On June 1, 2022, the Credit Derivatives Determinations Committee announced that Russia’s failure to pay approximately $1.9 million in interest that had accrued between the maturity date of Russia’s ten-year bonds on April 4, 2022, and Russia’s payment of principal and pre-maturity interest on those bonds on May 2, 2022, resulted in a “Failure to Pay” Credit Event that may trigger settlement of Credit Default Swaps referencing those bonds.[1] Ordinarily, the Determinations Committee would promptly schedule an auction to set the settlement price of the bonds and facilitate physical and cash settlement.
However, on June 6, the Office of Foreign Assets Control of the United States Department of the Treasury issued an updated FAQ clarifying that executive orders issued by the Biden Administration in March and April 2022 “prohibit[ed] U.S. persons from purchasing debt and equity securities issued by an entity in the Russian Federation.”[2] It is unclear whether or how a settlement auction could proceed in the face of such a prohibition, and accordingly on June 9, the Determinations Committee decided to “defer making any determinations in relation to holding an Auction or the Auction Date so as to allow credit derivatives market participants time to assess the implications that the updated OFAC FAQs may have on the ability of market participants to participate in an Auction.”[3] Although Russia missed additional bond payments on June 26, potentially resulting in a further credit event, the Determinations Committee announced on July 1 that it had “agreed to continue to defer making a determination in relation to holding an Auction.”[4]
As trial counsel in some of the largest and most contentious disputes regarding application of the ISDA Master Agreements, including several of the most hotly contested issues presented to the Determinations Committee in recent years, Quinn Emanuel has extensive experience interpreting and applying the complex ISDA framework across derivatives markets and specialized expertise in disputes related to CDS settlement. Drawing on this experience, we discuss herein the ordinary operation of the settlement mechanisms available to CDS counterparties upon the occurrence of a Credit Event, and the issues and concerns arising from the possible inability of market participants to conduct a settlement auction for the defaulted Russian Bonds.
I. Ordinary Settlement of Defaulted Credit Default Swaps
Counterparties to CDS trades governed by an ISDA Master Agreement have historically been able to choose between three methods of trade settlement in the event that a protection payment obligation is triggered by a credit event affecting the reference entity or obligation. Under Physical Settlement, the protection buyer must deliver the reference obligation to the protection seller, who must purchase the reference obligation at par. Under Cash Settlement, quotations are obtained for the reference obligation, and the protection seller must pay the protection buyer the difference between par and the quoted price. Following the financial crisis, ISDA introduced a third mechanism, Auction Settlement, to provide a standard and centralized method for both physical and cash settlement of trades. The rules governing each of these settlement methods are set out in ISDA’s Credit Derivatives Definitions, which—like the ISDA Master Agreement itself—have been periodically revised; as a result, the precise rules governing trade settlement will depend on the version of the Definitions referenced in the trade confirmation for each trade. Below, we describe the operation of each of the three main settlement mechanisms pursuant to the 2014 Credit Derivatives Definitions.[5]
- Physical Settlement
Where parties have elected Physical Settlement, the occurrence of a credit event gives the protection buyer the right to deliver a Notice of Physical Settlement giving notice that the buyer intends to settle through delivery of the reference obligation.[6] Settlement occurs roughly thirty days following notice, although that deadline (and many other deadlines applicable to settlement) are suspended if the Credit Derivatives Determination Committee is called on to determine whether a credit event has occurred.[7] At settlement, the protection buyer is required to deliver Deliverable Obligations of the Reference Entity (obligations meeting certain defined characteristics, typically those listed in the Credit Derivatives Physical Settlement Matrix published by ISDA[8]) in a notional amount set by the parties’ CDS contract.[9] Upon delivery of the Deliverable Obligations, the protection seller must pay to the buyer a Physical Settlement Amount effectively equal to the notional amount of protection.[10]
The 2014 Credit Derivatives Definitions provide that “[i]f, due to an event beyond the control of” either counterparty, “it is impossible or illegal for Buyer to Deliver” or “for Seller to accept Delivery” of the reference obligation, and if that impossibility or illegality persists for thirty days, then the trades must be settled according to a modified version of Cash Settlement, described further below.[11]
- Cash Settlement
Where parties have elected Cash Settlement, or where Cash Settlement must be used as a fallback method due to an event of illegality or impossibility, the occurrence of a credit event triggers a protection seller’s obligation to pay the protection buyer the “Cash Settlement Amount,” typically equal to the notional value of the trade multiplied by the difference between par and the “Final Price.”[12] The Final Price is determined according to the Valuation Method selected by the parties in the applicable trade confirmation, and is typically either an average of three or more quotations on the reference obligation (if the parties have selected the “Market” Valuation Method) or the highest quotation received on the reference obligation (if the parties have selected the “Highest” Valuation Method).[13] Parties may specify in their trade confirmations whether the requested quotations are to be on the bid side, the offer side, or at mid-market.[14]
Where Cash Settlement applies as a fallback due to the impossibility or illegality of physical settlement, the Final Price is ordinarily determined by applying the highest bid-side quotation obtained.[15] Notably, if fewer than two firm quotations are received on the entirety of the outstanding reference obligation, the Final Price may be determined by firm quotations on less than the entire outstanding reference obligation, or by indicative quotations, which “reflect [a] Dealer’s reasonable assessment of the price of” the undeliverable obligation “based on such factors as [the] Dealer may consider relevant, which may include historical prices and recovery rates.”[16]
- Auction Settlement
Where parties have elected Auction Settlement, the occurrence of a credit event triggers a protection seller’s obligation to pay the protection buyer the “Auction Settlement Amount,” which is typically the notional value of the trade multiplied by the difference between par and the “Auction Final Price.” That price is set, in turn, according to an auction conducted under settlement terms that are specific to the defaulted obligation, but that generally follow a standard process published by ISDA.[17]
A standard auction has two phases. In the first phase, Participating Bidders—the members of the Determinations Committee that declared the default, as well as any other approved institution that wishes to participate—must accept physical settlement requests from their customers.[18] Each Participating Bidder then submits both (a) a bid and offer on the defaulted reference obligation, and (b) a physical settlement request made up of requests received from its customers, together with the bidder’s own physical settlement requests (if any).[19] Crossing and meeting bids and offers are then matched, and the best half of the remaining bid-offer pairs are averaged to calculate an Initial Market Midpoint.[20] All physical settlement requests are then paired as well, with each paired set of physical settlement requests resulting in a trade at the Auction Final Price.[21]
In the second phase of the auction, the net open interest to buy or sell is calculated based on the size and direction of any physical settlement requests that were not paired, and that net open interest is published together with the Initial Market Midpoint.[22] Participating Bidders (and their customers) may then submit limit orders to fill the net pen interest, and those orders are matched against the outstanding physical settlement requests from highest bid down or lowest offer up, as the case may be.[23] Where there is a net open interest to sell Deliverable Obligations, Participating Bidders submit limit orders to buy. Where there is a net open interest to buy Deliverable Obligations, Participating Bidders submit limit orders to sell. If there are sufficient limit orders to fill all outstanding physical settlement requests, the Auction Final Price is the lowest matched bid to buy or highest matched offer to sell, as the case may be.[24] If there are not enough limit orders to fill all outstanding physical settlement requests, and the open interest is to purchase Deliverable Obligations, the Auction Final Price is the greater of 100% and the highest offer received, although settlement of Auction Covered Transactions (those that settle based on the Auction Final Price) is capped at 100%; if the open interest is to sell Deliverable Obligations, the Auction Final Price is zero.[25]
II. Issues Concerning Settlement of CDS on Russian 2022 Bonds
The prohibition on secondary market trading of Russian debt threatens to derail the settlement of CDS on the defaulted Russian bonds. As described above, the Auction Settlement process both requires and results in the trading of bonds as a means of clearing out open interest and thereby setting an auction clearing price for the reference obligation. If Participating Bidders are prohibited from transacting in Russian bonds, the Auction Settlement Mechanism will not work.
The 2014 ISDA Credit Derivatives Definitions permit the Determinations Committee to decline to hold an auction, in which case trades are to be settled according to the fallback method selected in the parties’ trade confirmation.[26] Notably, in its June 9, 2022 statement acknowledging the complications created by OFAC’s apparent prohibition on secondary market trading of Russian debt, the Determinations Committee specifically stated that its decision to “defer making any determinations in relation to holding an Auction or the Auction Date” did “not trigger a No Auction Announcement Date” requiring the use of a fallback method.[27] The Determinations Committee reiterated that position in its July 1 statement.[28]
If an auction is to proceed, the Determinations Committee will have to decide which Russian bonds constitute Deliverable Obligations for purposes of settlement.[29] For example, certain Russian bond issuances are initially payable in U.S. dollars, but are convertible to payment in Rubles at the option of the Russian Federation. The Determinations Committee has already determined that six bond issuances with this Ruble fallback provision fail to meet the Not Domestic Currency and Specified Currency requirements of Deliverable Obligations for the defaulted bonds.[30] The Determinations Committee may be called on to decide whether restrictions on the trading of other outstanding Russian bonds means that those bonds are not “Transferable,” which bonds typically must be in order to qualify as Deliverable Obligations, or whether those restrictions trigger the Cash Settlement fallback discussed above based on impossibility or illegality.
Parties who have elected Physical Settlement, either as a primary method of settlement or as a fallback, may likewise be unable to settle their trades in light of the prohibition on secondary market trading of Russian debt. If Russian bonds cannot be delivered or accepted due to impossibility or illegality, counterparties may be required to revert to the modified version of Cash Settlement set forth in Section 9.1 of the 2014 ISDA Credit Derivatives Definitions.
Whether parties have selected Auction Settlement, Physical Settlement, or Cash Settlement, it is therefore possible that all CDS referencing the defaulted Russian bonds will ultimately be required to be settled using some version of Cash Settlement. Notably, while the 2014 ISDA Credit Derivatives Definitions permit the use of indicative quotations where Cash Settlement is required as a fallback in the event that Physical Settlement is impossible or illegal, the Definitions do not appear to contemplate the use of indicative quotes where counterparties have chosen Cash Settlement as a primary settlement method or as a fallback to Auction Settlement, potentially creating uncertainty regarding the appropriate method of determining a valuation where firm quotations cannot be obtained.[31] Moreover, even where the use of indicative quotes is expressly permitted, counterparties may have reason to question the “reasonable[ness]” of a Dealer’s “assessment of the price” of the defaulted bonds where active trading is prohibited.
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This note summarizes many of the key terms governing the settlement of credit default swaps under both the 1992 and 2002 ISDA Master Agreements, but as the foregoing should make clear, any party’s precise legal rights and obligations will depend on the circumstances and the specifics of their ISDA documents. If you have any questions about the issues raised in this memorandum, please do not hesitate to reach out to us.
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If you have any questions about the issues addressed in this memorandum, or if you would like a copy of any of the materials mentioned in it, please do not hesitate to reach out to:
David Mader
Email: davidmader@quinnemanuel.com
Phone: 1 212-849-7148
Leo Kitchen
Email: leokitchen@quinnemanuel.com
Phone: 44 20 7653-2088
Blair Adams
Email: blairadams@quinnemanuel.com
Phone: 1 212-849-7615
To view more memoranda, please visit www.quinnemanuel.com/the-firm/publications/
To update information or unsubscribe, please email updates@quinnemanuel.com
[END NOTES]
[1] EMEA Determinations Committee Decision, Issue No. 2022052501, June 1, 2022, available at https://www.cdsdeterminationscommittees.org/documents/2022/06/dc-decision-01-06-22-russian-federation-interest.pdf/.
[2] U.S. Dep’t of the Treasury, Frequently Asked Questions, No. 1005, June 6, 2022, available at https://home.treasury.gov/policy-issues/financial-sanctions/faqs/1005.
[3] EMEA Determinations Committee Meeting Statement, Issue No. 2022052501, June 9, 2022, available at https://www.cdsdeterminationscommittees.org/cds/the-russian-federation-3/.
[4] EMEA Determinations Committee Meeting Statement, Issue No. 2022052501, July 1, 2022, available at https://www.cdsdeterminationscommittees.org/cds/the-russian-federation-3/.
[5] Upon publication of the 2014 Credit Derivatives Definitions, ISDA permitted counterparties to outstanding CDS trades to apply the new definitions retroactively through adherence to a 2014 Credit Derivatives Definitions Protocol. A list of adhering counterparties is available at https://www.isda.org/protocol/isda-2014-credit-derivatives-definitions-protocol/adhering-parties.
[6] 2014 ISDA Credit Derivatives Definitions, §§ 8.1, 8.2.
[7] Id. §§ 10.1, 1.25.
[8] Id. §§ 3.2 (definition of “Deliverable Obligation”), 3.14 (“Method for Determining Deliverable Obligations”); see also Credit Derivatives Physical Settlement Matrix, dated May 2, 2022, available at https://www.isda.org/a/GLVgE/Credit-Derivatives-Physical-Settlement-Matrix-20220502.xlsx.
[9] 2014 ISDA Credit Derivatives Definitions, §§ 10.1, 1.25.
[10] Id. §§ 8.1, 8.18, 12.17, 5.6.
[11] Id. § 9.1.
[12] Id. §§ 7.1, 7.3.
[13] Id. §§ 7.5, 7.6, 7.7.
[14] Id. § 7.9.
[15] Id. §§ 9.6(e), (f).
[16] Id. §§ 9.6(e), (j), (k), (l), (m).
[17] ISDA, Form of Credit Derivatives Auction Settlement Terms, available at https://www.isda.org/a/ kS6EE/Auction-Settlement-Terms-CLEAN.doc.
[18] Id. §§ 1, 3.
[19] Id. § 4.
[20] Id. §5.
[21] Id. § 6.
[22] Id. §8.
[23] Id. §§ 10, 11, 12.
[24] Id. § 12(d).
[25] Id. §§ 12(e), (f). The amount by which the Auction Final Price can move against the direction of the net open interest (i.e. move up where there is a net open interest to sell, or move down where there is a net open interest to buy) is capped. Id. §§ 11, 12(d).
[26] 2014 ISDA Credit Derivatives Definitions, §§ 6.1, 6.11.
[27] EMEA Determinations Committee Meeting Statement, Issue No. 2022052501, June 9, 2022, available at https://www.cdsdeterminationscommittees.org/cds/the-russian-federation-3/.
[28] EMEA Determinations Committee Meeting Statement, Issue No. 2022052501, July 1, 2022, available at https://www.cdsdeterminationscommittees.org/cds/the-russian-federation-3/.
[29] October 3, 2020 Amendment to Section 3 (Resolutions of a Convened DC) of the 2018 ISDA Credit Derivatives Determinations Committee Rules, § 3.2(c); see also Sept. 28, 2018 Credit Derivatives Determinations Committees Rules.
[30] EMEA Determinations Committee Meeting Statement, March 11, 2022, Issue No. 2022030801, available at https://www.cdsdeterminationscommittees.org/cds/the-russian-federation/.
[31] Compare 2014 ISDA Credit Derivatives Definitions, §§ 7.6, 7.7 (defining “Market Value” and “Quotation” for purposes of Cash Settlement) with id. §§ 9.1(j), (k) (defining “Market Value” and” Quotation” for purposes of Partial Cash Settlement Due to Impossibility or Illegality).