The Intenational Swaps and Derivatives Association's (ISDA) much-awaited updates to its definitions for standardized credit derivatives contracts have been delayed until September 2014.
The delay is probably hindering the market for credit default swaps that pay protection buyers if a government borrower fails to pay its bonds. This is because the current standardized definitions do not include a failure to pay that results from a bail-in by creditors, which can leave buyers of CDSs not being fully compensated for their actual economic losses. (A bail-in takes place when the payment rights of creditors are delayed or reduced to improve the the financial condition of the borrower.)
A similar contract-definition problem exists with certain types of governmental restructurings and came to prominence when the Greek government forced an exchange on bondholders that was technically outside the scope of what triggers a payout to CDS holders.
But parties that want to trade sovereign CDSs that will pay out regardless of how governmental actions cause bondholder payment losses do not necessarily need to wait for ISDA's definitions to become official later this year.
ISDA has already published a draft of its revisions that include a broad definition of "Governmental Intervention" as an event that will trigger a payout to CDS protection buyers.
The revised draft definition of Governmental Intervention in Section 4.8 includes the following as grounds for a pay out:
"(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);
(C) 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;
(D) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation; or
(E) any change in the currency of any payment of interest, principal or premium to any currency which is not a Standard Specified Currency (excluding any lawful currency of France or Germany (other than the euro) and any successor currency thereto);
(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" above.
Under any reading of this definition, government initiated bail-ins and debt exchanges would qualify as a Governmental Intervention credit event.
Parties wanting to enter a CDS that triggers a pay out under such circumstances can adopt this (draft) definition in their current CDS. In addition, they can agree to incorporate any change in the final definition of Governmental Intervention on a prospective basis.
Although the sovereign CDS market will be best off waiting for ISDA's final revised credit derivatives definitions to come into effect, bondholders seeking to protect themselves now against all sorts of governmental interventions may want to move ahead of ISDA and incorporate the definitions into any new agreement themselves.