The use of credit derivatives in the international capital markets has increased exponentially since their introduction in the 1990s, with the aggregate outstanding notional amount of credit default swaps doubling every two years or so to its current value of over $5 trillion. The most dynamic segment of the market continues to be the structured credit product arena, in which structurers combine capital markets instruments with credit derivatives. The asset class that has come to dominate this market segment is the synthetic collateralized debt obligation (CDO). A synthetic CDO is an issue of debt obligations structured so that the investor is exposed to the credit risk of a portfolio of underlying assets by virtue of a credit derivative entered into by the issuer of the obligation.

Ian Sideris and Simon Puleston Jones ask whether credit default swaps in synthetic CDOs are becoming more commoditized and analyze the technical issues in swap documentation

The use of credit derivatives in the international capital markets has increased exponentially since their introduction in the 1990s, with the aggregate outstanding notional amount of credit default swaps doubling every two years or so to its current value of over $5 trillion. Each passing year sees the development of new credit derivative products in response to a continuing demand for yield and diversification on the part of investors and the pursuit of arbitrage opportunities on the part of arrangers. The most dynamic segment of the market continues to be the structured credit product arena, in which structurers combine capital markets instruments with credit derivatives. The asset class that has come to dominate this market segment is the synthetic collateralized debt obligation (CDO). A synthetic CDO is an issue of debt obligations structured so that the investor is exposed to the credit risk of a portfolio of underlying assets by virtue of a credit derivative (usually one or a number of credit default swaps) entered into by the issuer of the obligation.

The 2003 ISDA Credit Derivatives Definitions

The swap agreement in a synthetic CDO is based on the standardized documentation published by the International Swaps and Derivatives Association (ISDA). There is an ISDA Master Agreement in standard form, together with a schedule that sets out the customized changes agreed by the parties to the standard form. The economic terms of the transaction are set out in a swap confirmation that cross-refers in particular to the 2003 ISDA Credit Derivatives Definitions. These definitions contain the market standard terms that are intended for use in credit default swap confirmations. The Credit Derivatives Definitions were agreed upon by participants in the credit market and contain numerous differences from the 1999 ISDA Credit Derivatives Definitions that the market had previously used, reflecting the rapid rate of change in the market.

The forms of the ISDA Master Agreement and the Credit Derivatives Definitions are drafted on the basis that the two counterparties to the credit default swap are both dealers in the market and that the transaction is referenced to a single corporate or sovereign entity. But in a typical synthetic CDO transaction, one party to the swap will be a special purpose vehicle (SPV) established in a tax-neutral jurisdiction to issue the notes and the other (the swap counterparty) will be the arranging bank. The swap will typically be a portfolio swap referencing 50 or more entities. Accordingly, the Master Agreement and the Credit Derivatives Definitions need to be amended on a case-by-case basis to account for the particular parties and terms of the transaction in question. The principal drafting and structuring issues that arise are as follows:

Form and parties: The market still typically trades under the 1992 ISDA Master Agreement rather than the 2002 ISDA Master Agreement, partly to reduce basis risk with hedging swaps that the swap counterparty will have entered into. The provisions of the Master Agreement are typically adapted to take account of the fact that one of the parties is an SPV. So, for example, the standard Events of Default and Termination Events in Section 5 of the Master Agreement are customized. Also, further Termination Events are added to provide for the early termination of the swap if the notes fall due for early redemption or if a default occurs in respect of any underlying assets that secure the SPV's obligations under the notes and the swap. Limited recourse and non-petition provisions are incorporated into the swap to provide that, in the event of a default by the SPV, the swap counterparty has recourse only to the secured assets underlying the CDO transaction and, save in limited circumstances, the swap counterparty cannot petition for the winding-up of the SPV.

Portfolio transactions: For transactions that reference several reference entities, the Credit Derivatives Definitions should be amended to provide for the delivery of multiple credit event notices and to make sure that the occurrence of a credit event does not lead to an automatic early termination of the swap on the relevant cash settlement date. Also, the consequences of a credit event need to be amended to provide for a reduction in the outstanding notional amount of the swap following each cash settlement date and a corresponding reduction in the amount of premium payable by the buyer of credit protection (the swap counterparty) to the seller of protection (the SPV).

Credit events: The market standard is to use Bankruptcy, Failure to Pay and Restructuring, each as defined in the Credit Derivatives Definitions. Of these, Restructuring has generated the most controversy because it is broad enough to encompass so-called soft credit events that may not result in a loss but which still require a payout under the swap if triggered. There is still no unanimity on a single global standard for Restructuring and this has provoked debate in the market as to whether Restructuring (on any of the various alternative definitions under the ISDA framework) is appropriate as a payout trigger in a synthetic CDO.

Trading standards: The trading standards that the market applies for each reference entity (the credit events that apply to it, what types of obligations comprise valuation obligations or deliverable obligations, the duration of physical settlement periods, whether All Guarantees or Qualifying Affiliate Guarantee are applicable in relation to it and so forth) vary according to the type of entity and the jurisdiction. Accordingly, it is now common for the swap confirmation to specify that for each type of reference entity (for example, North American Investment Grade or Emerging Market Sovereign), the trading standards that apply are set out in a schedule annexed to the swap confirmation. This enables the parties to conform the terms of the swap to the applicable local trading standards for each name listed in the credit portfolio.

Settlement mechanics: Although the standard for the bilateral swap market is physical settlement, the difficulty of physically settling with noteholders in the capital markets leads most synthetic CDO swaps to provide for cash settlement. Rating agencies pay particular attention to the settlement mechanics that apply after a credit event. The key issues that are the subject of negotiation are: Timing of valuation. There must be long enough from credit event to valuation to avoid the discounted prices that might be prevalent in the immediate aftermath of a credit event. Typically the swap confirmation provides for valuation to take place between 45 and 90 days after the credit event (where the valuation obligation is investment grade), although different rating agencies have differing views as to how long it takes for prices of valuation obligations to settle and adjust to the occurrence of a credit event. Dealer poll. Rating agencies are also keen to make sure that the valuation obtained is as representative as possible of true market value. Accordingly, they typically require that quotations be sought from five or more dealers in obligations of the type of the valuation obligation (of which at least four should be independent from the swap counterparty and its affiliates). The swap may also provide for a so-called last look right, entitling the underlying noteholders to provide a firm bid quotation at a price equal to or greater than the highest firm bid obtained from the dealer panel. This provision would typically be included to provide investors with the chance to limit losses that they might otherwise incur as a result of, for example, low quotations being provided by the dealer panel due to the illiquidity of the relevant obligation. Valuation method. The valuation methodology typically provides for weighted average quotations, so that quotes are required for part only of the valuation amount if it is impossible to obtain a specified number of firm bid quotations from the dealer panel for the full valuation amount. Again, this is to make sure that an accurate market valuation is obtained so far as possible and to limit the loss suffered by noteholders.

Recently there has been a growing trend to abandon the formal price discovery process altogether in the interests of greater transparency, and to substitute a negotiated fixed recovery amount per defaulted reference entity. Swaps that include this feature are called binary or digital swaps.

Subordination (attachment points) and cross-subordination: For both single-tranche and multi-tranche synthetic CDOs, a level of subordination is typically incorporated so that losses incurred as a result of credit events do not automatically lead to a reduction in the outstanding notional amount of the swap and in the outstanding principal amount of the related notes. The level of subordination will depend upon the rating that the arranger seeks to have assigned to the relevant tranche of notes.

The concept of subordination does not appear in the Credit Derivatives Definitions, so the swap confirmation will need to provide for a reduction in the outstanding notional amount only once aggregate losses that have accumulated following the occurrence of one or more credit events pass a specified threshold (known as the attachment point).

CDOs as reference obligations

One major recent structural innovation is the development of synthetic CDOs that reference asset backed securities (ABS) or other CDOs (so-called CDO-squared transactions), which provide investors with exposure to a number of separate credit portfolios. Such transactions raise particular issues in drafting swap documentation.

Credit events: The Credit Derivatives Definitions are drafted to apply to corporate and sovereign reference entities. Where the reference entity is an SPV or the reference obligation is an ABS or a CDO there is a danger that the Credit Derivatives Definitions either fail to capture the true credit risk of the entity or security in question or pass along non-credit risk. The absence of standard ISDA definitions for this type of asset has led to the development of customized definitions of default that take into account the particular features of ABS or CDOs and that meet the rating agencies' requirement that only the risk of real credit loss be transferred to investors. The consensus is that Bankruptcy and Restructuring credit events are not appropriate for these asset classes (unless their inclusion is required to meet the rules for regulatory capital relief applicable to the swap counterparty). Failure to Pay must be redefined to take into account the amortization and interest deferral features typical of ABS. Furthermore, there has developed a category of credit events that address credit risks that are particular to ABS and CDOs. These relate to the reduction of principal without repayment and rating downgrade.

Settlement mechanics: The rating agencies require a longer interval between credit event and valuation than in the case of corporate portfolios. This is principally because of the need to allow time for the possible realization of cashflows on the defaulted reference obligation (and/or the liquidation of the asset portfolio underlying it) and distribution of proceeds. Also, the longer a defaulted credit is available in the market, the easier it is for dealers to perform the necessary research to make an educated valuation decision. Binary swaps are also common in CDO squareds.

The terms and conditions of portfolio credit-linked ABS typically provide for a reduction in the outstanding principal amount when a credit event occurs. The amount of the principal reduction is determined by reference to the decline in value of a valuation obligation issued or guaranteed by the defaulted reference entity. The terms of many credit-linked ABS are drafted on the assumption that the market value of the relevant valuation obligation is reduced to zero as a result of the relevant credit event. Once the true market value of the valuation obligation has been determined, the outstanding principal amount of the ABS is then increased to take account of the market value of the valuation obligation, to the extent that the market value is determined to be greater than zero. For synthetic CDOs that reference portfolio credit-linked ABS, it is important that a credit event under the synthetic CDO (typically, the occurrence of a reduction in principal of the relevant portfolio of credit-linked ABS that comprises a reference obligation) is not triggered too soon and that the price discovery that follows takes account of any subsequent increase in the outstanding principal amount of the relevant valuation obligation.

Other provisions of the Credit Derivatives Definitions: Many other provisions will be inapplicable if the underlying reference obligations are ABS. For example, the information relating to the occurrence of credit events is unlikely to be publicly available, leading to a negotiation among the transaction parties and the rating agencies as to the appropriate sources of information for the swap counterparty's determination that a credit event has occurred. Typically, the swap counterparty or calculation agent may deliver a certificate declaring that a credit event has occurred. Furthermore, if the reference obligation provides for amortization of principal and/or redemption in instalments, there will need to be corresponding reductions in the notional amounts of credit protection or the amortized portions of the reference obligation notional amounts will need to be re-invested in other reference obligations, subject to agreed guidelines.

To foster the development of a secondary market in single-name credit default swaps referenced to ABS, ISDA is in the process of agreeing pro forma swap confirmations for such swaps for cash and physical settlement and on a pay-as-you-go basis, which take these and other considerations into account. It remains to be seen whether the credit event definitions and settlement mechanics in the new ISDA forms will be adopted generally in the synthetic CDO market.

Increasingly, the market is seeing CDO-squared transactions that use cross-subordination - these transactions reference several different portfolios, but enable the transfer of subordination from one portfolio to another, so as to reduce the risk that losses breaching the attachment point in relation to one or more portfolios will lead to a reduction in the notes' principal.

Managed synthetic CDOs

A portfolio manager is sometimes appointed to manage the portfolio of reference entities to which the swap in a synthetic CDO is referenced. The purpose of portfolio management in this context is to trade out of deteriorating credits by substituting reference assets in the credit default swap, subject to agreed parameters and guidelines, in order to mitigate the risk of investors facing a credit loss. In more complex transactions, the manager may additionally unwind existing swaps, buy credit protection from another swap counterparty on the same reference assets or buy protection on other reference assets.

The Credit Derivatives Definitions do not envisage a managed portfolio, so further provisions need to be added in the swap confirmation to specify the procedure for substituting one reference entity for another. This can be achieved by setting out the replacement procedures in the swap confirmation itself or in the separate portfolio management agreement pursuant to which the manager is appointed. The procedures will specify who initiates the replacement, how and when a replacement is achieved, the portfolio change criteria and the eligibility criteria for replacement reference entities. For rated transactions these considerations will primarily be driven by the particular requirements of the rating agencies. Each rating agency has different requirements, which makes standardization of these provisions difficult.

Index-linked CDOs

During 2004 the market sought to standardize the terms on which credit derivative transactions that reference certain credit indices (for example, the iTraxx indices) are entered into and documented - ISDA has now published pro forma swap confirmations for use in cash and physically settled transactions which reference iTraxx indices. These pro formas contain the various amendments that need to be made to the Credit Derivatives Definitions to make them work for index-linked deals. It will be interesting to see whether the market starts to adopt the format and structure of the iTraxx pro formas even for non-index deals.

The iTraxx indices merely comprise a list of corporate names. Unlike index-linked equity derivatives, the value of an index-linked credit derivative is not linked to the rise or fall in value of shares in the companies underlying the index, but rather to the likelihood of one or more credit events occurring in respect of those companies. Accordingly, an index-linked credit derivative transaction does not reference the index as a whole but comprises in effect a series of separate credit derivative transactions - one for each company in the index. So there is no need to consider market or price disruption events (as dealt with in the 2002 ISDA Equity Derivative Definitions), as the market value of the shares issued by the companies in the index is irrelevant, as is the level of the index.

Equity default swaps

Another recent innovation is the emergence of a new generation of synthetic CDOs referencing not only the credit of certain names, but also involving the SPV entering into equity default swaps in relation to the portfolio. An equity default swap provides for a payment by the SPV to the swap counterparty should the share price of one or more companies fall below a specified level (typically 30% of the share price as at the trade date). This is another way of providing investors with exposure to the portfolio, but using a different trigger mechanism from credit default swaps.

While equity default swaps have much in common conceptually with credit derivatives technology, they are usually documented under ISDA's Equity Derivatives Definitions, as these contain the relevant provisions regarding determination of share price, market disruption and so on. Equity default swaps will be documented in a separate swap confirmation from the credit default swap transaction entered into in relation to the notes.

No single standard

While attempts have been made to standardize the terms on which many differing types of credit derivatives are traded and documented, ISDA's Credit Derivatives Definitions are not enough on their own to cater for the wide array of structured credit products in the market. ISDA is producing pro forma confirmations for some of the more recent products (such as credit default swaps that reference ABS and certain credit indices), but it is unclear whether the market will adopt these in the synthetic CDO arena.

Ultimately, it is unlikely that a single standard form of swap is going to emerge in the synthetic CDO market. The differing requirements of the rating agencies, the continuing demand by investors for bespoke products and the desire of investment banks to create new credit products through which they can make profits in an environment of tightening credit spreads all mitigate in favour of continuing diversity and complexity in the documentation of synthetic CDOs.

Ian Sideris is a partner and Simon Puleston Jones an associate in the London office of Simmons & Simmons