ISDA Consults on Proposals to Clean Up CDS Market

The proposals seek to end a trading practice of encouraging otherwise healthy companies to default by offering them favourable financing in order to pocket CDS payouts.

An ISDA (the International Swaps and Derivatives Association) working group is proposing amendments to the 2014 ISDA Credit Derivatives Definitions to address issues related to NTCEs (narrowly tailored credit events), also known as ‘manufactured defaults’.

An NTCE is an arrangement with a corporation aimed an engineering a payment default to force settlement of CDS (credit default swap) contracts — instruments used as insurance against defaults — in order to pocket the CDS payouts. The default occurs with no or minimal actual deterioration in the creditworthiness or financial condition of the corporation, and is used merely as a CDS trading strategy.

Under such arrangements, the payment default that occurs “does not reflect the normal incentives of borrowers and lenders”, and reduce the efficiency, reliability and fairness of the overall CDS market, the ISDA working group said.

According to an FT report, Goldman Sachs and Apollo Global Management are among the companies that have drawn up the proposals, after the CFTC (Commodity Futures Trading Commission) said last April that arrangements requiring companies to intentionally default could “constitute market manipulation”.

The CFTC statement came in the wake of a legal battle between hedge fund Solus and homebuilder Hovnanian, which was attempting to default as part of a debt refinancing deal with Blackstone-backed hedge fund GSO Capital Partners. The deal would have caused a trading loss at Solus, but the two sides eventually settled amid pressure from regulators.

The ISDA proposals will amend the definitions that address NTCEs, in a bid to end the trading practice of encouraging otherwise healthy companies to default by offering them favourable financing in order to pocket the CDS payouts.

Under the plan, any CDS payments will be more closely tied to the financial health of the company in question and prevent intentional defaults.

Although the ISDA working group has not yet completed its work, the amendments represent some of the most important aspects of the proposed changes agreed to date.

ISDA is seeking feedback on the proposals, available here, by 27 March 2019.

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