From Joshua Rosner of Graham Fisher
Credit Event, Or Not? Is Another Market Being Manipulated? (pdf)
As investors and market participants become increasingly aware of the regulatory failures that allowed for manipulation of LIBOR, FOREX, municipal bond bidding and certain commodities markets, regulatory sources are increasingly expressing concern that they have paid too little attention to potential manipulations of an arguably larger, more systemically important and less regulated market – the CDS market as self-governed, through ‘regulatory license’, by the International Swaps and Derivatives Association (ISDA).
It appears regulators are now turning their attention toward the CDS market, its problematic self-regulatory structure, the myriad of conflicts of interest, the potential avenues for manipulation by large dealers and the opaque and potentially self-serving manner in which determinations of “credit events” are privately decided by ISDA’s Determinations Committees (DCs). A growing volume of news stories, the publication of several new academic papers, the reversal of Dodd-Frank’s “Push-Out” rule which would have forced banks to move their derivatives out of the depository, and the DCs’ handling of several recent questions have only served to increase regulatory concerns and cause some to point out numerous similarities between the various manipulation scandals, the possibility of manipulations in the CDS market and the implications to the global economy.
Source: Dan Awrey
Since 2000, and the insertion of language into the 2000 Commodity Futures Modernization Act which exempted CDS from regulation by the Commodity Futures Trading Commission, the U.S. derivative market has been largely self-regulated. After the global financial crisis, the President’s Working Group on Financial Markets (PWG) recognized that the opaque world of derivatives needed substantial changes. However, the President’s Working Group left implementation of needed changes and oversight to the industry. In effect, the same sell-side driven derivatives market that led the world to crisis was told ‘Sinner, heal thyself’.
Today, as a result of the rapid growth of the OTC Derivatives market, including CDS, the systemic risks posed by this market and the obvious conflicts of interests inherent in its current oversight, regulators are finally casting a close eye on the actions and decisions of this self-regulatory regime.
In each global region, determinations regarding credit events are made by 15 of the largest users of credit default swaps. Ten voting members are sell-side firms, and five are buy-side firms. The voting members are the institutions rather than the individuals voting on their behalf. These users of CDS, who vote to determine when a credit event has occurred and therefore whether there will be a payout on the swaps, appear likely to have positions in nearly every issue they are tasked to decide – and their decisions are binding on all market participants and issuers. The determinations of these DCs, which are less regulated than rating agencies and expressly shielded from certain types of legal liability, have become more powerful and of more importance those of the ratings firms. The DCs’ disclosure language highlights the problems inherent in the current process:
The procedures of the Determinations Committees are set forth in the DC Rules. A Determinations Committee in accordance with the DC Rules may amend the DC Rules. None of ISDA, the institutions serving on the Determinations Committees or any external reviewers owes any duty to you in such capacity, and you may be prevented from pursuing claims with respect to actions taken by such persons under the DC Rules. Institutions serving on a Determinations Committee may base their votes on information that is not available to you, and have no duty to research, investigate, supplement or verify the accuracy of information on which a determination is based. In addition, a Determinations Committee is not obligated to follow previous determinations or to apply principles of interpretation such as those that might guide a court in interpreting contractual provisions. Therefore, a Determinations Committee could reach a different determination on a similar set of facts. If we or an affiliate serve on a Determinations Committee, we may have an inherent conflict of interest in the outcome of any determinations. In such capacity, we or our affiliate may vote and take other actions without regard to your interests under a Credit Transaction.
Yet, more troubling, the Determinations Committees’ Rules appear to actively court trading ahead and/or manipulation. These rules do not offer any meaningful guidance regarding Determinations Committees’ members’ conflicts of interests; ability to vote on issues in which they have a financial interest; recusal from voting; or sharing of information regarding discussions and determinations of DCs with others (including traders) within their own firms. Even those rules that exist appear meaningless given that ISDA doesn’t appear to monitor compliance and, given that it is a trade association, is unlikely to sanction its own members even if there were a mechanism to do so. As a result, it is not impossible to believe that in cases in which a vote is delayed for another meeting, or in cases in which a second vote occurs, a DC member may use any delay to reposition their book in anticipation of a final determination.
The ISDA Determinations Committees wields unprecedented, largely unbridled and unchecked power to declare corporations and sovereigns in, or not in, default, and they are therefore are in a position to define the contractual solvency of their member firms.
Recently, it has been proven that without governmental oversight, there are many opportunities for ISDA member banks and the voting members of the DCs to secretly manipulate markets for their own benefit. As example, recent lawsuits have been filed based on CFTC referrals to the Department of Justice. The CFTC has claimed that criminal behavior has been found which demonstrates ISDA member banks manipulated “ISDAFIX”, a benchmark used to set rates on trillions of dollars of derivatives. If proven, the scale of these manipulations may be far larger than LIBOR, FOREX or the municipal bid-rigging manipulations.
As witnessed through the lens of AIG’s failure, in which the majority of CDS that AIG insured were used by banks and investment banks for regulatory relief, CDS have become a means for banks to engineer a reduction of their risk-weighted assets and raise their capital ratios.
The potential use of CDS to artificially manipulate corporate solvency, the imbalances in the amounts of CDS outstanding relative to referenced debt and ongoing allegations that ISDA’s Determinations Committee is deeply conflicted and “operates as a quasi-Star Chamber or cartel”, are finally being scrutinized.
As one source recently suggested, “It would be a surprise if determinations of default, made by a committee of interested parties, don’t lead to findings of manipulation similar to those found in LIBOR and FOREX”.
The Problems of Determinations Committees
As highlighted by John Biggins, “direct public regulation of OTCD trading between sophisticated counterparties in the US was substantially abolished at the turn of the 21st century”. While Dodd-Frank in the U.S. and regulations overseas have sought to rein in certain activities, move trading to centralized exchanges and move certain exposures out of banks, there has been little done to create direct government oversight of the processes of determining defaults, clearing positions, overseeing auctions or settling trades. The bulk of these activities remain in the hands of private players – some with inherently conflicting roles – such as ISDA.
When, in the wake of the global financial crisis, the industry saw that it was going to come under increased scrutiny and pressure, ISDA took a lead in lobbying and in the creation of new standards of self-regulation. Included in these was the creation of the Determinations Committees. Before the DC member selection process was finalized, investors were told that the DCs would be “balanced between dealers and investors” and that “It only works if people believe in it”. Yet in fewer than five years since the creation of the Committees, it has become clear that they are neither balanced nor worth meaningful belief.
While ISDA has routinely sought to defend itself from criticism, the realities of the DCs is that even a routine review of their actions undermines their credibility as market gatekeepers.
Claims Versus History
ISDA, in defense of the DCs, claims that clear risks of individual firms voting based on their own books are ameliorated by the process in which 80% of the 15 members are needed to come to a decision. These claims appear dubious given that there is no duty, for the Committees, to disclose a transcript of the meetings or an accounting of their reasoning. Doubts are only heightened by the almost inevitable, seemingly impossible, cartel-like unanimity of the Committee’s determination votes. As example, for at least the last three years, every single one of the dozens of the Determinations Committee for the America’s has been unanimous. As one observer pointed out:
“Doesn’t it potentially create a dynamic where no one wants to be seen to be dissenting? Does this stifle genuine debate and put pressure on those who may have a different opinion? Wouldn’t true transparency mean that DC members disclosed the financial interests of their firm and their votes?"
The fact that Pimco’s Chief Investment Officer criticized the determination that Greece had not triggered its CDS, even though Pimco was part of the unanimous vote making that determination, is profoundly troubling to say the least. The discrepancy appears to suggest that the official votes of DC members do not necessarily reflect the actual views of those members and that the voting process has thus been perverted. The fact that the DC has no obligation to “research, investigate, supplement or verify the accuracy of information on which a determination is based” and members “may have an inherent conflict of interest in the outcome of any determinations” only adds credence to suggestions that the “CDS market is being manipulated and gerrymandered by the all-powerful investment banks”.
Questions about the CDS and reference debt held by Committee members are almost certain to be the subject of regulatory and legislative inquiry given the importance of Committee votes, to investors and issuers – including sovereign governments. While the public rarely has the ability to know where a specific conflict exists on the books of a Committee member, there have been circumstances in which the conflicts appear clear. Last summer, the DC met to decide whether Argentina’s failure to pay holders of exchange bonds was a triggering credit event. Given the decade-long dispute between Elliott Management – who is a voting member of the Determinations Committee - and Argentina, one has to wonder why, with obvious conflicts, Elliott didn’t recuse itself , or was it not forced to recuse itself, from the vote. One also has to wonder why ISDA doesn’t appear to have any policies governing either public disclosures of conflicts or requirements for recusal where a conflict may color a member’s vote.
Perhaps ISDA will state, in its defense, that in circumstances in which members’ views – or financial interests – make it difficult to come to the required decision by 80% of the Committee members, the determinations are subject to an external panel to review and make the determination. To be sure, external review is a good and healthy process, to the extent that it is conducted properly. In fact, one could easily argue that truly independent and non-conflicted reviewers should vet all credit event determinations in the first instance, and that the DC itself is unnecessary, serving largely as a superfluous vehicle for potential market manipulation. However, external review does not appear to happen nearly often enough. Instead, it seems reasonable to suspect that the infrequency with which external reviews occur is the result of a more frequent outcome in which most or all of the committee members (likely frequently the ten bank members) vote in unanimity and then sway at least two or more of the remaining committee members (likely frequently the investors), after which the remaining committee members fall in line.
Even the process by which issues are submitted to external review appears biased in favor of the ten banks. These banks often vote largely as a block, and due to a bizarre and potentially deliberate quirk in the determination process, a 10-member majority cannot be overturned by anything short of a completely unanimous rebuke by the entire external review panel. On the positive side, unlike Committee determinations, External Reviews are required to provide the DC with a summary of the reasoning for their decisions and that reasoning is required to be disclosed publicly. Also, although the external review process does require the reviewer to make a judgment as to whether it has any conflicts of interest regarding the issue at hand, it is unclear whether such disclosures and/or recusals have ever occurred. Moreover, given that the reviewer is supposed to consider, as conflicts, only issues “with respect to either the Reviewable Question or the related DC Questions which may be deliberated by the Convened DC”, the rules do not appear to prohibit reviewers from having conflicts relating to financial remuneration historically received by them from members of the Committee. It seems obvious, given that the external reviewers are proposed by Committee Members, that these types of conflicts are commonplace. In fact, even a cursory Internet search for pool members turned up external reviewers who clearly receive income from Committee Member firms.
These questions seem particularly timely given the DC’s meeting on December 24th to determine whether Caesars’ failure to pay all of the interest and principal owed on December 15, 2014 triggered a failure to pay credit event. Section 4.01 of the relevant 2nd lien indenture states that “[a]n installment of principal of or interest shall be considered paid on the date due if on such date the Trustee or the Paying Agent holds as of 12:00 p.m. Eastern time money sufficient to pay all principal and interest then due ...”. Thus, in the event all principal and interest then due is not paid, which was certainly the case on December 15th, neither principal nor interest is considered paid. This clearly triggers a failure to pay credit event under the relevant ISDA documents. Yet the DC’s December 24th meeting concluded with a public announcement that the Committee had postponed a vote until December 29th, and the December 29th meeting concluded with another deferral, this time to January 5th.
Where the language in an indenture is completely straightforward, as appears to be the case in Caesars, it is unclear what the reasons for these consecutive postponements may be. One has to wonder whether the DC is deliberating based on the facts or merely seeking to act in the pecuniary interests of the majority of its members. If the former, then why has the committee not yet announced the obvious - that there has been a failure to pay?
Regulatory investigations and legislative inquiries would certainly be timely given the importance of reducing systemic risks, supporting the functioning of fair and transparent markets (in which asymmetries of available information are reduced), and increasing the certainty of rights among issuers, dealers and all investors.