obligations

Only certain qualifying debt, or “Deliverable Obligations,” of

the reference entity are eligible to be used in connection

with the settlement of the CDS contract (i.e., delivered

to the protection seller under physical settlement or

bided upon in a CDS auction). Deliverable Obligations are

determined based upon certain criteria and characteristics

set forth in the Definitions.

Generally speaking, bonds or loans documented on market-

standard terms qualify as Deliverable Obligations. That said,

some of the main characteristics that must be satisfied in

order for an obligation to be a Deliverable Obligation are as

follows:

• Not subordinated. This term refers exclusively to

contractual subordination. Any security and collateral

arrangements (such as collateral subordination or

collateral proceeds priorities) and the existence of

preferred creditors arising by operation of law do not

impact an obligation’s deliverability.

• Transferable (bonds). A bond must be generally

transferable to institutional investors without any

additional contractual, regulatory, or statutory restrictions.

Common restrictions such as 144A/Reg S or regulatory

limitations on investments for pension funds or insurance

companies are permissible.

• Assignable / consent required loan. Similar to bonds,

loans must also be generally transferable. For a loan

containing no borrower/agent consent requirements,

a loan must be transferable to commercial banks or

financial institutions. For loans containing a borrower

and/or agent consent right, the loan must generally be

capable of assignment with such consent. The External

Review Panel in Sears Roebuck Acceptance Corp. held

that limitations on eligible assignees for a Consent

Required Loan may still be permissible provided such

limitations were consistent with market practice and did

not serve to materially restrict the universe of assignees.

• Maximum maturity. A Deliverable Obligation may have

a maximum of 30 years left to maturity from the date

deliverability is determined.

One critical component of the Deliverable Obligation

determination is the requirement that the obligation,

and the terms demonstrating its compliance with the

relevant characteristics, must be publicly available. The DC

Rules require the DC to consider whether an obligation

satisfies the requirements to be listed as a Deliverable

Obligation based upon publicly available information.

Market participants may also identify obligations to the DC

and provide the DC with additional information as part of

that process. However, any market participant submitting

information to the DC in that respect must represent that

the information it is providing is (or can be) made publicly

available.

Guarantees

Guarantees by the reference entity of qualifying debt

issued by a reference entity’s affiliates may also constitute

Deliverable Obligations as long as both the debt and the

guarantee satisfy certain criteria. North American CDS

contract terms provide that only qualifying guarantees

of debt obligations issued or borrowed by so-called

downstream affiliate are taken into account as a Deliverable

Obligation. A downstream affiliate is defined as an entity

whose outstanding voting shares are more than 50%

owned, directly or indirectly, by the reference entity.

CDS Auction

The determination as to whether or not to hold an auction

is made by the DC based on certain criteria set forth in

the DC Rules. If there are at least 300 CDS transactions

on a reference entity providing for auction settlement

as the primary settlement method and at least five major

swap dealers are party to those transactions and elect to

participate in the auction, CDS contracts should settle

via auction settlement. The auction process enables

CDS market participants to use cash settlement in their

CDS contracts using the Final Price for the Deliverable

Obligations set by the auction. In addition, CDS market

participants who wish to replicate physical settlement for

up to the net position of their CDS contracts may elect to

participate in the auction by submitting requests to either

buy the Deliverable Obligations (for a CDS protection

seller) or sell the Deliverable Obligations (for a CDS

protection buyer), in each case at the Final Price set for the

Deliverable Obligations in the CDS auction.

The CDS auction is highly complex but generally comprises

the following two stages:

(1) Initial Market Midpoint and Physical Settlement

Requests:

a) The DC-member dealers make submissions of

bid and offer prices on the Deliverable Obligations.

Qualifying quotations are average to produce a

“market price,” referred to as the Initial Market

Midpoint, which will be used as the starting price in

the second stage of the auction process.

b) Participating dealers, on behalf of themselves or

their customers, submit requests (physical settlement

requests) to either buy or sell a certain quantity of

Deliverable Obligations. Physical settlement requests

submitted by market participants must be in the

same direction (i.e., a net CDS protection buyer

may only submit a physical settlement request to

sell the Deliverable Obligations) and not exceed the

net position of the market participant submitting the

request (either directly or via a participating dealer).

For example, a market participant having bought

$100mm of CDS protection may only submit an

offer to sell Deliverable Obligations and may only

make a physical settlement request to sell of up to

$100mm. Those requests only indicate an amount

of Deliverable Obligations that the CDS protection

buyer/seller wishes to sell/buy in the auction. They

may not designate a specific Deliverable Obligation

or a price. The net of these buy and sell requests

across all dealers, referred to as the Net Open

Interest, determines whether traders in the second

stage of the auction will bid to purchase or offer to

sell the Deliverable Obligations in an amount equal

to that Net Open Interest.

c) This first stage of the auction occurs in the

morning, with the dealers being required to submit

their initial market bids/offers and net physical

settlement requests within a designated 15-minute

window. Within 30 minutes following the end of that

period, the results of the first stage of the auction

are published on CreditFixings, here.

(2) Dutch Auction:

a) Following the publication of the results of the

first stage, there is a 2–3 hour window during

which a Dutch auction is run to fill the Net Open

Interest. For a Net Open Interest to buy, the

offers to sell Deliverable Obligations are floored

at the Initial Market Midpoint minus 1%. This limit

is auction-specific and specified in the auction

settlement terms. Offers will be made at a price (in

increments of .125) and for a specified face amount

of Deliverable Obligations (typically in minimum

increments of $1mm). The offers will be taken in

ascending order until the total face amount of the

offers reaches, or fills, the Net Open Interest. The

price associated with the offer that fills the Net

Open Interest constitutes the clearing “Final Price” at

which the CDS contract cash settles. Conversely, if

there is a Net Open Interest to sell, there is a bid

cap at the Initial Market Midpoint plus 1%. The bids

will then be sorted in descending order.

While the auction is fundamentally a cash-settlement

mechanism, market participants making physical settlement

requests in the first stage of the auction may also physically

settle their CDS contracts up to the amount they requested

in the first stage (assuming the Net Open Interest is entirely

filled). Those trades are called Representative Auction-

Settled Transactions (RAST) and the RAST physically settle

with the CDS protection buyer delivering Deliverable

Obligations to the CDS protection seller (in the size of

the physical settlement request) in exchange for the Final

Price. Because CDS market participants do not select a

Deliverable Obligation or designate a price when submitting

a physical settlement requests, market participants assume

that they will trade the cheapest Deliverable Obligation of

the reference entity, and the Final Price tends to revolve

around that price assuming sufficient supply.

For each auction, the DC publishes a set of Auction

Settlement Terms setting out the auction procedure,

metrics, timeline, and relevant rules governing the bidding

process. These terms are generally uniform from auction to

auction but the DC provides a blackline against the terms

for the most recent prior auction to show any changes.

Succession Events

Succession events may cause the Reference Entity under a

CDS contract to change depending on the amount of debt

issued or borrowed by the Reference Entity assumed by or

transferred to other (successor) entities.

Successions

A succession event occurs where one or more entities

succeed to a sufficient amount of bonds and loans of

the Reference Entity (typically more than 25%). In those

instances, a determination is made as to whether the

CDS contract written on the Reference Entity should

reference one or more of such successor entities (and in

which proportion). Any request to the DC to determine a

successor will only be taken into account if the date of the

event in question is not more than 90 days prior to the

date of the request.

“Succession” (and “succeed”) under the Definitions means

that one or more successor entities have assumed the

relevant obligations of a Reference Entity either by

agreement or operation of law (e.g., a merger) or via an

exchange offer where the Reference Entity’s obligations are

exchanged for new obligations issued by such successor

entities. The Reference Entity may be a successor if it

retains at least 25% of its qualifying bonds and loans.

Once the number of successors has been determined, the

notional amount of the CDS contract will be reallocated

equally among the successors.

For purposes of determining whether an entity succeeds

to the relevant obligations of the Reference entity and

in which proportion, the assumed or exchanged for

obligations are measured against all relevant obligations of

the Reference Entity outstanding immediately prior to the

succession event. Obligations succeeded to by an affiliate

of the Reference Entity (only a “downstream” affiliate in

the North American CDS contract), but that are guaranteed

by the Reference Entity are not deemed to have been

succeeded to because the Reference Entity continues to be

an obligor with respect to those obligations.

Steps Plans

For multistage refinancings, the 2014 Definitions introduced

the concept of a Steps Plan. Under a Steps Plan, all steps

of a transaction contemplating a series of successions

are aggregated for the purposes of the succession event

analysis. In order to establish that a Steps Plan has

occurred, there must be publicly available information

indicating that a series of transactions are contemplated.

For example, if disclosures surrounding a refinancing

indicated that an exchange offer would occur with respect

to certain relevant obligations of the Reference Entity

and, some time later, another relevant obligation of the

Reference Entity is assumed by a successor, all obligations

subject to the exchange offer and the assumption would

be aggregated for the purposes of the succession event

analysis.

Universal Succession

In addition, the Definitions also addresses circumstances in

which a Reference Entity is entirely replaced. A “Universal

Successor” exists where an entity assumes all of the

obligations of a Reference Entity and, at the time of

determination, the Reference Entity has ceased to exist

or is in the process of dissolution or winding up. Where

there is a Universal Successor, no backstop date applies for

the purposes of whether the DC will take into account a

request.

Index CDS

In addition to single-named CDS (i.e., a CDS contract

referencing a single reference entity), index CDS comprises

a significant portion of overall CDS trading volume. An

index CDS is a CDS contract referencing a basket of

multiple reference entities. Following a Credit Event, an

index CDS contract is partially settled, with the affected

component being removed from the index. The settlement

payment is the product of the CDS auction Final Price

and the portion of the notional amount attributable to the

affected component. The notional amount is essentially

divided between the number of components. For example,

$100 million notional of a CDS index comprising 100

components would be divided $1 million per component.

Index components are reviewed periodically by Markit and

the latest version of each index is posted on the Markit

website. The relevant version of the index is specified in

the trade confirmation. An index CDS is impacted by the

same Credit Events as a single-name CDS, albeit those

events will apply on a constituent-by-constituent basis.

However, market participants holding only index CDS

positions are not able to participate in the first stage of the

CDS auction, meaning they cannot impact the Net Open

Interest nor elect to establish physically settled trades as

part of the auction.

Index CDS allows a market participant to take a broad

view on segments of the market, such as North American

investment grade or high yield reference entities. U.S.

indices are generally included in the CDX family and EMEA

and APAC indices are included in the iTRAXX family.

Different indices have varying numbers of constituents,

from around 10 in the smallest indices to 125 in the North

American and European investment grade indices. It is also

notable that index CDS is exclusively a cleared product,

unlike single-name CDS for which there remains a sizeable

OTC market. Index CDS is currently cleared through ICE.

Regulations

The underlying reference for most CDS is a single entity or

an index of entities. Any swap that is triggered by an event

relating to the financial statements, the financial condition,

or the financial obligations of a single security issuer (such

as an issuer bankruptcy or a default on one of the issuer’s

debt securities) is a security-based swap. Single-name

CDS, on that basis, is clearly a security-based swap and,

therefore, is regulated in the U.S. by the SEC.

With respect to index CDS, the question is a little more

complicated and dependent upon the index in question.

Where the underlying reference for an index CDS is either

(1) itself a narrow-based security index, or (2) issuers of

securities in a narrow-based security index, the index CDS

is also a security-based swap. On the other hand, an index

CDS where the underlying reference is not a narrow-based

security index or the issuers of securities in a narrow-

based security index (i.e., a broad-based index) is a swap.

To define “issuers of securities in a narrow-based security

index and narrow-based security index” in the context

of index CDS, the SEC and CFTC adopted similar criteria

to those that apply for the equity and futures markets, as

well as some additional criteria. The criteria include the

requirements that the index must be comprised of a small

number of reference entities or securities (nine or fewer),

whether the effective notional amount allocated to a

reference entity or security included in the index comprises

more than 30% of the index’s weighting, or whether the

effective notional amount allocated to the reference entities

or securities of any five nonaffiliated issuers included in the

index comprises more than 60% of the index’s weighting.

Since the determination of whether a product is a swap or

security-based swap is made at or prior to the time parties

offer to enter into a transaction, the categorization of the

swap does not change if the security index underlying the

product subsequently migrates from broad to narrow (or

vice versa). This categorization is significant as swaps (as

opposed to security-based swaps) are regulated in the U.S.

by the CFTC. This creates an interesting market dynamic

whereby the CFTC regulates broad-based index CDS, and

the SEC regulates single-name and narrow-based index

CDS. Given the statutes granting the CFTC and SEC

authority over their respective markets contain slightly

different standards in some respects. Any party active in

single-name CDS should therefore be aware if the relevant

reference entity is included in any index as that could open

any trade up to both SEC and CFTC scrutiny.

Reprinted by permission.

LexisNexis, Practical Guidance and the Knowledge Burst logo are registered trademarks of RELX Inc.

LexisNexis.com/Praccal-Guidance

This document from Practical Guidance

, a comprehensive resource providing insight from leading practitioners, is reproduced with the

permission of LexisNexis

. Practical Guidance includes coverage of the topics critical to practicing attorneys. For more information or to sign

up for a free trial, visit lexisnexis.com/practical-guidance. Reproduction of this material, in any form, is specifically prohibited without written

consent from LexisNexis.

Fabien Carruzzo, Partner, Kramer Levin Naftalis & Frankel, LLP

Chair of Kramer Levin’s Derivatives and Structured Products practice, counsels asset managers, investment banks, commodity traders and

other market participants in the full spectrum of transactional and regulatory derivatives matters.

Recognized by Chambers Global and Chambers USA as one of the leading practitioners in derivatives and structured products, Fabien’s work

covers a wide range of equity, credit, currency, commodity, and fixed-income derivatives and bespoke structures, as well as structured

financing swaps, repos and other asset-based financing arrangements. Drawing on his experience advising clients on high-profile financial

insolvencies, Fabien counsels clients in assessing and mitigating the liquidity, credit, insolvency and regulatory risks inherent in trading

financial products. He also advises market participants on the implementation of regulatory reforms affecting the derivatives and futures

industry globally.

Fabien’s work with credit derivatives has also involved advising traders on numerous prominent credit and succession events over the years,

including recently, as counsel for the members of the International Swaps and Derivative Association (ISDA) Determinations Committee

in the landmark decision in Sears to include a syndicated leveraged loan in the list of instruments that can be used to settle Sears’ Credit

Default Swap (CDS) contracts.