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The ISDA Emperor Also Has No Clothes

Posted by Larry Doyle on March 2, 2012 7:42 AM |

Writing down sovereign debt by over 50% and subordinating one class of bondholders from another –those being the royalty ensconced within the European Central Bank — would not qualify as a “credit” event, now would it? No way! Of course not! Why would it?!

Not when those compelled to pay out on the supposed “insurance” within derivative contracts are the royalty within other large international banks, and they sit in the positions of judge, jury, and counterparty in the case.

Welcome to the world of international finance circa 2012. 

The ‘case before the court’ has to do with the restructuring of Greek sovereign debt and the fact that certain bondholders will take a very sizable haircut while others, primarily the European Central Bank, will not.

Would the holders of ‘insurance’ in the form of CDS (credit default swaps) collect payment on those swaps, which would largely offset the writedown in the value of their bond holdings? Welcome to the arcane world of the International Swaps and Derivatives Association (ISDA), which promotes itself as:

Since its founding in 1985, the International Swaps and Derivatives Association has worked to make over-the-counter (OTC) derivatives markets safe and efficient.

ISDA’s pioneering work in developing the ISDA Master Agreement and a wide range of related documentation materials, and in ensuring the enforceability of their netting and collateral provisions, has helped to significantly reduce credit and legal risk. The Association has been a leader in promoting sound risk management practices and processes, and engages constructively with policymakers and legislators around the world to advance the understanding and treatment of derivatives as a risk management tool.

Today, the Association has more than 815 members from 58 countries on six continents. These members include a broad range of OTC derivatives market participants: global, international and regional banks, asset managers, energy and commodities firms, government and supranational entities, insurers and diversified financial institutions, corporations, law firms, exchanges, clearinghouses and other service providers.

ISDA’s work in three key areas – reducing counterparty credit risk, increasing transparency, and improving the industry’s operational infrastructure – show the strong commitment of the Association toward its primary goals; to build robust, stable financial markets and a strong financial regulatory framework.

Sounds impressive, but then again “talk is cheap” and “words mean little” if the ISDA ’emperor’ cannot perform. Let’s navigate further.

In regard to the situation in Greece and this restructuring, the members of the ISDA committee released the following statement:

The EMEA DC determined that it had not received any evidence of an agreement which meets the requirements of Section 4.7(a) of the 2003 Definitions and therefore based on the facts available to it, the EMEA DC unanimously determined that a Restructuring Credit Event has not occurred under Section 4.7(a) of the 2003 Definitions. (LD’s highlight)

Granted there is little real surprise in this announcement as market participants have come to expect the ongoing charades within the international banking arena to continue. That said, for the record, let’s see what selected market participants had to say. The FT sheds real insight this morning in writing, No Insurance Pay-Out on Greek Debt:

Paul Griffiths, global head of fixed income at Aberdeen Asset Managers, said: “This may be bad news for the CDS market. In the longer-term, there is an almost metaphysical question. Why is CDS there? Why does it exist? “

Is this CDS market and the ISDA simply for institutional bondholders and heavyweights in the world of global finance? Do you own an international bond fund? Don’t think for a second we are not all impacted by the charades being played. We all eat the costs distributed.

While the risks of these charades may currently be disguised by the liquidity injected by global central banks, the risks and accompanying costs accrue and extend for future generations. To that end, the ISDA emperor has also been shown to have no clothes and joins with other regulatory bodies in being neutered by the titans of finance.

What does this all mean? Are the CDS contracts worth the paper on which they are written? What’s that you say? Does somebody in the back of the room have a comment? Please speak up so we can all hear…

Navigate accordingly!!

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets, our economy, and our political realm so that meaningful investor confidence and investor protection can be achieved.

  • fred


    So once again the system rewards the ‘foolish’ risk takers at the expense of those who practiced ‘prudent’ risk management.

    Even if ‘crew cutted’ creditors flip the issue over to the judiciary, the fix is in; it’s all ‘semantics’ and ‘splitting hairs’. If a lower court were to find in favor of the ‘skin heads’, the verdict would just be reversed upon appeal to a higher court.

    When are people going to get it, the ends always justify the means. Come hell or high water, the stock market shall rise, the global economy shall not falter! (At least not until after the next election).

    I would love to know exactly, how the price of Gold dropped by almost $100 on Wednesday. Was this the normal reaction of a deep and volitile market to Bernanke’s congressional testimony that QE3 might not be needed or something more sinister and orchestrated? (In my opinion lower inflation expectations and further QE possibilities can survive either higher oil or gold but not both).

    The Administration is already pulling out the blame the speculator ‘spin’ for the oil price spike; I’m sure it has nothing to do with weak Volt sales, the faltering alternative energy industry or the push to tax ‘greedy big oil’ profits. But, never fear, even if people don’t buy the ‘spin’, I’m sure a timely release from the strategic oil reserve will satisfy the ‘uncomitted’ crowd come November.

    LD, surely there’s a way to stop bureacrats, politic and politicians from dominating every aspect of our daily lives!

    • fred


      When Bernanke says he has done almost all he can with QE and it’s now up to fiscal policy initiative, what exactly is he implying, that the gov’t ramp up spending or that the gov’t should downsize and/or raise taxes to reduce our borrowing needs and alleviate the pressure on the Treasury market?

      • LD


        I believe Ben is indicating that the government needs to increase spending in the short term while then addressing the deficit down the road when the economy is stronger.

        How often have we heard various iterations from this sheet of music? Ad nauseam.

  • Huckleberry

    For me, the jury is still out on the basic idea of a CDS.

    That said, they exist, are contracts, and should be honored as such. But when is a contract not a contract? When counterparties can redefine terms as they see fit, then the contract would not be worth the paper it is printed on. And it would seem that some contracts are more equal than others.

    And what, then, is a default?

    It might seem/be a great over-simplication, but from what I have seen these past few years, a contract between parties of wildly disparate ways and means is no contract at all. A contract in this sense merely lays out the battlefield upon which the lawyers will wage a long and expensive fight. If one side cannot afford the fight, they should have never entered into the contract.

    This is not how we are raised to think about the American system. Yet this is what our system has become.

    I see much self-interest, but I see no enlightenment.

    There is one set of laws in this country but we see, every day, two systems of justice. This is not sustainable.

    Was this the inevitable result of a wildy financialized economy, with unhealthy concentrations of capital in the hands of a few who really do little but sit in the middle and take a cut? Or is this some kind of abberation,and if so, when and how did it occur?

  • coe

    Today’s landscape is littered with a surplus of hair splitting and rationalizations and legal nuances. Remember Bill Clinton’s militant support of his perverse definition of “it”.

    The ISDA premise is actually founded on well intended principles. The proliferation of all forms of derivatives – interest rate, credit, equity, and currency and commodity – has far exceeded the notional value of the exposures originally intended to be hedged by these instruments. They have become speculative, typically off-balance sheet, and both complex and opaque in nature. Well past the stage of regulatory sophistication and rule-making, they are the five hundred lb gorilla in the room.

    Think about residential mortgages – there is an explicit and in some forms, an implicit derivative embedded in those “contracts”. Are they fairly priced? I don’t think so.

    I guess my point, LD, is that the derivative market makes all the sense in the world, but our financial system has found a way to turn the functionality into a powder keg.

    Another example – In the accounting world, one can “modify” vs “extinguish” debt by extending and/or altering old or embedding new derivatives if a present value calculation falls in fair territory..investors have no clue that this debt has been “modified”..I guess it is the same with CDS and the “restructuring” vs the “default” on Greek debt.

    Where in the name of sanity and common sense does that leave the trillions of dollars of CDS regarding the premise of performance? Forget the words in the contract – it’s left to the interpretation of the insiders. Food for thought for sure…caveat emptor – true then, truer now!

    • fred

      The fact remains that no issuers of CDS, backed by implicit or explicit gov’t guarantees, were req’t to hold reserves in the case of default nor did they feel it prudent to do so of their own accord. Why?

      Issuers played chicken with global gov’t bureaucrats and were successful, Why? Where were the regulators, pre/post 2008?

      “The greater risk to personal freedom is not socialism but bureacracy. The greatest risk of socialism is not the loss of personal freedom but the creation of more bureacracy”.

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