ISDA PRESS REPORT - OCTOBER 24, 2001

CREDIT DERIVATIVES
	*	Documentation Into The Future - FOW
	*	The Direction for Derivatives - FOW

Documentation Into The Future
FOW - October 2001
By Alessandro Cocco and Joe Kohler

Credit derivatives are instruments used for buying or selling the risk that
an obligor defaults on one or more specific obligations. In this article, we
will examine the foundation stone that underpins the vast majority of credit
derivative documentation, the 1999 ISDA Credit Derivatives Definitions,
pointing out some of the documentation's key features and where they have
already been refined.

The definitions are a set of contractual provisions that can be incorporated
by reference into confirmations relating to credit derivatives that take the
form of single name default swaps. This allows parties to a transaction to
use a short form of confirmation containing only the economic and
deal-specific terms relating to that transaction.  The objective of this
structure is to provide market participants with a tool for producing
documentation that is sufficiently sophisticated to deal with the majority
of issues arising from such transactions, simple enough to facilitate rapid
processing, and cost effective. The definitions achieve this by codifying
market practices, but more importantly, the prospect of their generation
helped to focus minds on establishing some of these practices in the first
place.

As with all ISDA documentation, the definitions allow for numerous elections
to be made by the parties, and the parties are also free to make whatever
amendments or additions they agree by inclusion in the confirmation of
appropriate language. The definitions also provide for a number of fallbacks
to apply in case the parties do not specify otherwise.

Market participants recognise the particularly important role of
documentation in the credit derivatives market. As a consequence of the
Russian and Asian financial crises, it became clear that in the case of
credit derivatives, more than for other derivative transactions, the payment
of large sums of money may depend on the interpretation of the wording of a
specific clause.

The 1999 ISDA Credit Derivatives Definitions

Scope
The definitions apply to credit default swaps relating to obligations for
the payment of money by a reference entity.With appropriate modifications,
the definitions can also be used to document credit derivative transactions
that refer to baskets of reference entities, or to form the basis of
documents relating to funded products. In a transaction, the party buying
credit risk protection, or buyer, undertakes to pay the seller of protection
a predetermined amount. In return the seller undertakes to make a payment in
favour of the buyer in case the defined credit events occur. Credit events
serve as indicators of the deterioration of the creditworthiness of the
reference entity.

One of the main characteristics of a credit derivative is that the buyer
does not have to suffer a loss as a result of a credit event in order to
qualify for the payment from the seller. For example, A buys from B the
right to receive from B a payment of $10m in case company X is subject to
bankruptcy proceedings or does not repay loan Y If company X undergoes
bankruptcy proceedings or loan Y is not repaid, a credit event occurs. The
occurrence of one of these events, in circumstances involving the
satisfaction of any other condition to payment that the parties may have
specified in the transaction, would give A the right to receive from B the
agreed payment, irrespective of whether A had any credit exposure to company
X or loan Y.
This feature is of crucial importance to the determination of the regulatory
environment applicable to credit derivatives. In the UK if entering into
credit derivatives transactions constituted the carrying on of insurance
business, there would be a requirement for authorisation under the Insurance
Companies Act 1982. The fact that a buyer of a credit derivative does not
have to hold the obligations in question in order to obtain a payment from
the seller means that the credit derivative does not fall within the scope
of this legislation. This analysis was set out in full in a legal opinion
obtained by ISDA in 1997.

Reference entity
It is essential that the reference entity is identified with sufficient
precision. For example, to what extent are successors or affiliates of an
entity to be included? This point is particularly important when dealing
with a sovereign.What, if any, governmental agencies or authorities should
be included within this definition?

The demerger of National Power last year led to further debate surrounding
the definition of successor. National Power shifted a large number of
obligations to a new company called Innogy. Following the demerger, Innogy
became a stronger credit than National Power had been beforehand, and
National Power, in its new guise, became weaker. As a consequence, buyers
and sellers of credit protection in relation to National Power had opposing
views, from a commercial perspective at least, as to which was the
successor. ISDA is now looking into further refinements to the concept of
successor.

Credit events
The buyer and seller may buy and sell credit risk defined by reference to
different types of credit events. It is appropriate that both select
carefully the type of event on which they wish to trade. The definitions
offer a menu that comprises (1) failure to pay, (2) acceleration or default,
(3) repudiation/moratorium, (4) restructuring (in each case in respect of
one of the obligations identified in the confirmation) and (5) the
bankruptcy of the reference entity. In the case of all but the last of these
the parties can choose to implement a type of materiality threshold by
agreeing a payment requirement or default requirement that has to be crossed
before the credit event is deemed to have occurred.

The parties may consider the definitions' menu to be in need of amendment or
supplement in order to deal with the specific credit risk they wish to
trade. For example, the bankruptcy credit event focuses on events that
corporate obligors could experience and would require tailoring if the
Reference Entity were to take some other legal form.  The definition of
restructuring was one of the most controversial provisions in the drafting
process that led to the definitions. In the forerunner of the definitions,
ISDA's 1998 long form of confirmation, restructuring was defined by
reference to events that had the effect of making the terms of the relevant
obligation materially less favourable from an economic, credit or risk
perspective. This definition was generally considered to be too subjective,
and had given rise to a number of disputes.  The new definition now refers
to more objective criteria, such as a -reduction in the amount of principal
or premium.  A degree of subjectivity is, however, retained in that events
that would otherwise fall within the definition of restructuring do not
constitute a restructuring if they do not result directly or indirectly from
deterioration in the creditworthiness or financial condition of the
reference entity.

However, the market's disquiet regarding restructuring was not quelled by
these changes, and this recently gave rise to ISDA publishing a
Restructuring Supplement. The supplement restricts the types of obligation
to which restructuring can apply. It clarifies issues that the definitions
were not clear on and places certain additional parameters on the ways in
which a transaction can settle following a restructuring credit event.

Obligations
Apart from the bankruptcy of the reference entity, the question of whether a
credit event has occurred is determined by reference to obligations
identified in the confirmation. The definitions introduce a matrix system
based on the choice of one obligation category, and, if appropriate, one or
more obligation characteristics. The aim of this structure is to introduce
flexibility into the documentation process. The obligation categories are:

payment, borrowed money, reference obligations only, bond, loan, or bond or
loan. It is possible to give a very wide definition of obligations by
selecting payment (any obligation for the payment or repayment of money). On
the other hand it is possible to specify that credit events are only
relevant if they occur with reference to only one obligation, the reference
obligation. Choosing one or more obligation characteristics has the effect
of restricting the field of obligations in relation to which a credit event
may occur, because an event will be relevant only if it occurs in relation
to obligations of the chosen category, and which have the chosen
characteristics. Examples of obligation characteristics are: specified
currency, not domestic currency, not domestic law

Conditions to payment
The fact that a credit event has occurred is not sufficient to trigger the
payment of credit protection. Before that can occur, certain conditions to
payment must be satisfied. The definitions set out three conditions
involving the service of notice. A credit event notice must be served in any
transaction before the credit protection will become payable. The parties
may choose that a notice of publicly available information must be served to
cite news sources that confirm the occurrence of a credit event. Finally, if
the transaction is to settle physically, a notice of intended physical
settlement must be served by the buyer.

Term of a transaction
A credit event notice must refer to a credit event that occurs during the
term of the transaction. The term
begins on the effective date and ends on the scheduled termination date,
both of which are agreed by the parties in the confirmation. However, where
the credit event is a failure to pay, the credit event must be continuing at
the end of any applicable grace period or three days, whichever is the
longer. This requirement is intended to avoid a credit event being triggered
by a technical default, but it means that a default could have occurred on
or before the scheduled termination date, even though the grace period is
still pending at that time. The definitions provide that the parties have
two options in these circumstances. They may either postpone the end of the
term of the transaction beyond the scheduled termination date to the end of
the grace period, at which point, if the failure to pay is continuing, a
credit event notice may be served. Alternatively, they may agree that the
grace period must have expired before the scheduled termination date or no
credit event notice may be served. The latter is the fallback provision,
which applies unless the parties agree otherwise.

Physical and cash settlement
The parties agree at the outset whether cash settlement or physical
settlement applies to the relevant credit derivative transaction. These are
different means of realising the protection bought by the buyer where a
credit event actually occurs. If cash settlement applies, the payment to be
made by the seller to the buyer may be an amount fixed in advance or, more
usually, an amount to reflect the drop in value of the reference obligation
as determined by way of a dealers' poll. In the case of a physical
settlement, the buyer will deliver to the seller certain types of
obligations - deliverable obligations - against payment of a fixed amount,
usually the face value of those obligations.

The buyer realises its protection because it delivers to the seller assets
that are worth less than their face value, but obtains payment of full face
value from the seller. Physical settlement is widely used in the market,
because it avoids having to determine the exact market value of the relevant
obligation, and in circumstances where a credit event has occurred it may be
difficult to assess the drop in value of the reference obligation for the
purpose of cash settlement. On the other hand, some buyers may prefer cash
settlement because if the buyer has selected physical settlement and is
unable to obtain suitable deliverable obligations to deliver due to, for
instance, a squeeze of liquidity in the market, the buyer may lose some or
all of the protection it had under the credit derivative.

Deliverable obligations
Deliverable obligations are defined, as is the case for obligations, by
choosing one deliverable obligation category and any relevant deliverable
obligation characteristic. Although they are defined in the same way,
obligations and deliverable obligations play different roles. Whereas
obligations are what the parties refer to in order to assess whether a
credit event has occurred (other than in the case of bankruptcy),
deliverable obligations come into play only as a settlement tool and if the
parties have specified that physical settlement applies. The two do not need
to be the same.

Future developments
ISDA is working on producing dispute resolution guidelines. It is also
preparing a user's guide to the definitions. A goal in the future is to
expand the definitions to govern more types of credit derivatives.
Assembling market consensus support for such developments has proved tricky.
As a result, ISDA has recently introduced a new approach to the compilation
of standard documents involving the inauguration of a small working party to
make recommendations to the rest of the market. This working party,
nicknamed the G6, is formed of institutions representing constituencies on
both sides of the Atlantic and different parts of the market. The agenda it
has set itself includes review of other parts of the definitions including
the bankruptcy, repudiation/moratorium, acceleration and default credit
events, language for zero coupon bonds and convertible bonds, and a
clarification of the successor definition, with a view to producing further
supplements or guidance as to what constitutes market standard on various
issues. Developments expected to be implemented in the coming months will
show whether the C 6 approach is more efficient than the previous collegiate
approach.The credit derivatives market will continue to mature and expand.
These developments will mean that refining the definitions is a continuing
process that will inspire fierce debate.


The Direction for Derivatives
FOW - October 2001

There are several ongoing have hindered the development of credit
derivatives. Lack of a single body to oversee disputes, and concerns about
risk exposure transparency have all added to a reluctance by some financial
services organisations to use them. As a result, the development of
underlying technology supporting credit derivatives has progressed more
slowly than in other banking industry areas. But this looks likely to
change.

One of the major reasons for this is that the use of credit derivatives is
--beginning to climb. According to the Bank of England, the notional
principal outstanding exceeds $1 trillion globally. And the British Bankers'
Association says the credit derivatives market has grown from an estimated
$40 billion outstanding notional value in 1996 to an estimated $740bn at the
end of 2000.

This increase is being driven by various developments in the banking
industry, not least the push for transparency. Other key factors include the
need for banks to:
*	Diversify their risk portfolio, which is particularly important in a
recession or slowdown to limit exposure to individual market sectors
*	Achieve straight through-processing (STP) to improve efficiency and
cost savings
*	Demonstrate to regulators that they meet capital adequacy
requirements
*	Ensure an integrated, single view of investment and risk

As our current economic situation worsens, exposure to credit risk grows and
the use of financial instruments such as credit derivatives is increasing
This has coincided with growing pressure in recent years for financial
institutions to automate and integrate all their applications and processes
to meet regulatory requirements, minimise risk and keep pace with
technological innovation.

Recent market developments
Although not widely used, the advent of online credit derivatives trading
exchanges such as Creditex.com, CreditTrade.com and CreditDimensions.com is
a significant indication that the market is growing.

The exchanges are backed by major players. Creditex, founded in April 1999,
for example, has equity
investment and support from Deutsche Bank, JP Morgan Chase and Bank of
America among others, while CreditDimensions' eclectic mix includes
Algorithmics, Bureau van Dijk Electronic Publishing and Standard and Poor's.
Prebon Yamane and Internet Capital Group are among -the supporters of
CreditTrade.com, And a new entrant, Eprimus.com, is expected to join the
fray later this year, intending to act as a creator and investor by selling
credit protection in the form of default swaps on more than 1,500
investment-grade names.

These online exchanges also highlight the need for integrated systems,
particularly as banks are notorious for the number and diversity of
platforms and applications used.

Integration interlude
In the past, financial organisations have relied on spreadsheets to record
-credit derivatives transactions. And for most this is still the case. Yet
as STP and risk management become even higher on the agenda, so too does the
push for technologies that can effectively automate and manage transactions.
Banks must ensure that all processes are fully integrated and that back and
middle offices can keep pace with front offices. However, given the plethora
of proprietary trading platforms used by banks, offerings must be easily
designed, built and integrated into core systems to be a worthwhile
investment. Electronic initiation, execution and settlement is essential. It
is therefore crucial that any credit derivatives solution is:
	*	Open
	*	Scalable
	*	Stable
	*	Flexible
	*	Easy to integrate
	*	Future-proof

Software today
So what's on the market so far? Some vendors are pushing end-to-end
solutions while others are focusing on packaged, component-based solutions,
which can be 'bolted on' to core systems. And other vendors say their
solutions can be bought as a standalone module or as part of a suite.

Leading players so far include Front Capital, Murex, Summit, SunGard and
Savvysoft. The US companies appear to be benefiting from first mover
advantage in the UK marketplace at this stage. Current suppliers tend to be
global organisations with an HQ in New York. One exception is Front Capital
Systems, which has an office in London as well as in New York, Stockholm,
Frankfurt, Zurich and Johannesburg.

Many of the vendors are pushing front-to-back-office solutions covering cash
and derivatives trading as well as foreign exchange, energy and commodities,
equities and interest rates. Front Arena, from Front Capital Systems, for
example, combines fixed income, asset swap and interest rate derivative
capabilities with credit derivative functionality. With high yielding
securities and credit derivatives in the same system, monitoring all
positions simultaneously becomes easier.

Some vendors, such as Murex, offer a suite of integrated front and back
office systems sharing the same middle and back office platform. The
solution offers integrated, front-to-back office software solutions for cash
and derivatives trading and processing in fx, energy and commodities,
equities and interest rates. This includes listed, over-the- counter (OTC)
and exotics derivatives on securities and fx.

Summit's credit derivatives module can be run as a standalone application or
as part of a product suite and supported instruments include credit swaps,
credit- linked bonds, risky bonds (theoretical valuation) and forward bonds
purchase (binding and non-binding). Features include default probabilities
and recovery rates.

Vendors including SunGard and Savvysoft have created component-based
offerings. SunGard's Credit Derivatives Components module provides a
'building-block' asset, allowing any possible credit derivative product to
be structured and managed in a portfolio.

The module aims to offer staff the ability to structure, price, analyse,
trade and risk manage a variety of credit derivative instruments. It
supports several credit derivative instruments, including credit default
swaps, credit spread options and total rate of return swaps. The
functionality includes the ability to:
	*	Touch - Pay/receive par amount at the time a credit event
occurs
	*	End - Pay/receive par amount at the end of the contract's
life if a credit event occurs
	*	Annuity - Pay/receive a fee from the time a credit event
occurs until the maturity of the contract
	*	Fee Pay/receive a fee from the start of the contract until
the first of either a credit event occurring or contract maturity

And risk management is not forgotten. The solution emphasises the importance
of analytical integrity and the ability to support enterprise-wide risk
management. It includes risk measures for credit derivatives commensurate
with other interest-rate sensitive instruments such as bonds, caps and
swaps. This means that risk can therefore be aggregated across asset classes
and/or on a portfolio or enterprise-wide level. There is also an option to
produce specific credit derivatives reports.

Savvysoft's TOPS suite of products comprises nearly 70 OTC and
exchange-traded derivatives models. Savvysoft's newest product, TOPS Credit,
is geared to handling many types of credit derivatives, including total rate
of return swaps, credit default swaps, credit linked notes, credit spread
options and others. Like Summit, Savvysoft takes default probabilities into
account. In addition to letting the user specify the probability of an
issuer default, TOPS Credit can also base its calculations on the
probability of counterparty default and the correlation between these two
probabilities. The probabilities include functions of time, interest rate
levels and stock price levels to give users control over credit derivatives
valuations

Huge opportunity
The credit risk transfer market has the potential to increase the overall
robustness of the global financial system over time. But to do this, it is
essential that financial institutions can rely on a stable, scalable,
flexible solution that can be easily managed and integrated into core
systems.

The growing popularity of credit derivatives will offer IT vendors an
opportunity to extend their reach within financial institutions. But we are
currently at the early stages. The credit derivatives instrument is still in
development and the market is wide open for technology vendors particularly
UK based suppliers  to enter. This is an emerging market and we have a long
way to go before we know who will be the leader in this space and how it
will develop. 

**End of ISDA Press Report for October 24, 2001**

THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S
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Scott Marra 
Administrator for Policy and Media Relations
International Swaps and Derivatives Association 
600 Fifth Avenue 
Rockefeller Center - 27th floor 
New York, NY 10020 
Phone: (212) 332-2578 
Fax: (212) 332-1212 
Email: smarra@isda.org