7. EMIR Credit Derivatives

The following Credit derivatives would be reportable under EMIR:

  • CDS Credit Default Swap
  • CDS Swaption
  • CDT Credit Default Tranche
  • CDX Credit Default Swap Index
  • CDX Swaption
  • IOS IOS Index CDS
  • ELCDS European Loan CDS Documentation
  • EMBS European Mortgage Back Security
  • LCDS Loan Credit Default Swap
  • MBS Mortgage Backed Security
  • MBX Mortgage Backed Index
  • PrimeX Synthetic CDS
  • Funded Credit Derivatives as well as unfunded credit derivatives are reported

7.1. Background to Credit Derivatives

Credit derivatives tend to be more complex than other derivatives and the determination of a credit event is not straight forward. Prior to the Financial Crisis, regulators raised concerns about the risk of credit derivatives and highlighted the increasing backlog of confirmations for credit derivative trades in financial markets generally. This had occurred because most contracts were bespoke and confirmation of contracts was via a manual process.  Late confirmations meant that the level of risk could not be known with certainty and that there were multiple overlapping contracts obscuring the risk position.  Regulators viewed this as increasing the overall systemic risk and sought improvements from the industry.

7.2. Standardisation of Credit Derivatives

In 2009 ISDA launched the standardisation of North American CDS and credit derivative hardwiring.

The Standardisation of North American CDS contracts requires contracts to have the following features:

  1. Standardised Maturity/Roll dates – the maturity dates on all standard CDS contracts can be one of the 4 ‘IMM’ dates: 20th March, 20th June, 20thSeptember and 20th December. So if a 5 year CDS is traded on 15th April 2016, then the maturity date for that contract will be 20th June 2021
  2. Standardised Payment dates – the premiums on all standard CDS contracts are paid on the four IMM dates
  3. Full first coupon payments on all trades – the first coupon on any standardised trade is made on the next IMM date and is the accrued amount of the spread for the full period between two IMM dates
  4. Up-front payment – having a full first payment coupon on all trades means that the upfront payment on a CDS consists of two elements:
    • an element which compensates for the difference between the standard spread and the actual standardised spread for the trade; and
    • an element that is the accrual payment made to the protection buyer, to compensate for having to pay a full first coupon payment

A standard fixed coupon of 1% or 5% depending on the quality of the underlying and an upfront payment at the start of the contract to reflect the change in the price. The amount paid upfront is equal to the PV of the difference between the current market spread and the fixed coupon. The standardisation of coupons aids transparency and liquidity within the CDS market.

Following North American trades, European trades were standardised shortly after and now trades are standardised for the following regions as well; European Emerging markets, Latin America, Middle East (including Sukuk finance), Australia, New Zealand, Japan and Asia.

7.3. Coupon rates

Coupon rates are standardised for each region. The rates used for each region are as follows, again depending on the quality of the underlying.

Region/Country Corporate/Sovereign Coupon Rate
Australia and New Zealand Corporate and Sovereign 1% and 5%
Emerging Market - 1% and 5%
Asia Corporate and Sovereign 1% and 5%
Singapore Corporate and Sovereign 1% and 5%
European Transactions Corporate and Sovereign .25%, 1%, 5%, and 10%
Some European Transactions retroactively - 3% and 7%
Japan Corporate and Sovereign .25%, 1% and 5%

7.4. Hardwiring

Hardwiring involves a supplement for new trades and a protocol for the handling of historic trades.

Under hardwiring, the determination of when a credit or succession event occurs is undertaken by committees of dealers. The committee also determine recovery rates. These committees are supervised by ISDA. On the determination of a credit event, an automatic CDS auction settlement process takes place, where  previously the auction process was optional. This auction process is also overseen by committee. This automatic hardwiring of an auction process covers both new and historical trades.

7.5. Effective dates

The Effective date of a CDS is now standardised under a new convention, where effective dates for all credit events covered by the supplement will look back 60 days and for succession events will look back 90 days from today. This means that standardised CDS traded on different dates will be treated identically.

At the time of the development of standardised contracts, a CDS central clearing house was set up – ICE Clear Credit.

7.6. Standardised model for calculation of up-front payments (The ISDA CDS Standard Model)

This is open source software available directly from the ISDA. The software is in an Excel format and is used to convert upfront quotations to actual spread quotations in a standardised manner. This is required as all standardised credit derivatives will now have an upfront payment and a standard spread. By using the ISDA CDS standard model and using the agreed standard input parameters counterparties can agree calculations.

7.7. Standardised Quoting Conventions

Prior to Standardisation, CDSs were traded simply by quoting the premium (spread) that would be paid throughout the life of the trade. Now, the premium (spread) paid through the life of the trade is independent of market conditions, so this is not quoted. Instead, what is quoted now instead is one of the following:

Points Upfront
This is the upfront fee as a percentage of the notional. This quantity has a sign: if the points are quoted as negative then the protection buyer is paid the upfront fee by the protection seller. If the points are positive, it is the other way around.

Price
With price, the price is quoted in the same way as a bond. The price is taken away from 100 to get points. So as an example, if the upfront fee is 300 basis points i.e. 3% of the notional value, then the price will be 100 – 3 = 97. The protection buyer still pays the 3% as an upfront fee of course.

Spread
The spread on CDSs will still be quoted even though spreads are now standardised. The spread that would be quoted however, would not be the standardised spread but the spread that be paid prior to standardisation. This amount can be calculated from the upfront payment using the standard ISDA calculator.

Investment Grade – quoted in current market par spread in basis points running, upfront payment is calculated using the standard ISDA calculator.

High Yield/Distressed – quoted in current market clean upfront payment, accrued to date premium is added to allow a full first coupon payment.

7.8. Changes to Credit Events

Following the standardisation of CDS contracts, what constitutes a credit event has now been simplified, particularly whether restructuring constitutes a credit event.

Restructuring is the change to the payment schedules on an entity’s debt. This is not usually to the advantage of the entity’s creditors and is therefore defined as a category of credit event. Of all types of credit event, restructuring is the most disputed and complex type of event to deal with. Now, after the standardisation of CDS contracts, there are 4 standard definitions for restructuring that can be used in CDS contracts.

A credit event would now include trading without restructuring.

7.9. Standard Reference Obligation

The 2014 ISDA Credit Definitions introduced the use of a Standard Reference Obligation (SRO) across a given entity and layer of debt seniority. If a CDS has an SRO then a CDS traded for that seniority of debt and for that particular entity will be traded with the same Standard Reference Obligation. An SRO is set up by determinations committees.

The advantage of having an SRO is that when trades are being matched, it is easier to match the reference obligation, reducing the number of breaks in the matching process.

7.9.1. Confirmation and Matching

Across the CDS market, because of the standardisation of contracts, the vast majority of contracts can be and are confirmed electronically via the MarkitServ (DS match) confirmation matching platform. MarkitServ (DS match) performs the bilateral electronic submission and affirmation of confirmable transaction details by each party to the trade. When all of the details of the trade have been matched, a legal record of the transaction is created in the Trade Information Warehouse (TIW) system. Trades which are unmatched are investigated by both parties to the trade. Counterparties can elect to report to a GTR through DS match.

“The Markit Serv platform provides both detail and summary analysis of the current status of all transactions within the platform for efficient risk management of the confirmation process.”

7.10. The Reporting of Credit Derivatives under EMIR

The following fields are some of the fields that would be reported for Credit Derivatives.

Effective date
The effective date is the date from which protection would start. The effective dates for CDS contracts are now standardised, as detailed above, and so protection will start on quarterly dates, which might be before the execution date of the credit CDS contract.

Upfront Payment
Again, because of the Standardisation of CDS contracts, all contracts will have an upfront payment. This payment could be made by the buyer of the protection or the seller of the protection, depending on what the real economic spread would be for the protection in relation to the standardised spread of the contract.

Underlying leg 1/2 and Product ID1 Value
The underlying of a Credit Derivative may be for a single reference entity, a standardised reference obligation, as detailed before or for a basket, or for a credit derivative index. If the underlying is for a single reference entity, then the underlying value will be an ISIN, LEI or Aii, B for Basket or I for Index.

Many of the indexes traded are for Credit derivatives, the Product ID 1 field would give details of the derivative to say whether the product was simple or exotic and whether the product was based on a single entity or index. Many index contracts are based on iTraxx indices, which are owned and managed by Markit.

Termination Date
Date a contract has been terminated, if different from the maturity date. This field would not be populated if the termination date is the maturity date. The date of a credit event is not the termination date.

7.10.1. Price fields

Price/rate
The price of the credit derivative, which may be the actual economic spread, instead of the standardised spread or Par less the upfront payment expressed as a percentage of the notional.

Price notation
The price notation will explain how the price is quoted. For Credit derivatives, this would either be percent or basis points.

Price multiplier
The number of units of the credit derivative, contained in a trading lot. For credit swaps this would be one.

7.11. Examples of populating the relevant fields

Field Name Example Value
Effective date leg 2009-01-20
Upfront Payment 17681
Underlying JP375430A754
Product ID Code CR
Termination Date 2016-10-15
Price/Rate 1.35
Price Notation Percentage
Price Multiplier 1.0