Credit derivatives Markets

The biggest overhaul to the $19 trillion credit derivatives market in more than a decade will seek to solve flaws that have stopped some contracts paying out as buyers anticipated.

The changes come too late for investors in the junior debt of Banco Espirito Santo SA, whose credit-default swaps were devalued this month when the Portuguese lender was rescued and restructured by the government. Since the contracts are tied to the majority of a company’s debt, if the borrower is reorganized the swaps don’t necessarily stay tied to the securities they’re meant to protect.

Investors will start signing up to convert outstanding trades into new contracts as early as this week after the International Swaps & Derivatives Association rewrote the documentation to address the weaknesses. The biggest impact of the shakeup may be in the cost of swaps tied to subordinated bank bonds like those of Banco Espirito Santo, which will be about 50 percent more than existing contracts, according to Citigroup Inc.

“The fact that the new contract will afford more protection will mean it will cost more as well, ”said Sean Boland, a money manager at Cheyne Capital in London, which manages about $6.5 billion. “The past few precedents haven’t been too favorable. It’s extremely positive that as the market environment and regulatory environment changes, the CDS contracts are changing as well.”

Event Triggers

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. They’re used to hedge against losses or speculate on creditworthiness.

As part of ISDA’s overhaul, the list of events triggering payouts is being expanded to include bail-ins, which is when investors are forced to contribute to bank rescues like those at Banco Espirito Santo. The new definitions will also explicitly insure against debt writedowns, bond exchanges or conversions of debt into equity.

The changes will take effect Sept. 22, when investors can choose to exit existing swaps and buy improved contracts on banks and governments. Corporate swaps are less affected and investors have the opportunity to automatically convert trades, according to New York-based ISDA, the group that sets the industry’s standards.

‘Major Overhaul’

“The 2014 definitions address the most evident shortcomings in the old contract and attempt to anticipate future weaknesses, ” said Saul Doctor, an analyst at JPMorgan Chase & Co. in London. “They represent a major overhaul and upgrade of the ISDA CDS documentation that forms the backbone of the CDS market.”

When Banco Espirito Santo’s bonds were divided as part of a 4.9 billion-euro ($6.6 billion) rescue by the Bank of Portugal, the lender’s senior bonds and credit swaps were transferred to a new entity. The subordinated debt remained with Banco Espirito Santo, which meant that buyers of insurance contracts on the junior notes were left holding devalued contracts. Under the new rules, swaps will remain with the debt they’re designed to protect.

The cost of insuring Banco Espirito Santo’s subordinated debt dropped to about 750 basis points from 1, 270 after the bonds were split, according to data compiled by Bloomberg.

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