Sunday, August 16, 2009

SNAC on this: the standardization of single name CDS

A number of Sober Look readers have asked about the structure of single name credit default swaps that would be settled via a clearing house. Here is some background.

The cleaing house for CDS that has gotten the most traction is operated by ICE (the Intercontinental Exchange). CME is trying to get in the game as well. So far however only some index credit derivatives have been settled on ICE, while single name CDS settlement is still in the works.

As with any standardized contract, one tries to limit the number of variables. With single name CDS, the contractual variables are usually maturity, spread, points up front (upfront premium), and settlement mechanics. In the past all of these could vary. That created problems for active traders.

If you buy 100 futures contracts and sell 100 of the same contracts later, you are flat and have no further obligations. However if you buy and sell the same notional CDS with slightly different maturities (even by a few days) and/or slightly different spread (which is almost always the case), you now have two different contracts. And until they mature or get unwound (which is expensive), you will have to manage two different contracts. So if you actively trade these, you may end up with thousands of positions that may be neutral (buys and sells with the same amounts), but the contracts are still outstanding. That's why when the media quotes "trillions" of outstanding CDS contracts, a large part of these are long and short of very similar contracts that can not be netted. You could be flat and have locked-in gains on a bunch of CDS, but your trades were with Lehman, you've lost the bulk of these gains. That's where a clearing house becomes helpful.

The idea is to standardize maturity dates, spread, and settlement mechanics, while leaving points upfront as a variable. Settlement in the past gave one a choice of physical delivery (the protection buyer could deliver the defaulted security and get paid par for it) or an auction settlement. A corporate restructuring could be considered a credit event under some contracts. There were other variations as well. All of that has been standardized to auction settlement, with credit events now decided by a committee (which becomes binding under the new documents.)

Under the new standard, the maturity dates will be only March 20th, June 20th, September 20th, or December 20th. The spread will be either 100 or 500 basis points (100 bp for investment grade names and 500 bp for non-investment grade). Thus the spread will be constant and only points upfront will fluctuate. Now if you buy protection and sell it back, you will be doing it with the same contract (same maturity and spread), and the only difference is between the points upfront you paid when you bought protection and the points you received when you got out (which will be your P&L). And given that you will face ICE on both the buy and the sell, your contract will be netted out and you will have no remaining obligations.

The coupon (spread) accrual on these contracts will be handled the same way it is for bonds (and most index credit derivatives).

These standard contracts are sometimes called “SNAC” transactions - Standard North American Credit ISDA docs. Converting existing non-standard contracts to SNAC unfortunately can not be accomplished without unwinding existing trades, which could get costly. These non-standard contracts will also quickly become illiquid. The goal is to have SNAC compliance on the bulk of CDS transactions going forward, whether or not they are settled via a clearing house.

The document below from DTCC( discusses the detail of the clearing house standardization.

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