FT Alphaville " Ok guys, hands up who booked the weird Greece CDS trades... Twiddles thumbs, waits for Isda to announce whether there's been a credit event on Greece... Not all credit events are the same. There are actually "hard" credit events and "soft" credit events. Hard credit events are when a corporation or sovereign fails to pay a coupon or principal on some debt, files for bankruptcy, or becomes insolvent. The soft cheese credit events are restructurings. For an example of the latter, think about what just happened with Greece when the government deployed the collective action clauses: bondholders, who didn't want to have the principal due on their bonds cut, or the maturity date extended, were just forced to have that happen anyway. Specifically the case before Isda rests on the fact that some bondholders are having this swap involuntarily thrust upon them. And it occurred in the context of "a deterioration in the creditworthiness or financial condition of the Reference Entity" (namely, Greece) - another requirement of the definitions that govern CDS contracts. Why does the type of event matter though? Both types of credit event mean that an auction will be held to determine the payouts to CDS protection holders. But when the type of event is a restructuring, i.e. soft cheese event, then the mechanics of the auction usually differ. The mechanics for restructuring events are such that different auctions are held for different contract maturities. The (first) credit event of Paris-based media and electronics firm Thomson (they subsequently went bankrupt less than two months later, leading to another auction) was a restructuring, and had buckets and results like this: So, for example, a $10m CDS protection buyer getting paid out according to the results of the 5-year maturity bucket would have gotten $3.4875. Auctions for hard events look like this: That is, just one final price. Nothing with maturity buckets. All CDS contracts settle the same. (By way of reminder, Ecuador failed to make an interest payment, which triggered the contracts. Whoopsie.) Now, here's the funny, geeky thing... CDS contracts trade with different "restructuring clauses" CDS contracts that reference North American corporates trade with a clause abbreviated as "XR," or "no restructuring." Companies in the region tend to fail to pay or go bankrupt, and don't often have restructurings. So it's just easier that way. Companies in Europe, however, tend to have restructurings, so they trade with "MMR," or "modified modified restructuring." Why two modifieds? Cause MR, "modified restructuring" had to be well... modified. It didn't quite work the way market participants wanted it to. For how the credit derivatives market works under the auspices of trade organisation Isda, we refer you to the dialogue in our previous post: Now, the whole "restructuring" clause thing is also something that regulators supported (i.e. give credit for), as they thought it offers better protection when CDS are actually used as a hedge. CDS trades with MR or MMR clauses have bucketed auctions, like Thomson. Enter the Greece auction Onto sovereigns like Greece though, they trade with something called "full restructuring" which is often abbreviated "Old R" (or "CR" for some reason). This particular clause actually means that Old R trades won't have bucketed auctions even when the credit event in question is a restructuring. So the question becomes whether anyone traded anything other than Old R trades on Greece, hence necessitating an auction with buckets. Now, FT Alphaville didn't think anyone would do that. Or, if they did, we thought it would be a booking error that would be cleared up. But then, we saw this in a note from JP Morgan on February 24th (emphasis ours): A problem might arise with the CDS contracts that have Mod R or Mod Mod R clauses. Western European sovereign CDS generally use the clause "Old Restructuring" (Old R). Under Old R, there are no maturity limits on deliverables, hence for the majority of the Greek CDS contracts currently in place there will be a single auction with bonds up to 30y maturity deliverable without multiple maturity buckets. But there is a small portion of Greek CDS contracts with Modified Modified Restructuring clauses (Mod Mod R), which means that for these contracts there will be several auctions for multiple maturity buckets. For the settlement of these CDS contracts, there might be bond deliverability shortage for shorter maturity buckets up to 10 years, where only international law bonds will be deliverable, creating some room for a squeeze in the auction process. But again, the universe of these CDS contracts (Mod Mod R) is rather small. Now, that's weird. That was the first we'd ever heard of Greece CDS trades with MR or MMR. And we're still thinking that someone at some point made a mistake. For example, what could have happened, and seems more likely, is that some bank did a big ol" CDO (or two or three) with Greece among the credits, and booked the whole thing under MMR (mistakenly). Since then, MMR/MR single-name trades were needed to hedge the risk. So the question is, will the Greece auction need buckets? Isda spokeswoman quoted in WSJ: A single auction would be held, the ISDA spokeswoman said. That is unlike some corporate restructuring credit events, where several auctions are held to deal with a range of bond maturities. Tell that to the team at JPM... All, in any case, will be revealed when the Isda DC gets around to it. Related links: DERIVATIVES: ISDA unveils initial Greek deliverables list - IFR Shhh! Isda cabal is acting in a predictable way. - FT Alphaville Greece CDS: trigger happy - FT Alphaville Greece CDS: trigger sad - FT Alphaville Will the Greece CDS auction be "fair"? Part 1, Part 2 - FT Alphaville [Credit event auctions] Why do they exist?; A necessary condition for growth; Mechanics - FT Alphaville This entry was posted by Lisa Pollack on Friday, March 9th, 2012 at 15:30 and is filed under Capital markets. Tagged with CDS, credit event, credit event auction, Greece, isda, sovereign cds.