Compliance Insight: The challenge of implementing new international credit derivatives definitions
The International Swaps and Derivatives Association, Inc. (ISDA) has announced that its 2014 ISDA Credit Derivatives Definitions will go live from September 2014, creating a challenge for firms to implement the necessary operational and infrastructure changes.
In a press release earlier this month, ISDA highlighted that the revised version of the 2003 ISDA Credit Derivatives Definitions will contain the basic terms used in the documentation of most credit derivatives transactions. Furthermore, the announcement also indicated that the ISDA Credit Steering Committee (CSC) has been working over the past three months with infrastructure providers and clearing houses to develop an appropriate implementation schedule, “including an assessment of the various changes to existing infrastructure that are necessary to support the change.”
The steering committee was considering an early roll-out date for the 2014 credit derivatives definitions, but it was apparent that a longer time frame would enable market participants and infrastructure providers to make the necessary changes with minimal impact on markets.
ISDA was forced to consider these changes by the Dodd-Frank Act of 2010, and the current emerging crisis with certain sovereign’s securities affecting the credit default swap (CDS) markets and its participants. Market participants would now have to execute CDS transactions on a registered exchange, for clearing by a derivatives clearing organization. The challenge facing most participants is not only to understand the implication of the new ISDA’s amendments for their internal processes and operations, but to coordinate and communicate internally the changes.
This report will outline certain operative steps that should be considered in implementing the ISDA’s 2014 changes. The suggestions below can help illuminate the thought process needed to accommodate the requirements, even if specific steps may not be an exact fit for each firm. The recommendations in the next segment, under “Compliance Tips and Next Steps,” comprise a high-level management overview addressing certain fundamental steps which can be implemented within the organization.
A working group under the CSC has been dealing with the revisions to the 2014 ISDA Credit Derivatives Definitions, which has not yet been finalized (published in final form). However, according to ISDA’s release, the three significant changes in the definitions will include:
- Introduction of a new credit event for new transactions that would be triggered by a government bail-in of a financial reference entity. If the debt is written down or converted into other assets as a result of the bail-in, the changes will provide for the CDS contract to be settled based on such written-down debt or other assets based on the outstanding principal amount before the bail-in. If the debt is written down to zero without any conversion proceeds, the credit default swap (CDS) will settle at a pre-determined fixed cash settlement amount of 100 percent in favor of the Buyer.
- Suggested Course of Action: The industry’s legal colleagues have analyzed and reviewed this amendment ad infinitum, but the challenge is how market participants translate the requirements into an operational process, enterprise-wide. Depending on the organization’s (financial institution/market participant) framework, the following action steps should be considered:
- An inventory or internal assessment should be performed to determine CDS and non-CDS exposures to sovereign entities, from an organization’s global exposures and client’s portfolio perspective. This step would help the financial institution determine the extent of the risks to be considered in implementing remedies from a global point of view and from a “single-customer view” (Basel III).
- The financial institution should already have in place and in writing the processes taken when a credit event is triggered. Enhance the process to be sensitive to transactions involving sovereign debt. New controls should be employed to identify these types of transactions and the remedies to manage the risk events.
- At the time the credit event is triggered, the financial institution should have in place a guidebook listing the comparable assets that may be considered during the conversion. There should be no surprises for the counterparties when a credit event occurs. (Hint: ISDA has indicated that it will publish a list of comparable securities that could be considered in the “Asset Package” at conversion.)
- The financial institution should consider during the operating risk assessments the extent to which the new ISDA amendment would have an impact to the current operations from resources and systems perspectives. The assessment should include a measurement of the effectiveness of the internal systems utilized to capture not only front-office activities, but also middle and back-office capabilities. The change should trigger within the organization a review of its automated recordkeeping and reporting capacities. Manual spreadsheets may not be an option to consider in this case.
- In any case involving an event having a significant financial impact to an organization, the internal communication and reporting processes are very critical in getting it right. Once the information is escalated, the timely response by a senior manager or executive in providing approvals to developed strategies is the essential element that determines whether the organization experiences a positive outcome. In today’s global organizations is not unusual to engage and designating an authorized senior manager/executive to provide the timely response, even if the reporting lines differ from a business unit to another.
- For new transactions (only on sovereign reference entities), the definition is amended by introducing the ability to settle a credit event by delivery of assets other than “deliverable obligations”. The change would allow the CDS contract to be settled on the basis of an “asset package” into which pre-identified benchmark bonds of the sovereign are converted on a credit event.
- Suggested Course of Action:
- Prior to the event being triggered, the financial institution should be developing a market-risk profile and an impact analysis on the pre-identified benchmark bonds of the sovereign. The analysis should consider the interest rate risks, considering the value-at-risk and earnings-at-risk impact on the financial institution’s portfolio when the sovereign’s bonds are designated in the “asset package”. This circumstance and portfolio should be “stressed” tested to determine a worst-case scenario and its financial impact. The analyses should be prioritized based on country risk and the likely event of default.
- From a credit risk and market risk perspective, a specific “exit strategy” should be developed for this particular event to ensure that the financial institution would incur the nominal negative impact.
- The financial institution should also review its operational and financial reporting processes to address the Credit Event, and application of the probable strategies.
- From a compliance and independent audit perspective, performance of specialized reviews of the considered strategies should be evaluated to ensure the appropriate documentation is in place to evidencing compliance with the internal and external requirements. In this phase, both the second and third lines of defense should be able to collaborate in providing value-added advice and best practices guidance from an internal perspective. A high level of expertise and knowledge of the compliance and audit staff is essential to ensure that the quality of the advice provided reflects the industry’s best practices. Further, the audit and compliance staff should possess the knowledge about the subject matter, but they should also have an understanding of the organization’s framework and culture to ensure the reviews and continuing monitoring are reflected as enhancements to the organization’s processes.
- Introduction of a standard reference obligation for more frequently-traded reference entities. The standard reference obligation would be published and would apply to all contracts that adopt “standard reference obligation”. The new provisions would also standardize the procedures and standards for selecting a replacement reference obligation if the existing obligation is redeemed in full or in material part. This change is anticipated to apply to existing trades, but it is expected that parties will have a window following determination of a standard reference obligation in respect of a reference entity and seniority level to “opt-out” existing single-name CDS trades on a trade-by-trade basis.
- Suggested Course of Action:
- When published, the financial institution (including stakeholders highlighted in the above point) should compare the new Reference Obligation against its developed strategies and procedures to ensure that all requirements are being considered and in compliance.
- Continuing monitoring and re-evaluation of the processes implemented to address the credit event are significant endeavors the organization must establish and maintain for this event.
- Other technical amendments to the terms and conditions included in the 2003 credit derivatives definitions will include:
- Restructuring Credit Event;
- Qualifying Guarantee;
- Bankruptcy Credit Event.
Suggested Course of Action:
- The financial institution’s Legal and Compliance teams will need to ensure that the above terms and conditions are analyzed and integrated within the strategies and processes.
- Training sessions are essential to ensure that all stakeholders are in-sync and comfortable with the processes and understanding of the requirements.
Compliance Tips and Next Steps – Re-Cap
The compliance program requirements outlined under Dodd-Frank would serve as a guide to the financial institutions involved in the CDS markets. The following are several key components market participants should consider in implementing the ISDA changes, as highlighted in each of the above implementation stages:
- Develop a plan/strategy – identify the key stakeholders involved in developing the plan. Assign the task to senior executives/managers that are involved with the CDS business and hold them accountable to carry-out this strategy. Typically, the head of markets, chief operating officer (COO), and CEO of the business would lead this undertaking. The head of markets operations and chief financial officer (CFO) are contributors in assessing the impact to their business activities and complying with the appropriate reporting requirements.
- The plan would identify the business units and their representatives who will assist the legal department and its in-house ISDA negotiator in translating the ISDA new requirements into steps and assigned tasks. The plan would also designate the senior manager possessing the influence and authority to make critical business decisions involving issues such as evaluating and approving the value of the securities (other assets in an “asset package” upon the occurrence of a credit event) converted from existing sovereign debt.
- The chief compliance officer (CCO) and its staff would be collaborating and assisting the stakeholders in ensuring the policy, procedures/processes are documented to reflect the requirements listed in the ISDA amendments. Compliance would also be involved in developing a training module outlining the new ISDA changes along with tracking its implementation and ensuring that senior management and board of directors are aware of the project.
- The chief risk officer and the credit risk officer would conduct an inventory of the organization’s CDS exposures and with counterparties, and mainly involving sovereign debt exposures. Value-at-risk and earnings-at-risk analyzes should be performed and monitored for safety and soundness purposes.
- The operating risk officers would be Identifying and assessing internal controls to ensure risk mitigations are implemented throughout the CDS business processes. This process should be highlighted as part of the plan/strategy and outlined in the enterprise’s internal and external reporting mechanisms.
- The organization’s Internal Audit function would be involved in ensuring that the audit programs are updated to include the review of the ISDA’s new amendments and assessing whether the controls, processes, and training programs are effective. Valuable feedback as in enhancing developed strategies and processes should be considered.
- The Compliance team would be expected to ensure that a re-evaluation of the processes is conducted periodically to determine that any new changes relating to the business or risk are addressed. This process would include participation and contributions from the business units (i.e. markets, operations & operating risk) and legal function.
- Periodic reports and information regarding the processes and implementation status of the ISDA’s new amendments should be provided to management’s governance bodies (risk management and asset and liability committees).
- External communications protocol should be updated to include events associated with the ISDA’s amendments. Information provided to both internal stakeholders and counterparties would need to be synchronized to provide timely and accurate reporting. This process would also include complying with regulatory data reporting.
- Continuing training of all stakeholders is essential and requires developing specialized training modules to address the requirements established under the ISDA credit definitions. The financial institution should incorporate an appropriate mix of internal and external training programs to ensure that industry’s best-practices are incorporated internally across the organization, by communicating the relevant processes.
- There is a tendency from an organizational point-of-view to lag behind in providing adequate investments in resourcing the compliance and audit departments. The regulatory and industry requirements are attaining a higher level of complexity and there is an affinity for financial institutions to undervalue the second and third lines of defense because of the contributions (or lack of) to the bottom line. Regulators have also focused on this issue and it will be crucial for the institution to demonstrate the willingness to invest in the enhancement of the internal compliance and audit functions.
As highlighted in this report, there are other changes for which that ISDA’s working group did not come up with a final determination, and these were outstanding at the time the ISDA’s pre-publication draft was published. The final versions of these remaining Definition changes will be revealed at the time the definitions “go live” in September. It is important that the compliance plan and strategies would be flexible to incorporate any other expected and unexpected amendments, which will test the organization’s governance, compliance, and risk framework.
(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)