New Muni CDS Protocol upcoming deadline

There’s only a week left until the updated protocol for municipal credit default swaps goes into effect (April 3, 2012). As taken from the ISDA release,

The purpose of the Protocol is to make similar changes to US Municipal CDS transactions as were made to corporate and sovereign CDS by the 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement CDS Protocol (‘Big Bang’ Protocol). The Protocol will align the US municipal CDS market with the corporate and sovereign CDS markets.

The Protocol will incorporate auction settlement terms into standard documentation for new and existing US Municipal CDS trades. These terms include the following:

First, addition of the concept of auction settlement as a settlement method that eliminates the need for physical settlement of US Municipal CDS transactions.

Second, incorporation of the resolutions of the ISDA Credit Derivatives Determinations Committee for the Americas (DC) into the terms of standard US Municipal CDS contracts.

The DC comprises dealer and buy-side representatives and makes binding determinations for issues such as whether a credit event has occurred; whether an auction will be held; and whether a particular obligation is deliverable. Information related to the DC is available at www.isda.org/credit.

The 2012 ISDA U.S. Municipal Reference Entity Supplement to the 2003 ISDA Credit Derivatives Definitions (the “2012 Muni Supplement”) brings the terms of U.S Municipal CDS (“Muni CDS”) contracts in line with the terms applicable to standard corporate and sovereign CDS contracts. The key changes to current Muni CDS terms are the use of auction settlement following a credit event and reliance on the ISDA Credit Derivatives Determinations Committee for the Americas (the “DC”) to make binding determinations for issues such as whether a Credit Event has occurred; whether an auction will be held; and whether a particular obligation is deliverable.

These provisions have applied to market standard corporate and sovereign CDS transactions since the Big Bang and Small Bang Protocols in 2009 and are contained in the 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restricting Supplement to the 2003 ISDA Credit Derivatives Definitions (the “2009 July Restructuring Supplement”). Please see here for further information on the Big Bang Protocol, and herefor further information on the Small Bang Protocol.

What remains to be seen, however, is what the ultimate effect on the municipal bond market could be. Currently the muni CDS market is a fraction of the size of the municipal bond market (if even much at all) but certain provisions set out in the new protocol such as the removal of physical-only settlement and the accommodation of cash settlement could actually further enhance the popularity of using CDS as an alternate form of municipal investment (bypassing the traditional way which was to actually buy/sell the cash bond – and thereby depriving the municipal entities of the actual cash that would need to be raised at issuance in order to do so). Municipal CDS has long been a source of contention and debate in America led by states such as California though to date the California Treasurer’s office has not commented on the latest protocols.

For a separate municipal CDS primer from Zerohedge, click here

And for a study on Municipal CDS trading volumes by Kamakura, click here

A Federal Reserve Bank of New York report on “How Might Increased Transparency Affect the CDS Market?” published late last year.


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