ISDA publishes Narrowly Tailored Credit Event Protocol (the NTCE Protocol)

Background

In April 2018, ISDA published a statement noting concerns that narrowly tailored (or 'manufactured') credit events (NTCEs) had the potential to damage the integrity of the CDS market, and established a working group to look at potential changes to the 2014 ISDA Credit Derivatives Definitions (the Credit Derivative Definitions) to address these concerns.

Although not directly referred to by ISDA, these concerns related to a number of recent 'unconventional' Credit Events, including iHeart and Hovnanian.

NTCEs take a number of forms, but one example is where a restructuring or refinancing of a Reference Entity is deliberately structured in a way that triggers a CDS payment and allows a buyer of credit protection to separately offer more favourable refinancing terms to the Reference Entity.

These events challenged a key premise of the CDS market, namely that a Reference Entity will seek to avoid default.

Following a market consultation, ISDA published its proposed changes. These were contained in the 2019 Narrowly Tailored Credit Event Supplement published on the ISDA website on 15 July 2019 (the NTCE Supplement) and which is available for parties to incorporate into their new CDS transactions.

On 27 August 2019, ISDA published the 2019 NTCE Protocol on the ISDA website (the NTCE Protocol).

This allows parties to apply equivalent changes to those set out in the NTCE Supplement to their existing CDS transactions.

Summary of key changes

The NTCE Supplement and NTCE Protocol introduce a 'Credit Deterioration Requirement' (CDR) to the Failure to Pay Credit Event in Section 4.5 of the Credit Derivative Definitions, which excludes from Failure to Pay any event which "does not directly or indirectly either result from, or result in, a deterioration of the creditworthiness or financial condition of the Reference Entity”.

The NTCE Supplement includes interpretive guidance with non-exhaustive examples of factors that indicate that the CDR may or may not be met. Examples of indicators that the CDR may be met include where:

• the Reference Entity has announced that it is in financial distress
• the Reference Entity has appointed financial advisers specialising in restructuring and/or insolvency, or
• the non-payment occurred on debt obligations held by a number of parties.

Examples of indicators that the CDR may not be met include where the non-payment:

• arises from agreement with the Reference Entity with the purpose of creating a benefit under a CDS contract
• does not result in acceleration of the Reference Entity’s other debt obligations, or
• is promptly cured following a grace period.

The determination is made by the Determinations Committee, taking into account all information available at the time, without obligation to investigate.

The only changes to the March 2019 consultation draft (which we reported here) are

• (i) clarification that the CDR is presumed where the Credit Event relates to, or is subject to defence upon, a lack of authority or change in law and

• (ii) an acknowledgement that the CDR may exclude events which are not arranged for the purpose of triggering a Credit Event under a CDS.

The NTCE Supplement and the NTCE Protocol also make a number of technical changes to the definition of “Outstanding Principal Balance”.

These are intended to address situations where a Reference Entity in financial difficulties issues debt with an original issue discount by ensuring that such discount is taken into account in calculating the Outstanding Principal Balance for the purposes of CDS transactions.

NTCE Protocol Adherence

By adhering to the NTCE Protocol, a party agrees that the changes to address NTCEs should apply to those of its CDS transactions that are

• (i) in scope of the NTCE Protocol and

• (ii) entered into with another party that has also adhered to the NTCE Protocol. In-scope transactions are those documented under the 2014 ISDA Credit Derivative Definitions and in which the Reference Entity is not a sovereign.

It is expected that CCPs will amend their clearing rules to take account of these changes and so parties who have only entered into cleared CDS transactions should not need to adhere to the NTCE Protocol.

The NTCE Protocol had a pre-adherence period which runs from 27 August 2019 to 13 September 2019. During this time only key market participants can adhere to the NTCE Protocol.

This was designed to ensure that there was a substantial demonstration of support for the NTCE Protocol by the time it launched the main adherence period. The list of adhering parties is available on the ISDA website.

The main adherence period began on 16 September 2019 and runs until 14 October 2019. The changes made by the NTCE Protocol will then become effective on the "Implementation Date", which is expected to be 13 January 2020.

Process for Adherence

To adhere to the NTCE Protocol, market participants must submit an Adherence Letter which will be available on the ISDA website and pay a one-time fee of US$500. The section of the ISDA website relating to adherence is here.

Decision to adhere

Although we expect that most market participants will choose to adhere to the NTCE Protocol, for some there may be potential downsides to adherence that need to be considered.

This may be the case where a party is a substantial net buyer of credit protection and where the narrowing of the circumstances in which a credit event will be triggered may be unattractive. There is no ability to apply the NTCE Protocol selectively to particular CDS transactions.

If you would like additional advice on the implications of the NTCE Protocol for your positions, please contact us.