Randy Priem reviews the current discussions about fortifying the independence of determination committees deciding whether a credit event took place for single-name credit default swaps. He offers several possible strategies.
Single-name credit default swaps (CDS) are financial derivative contracts between two counterparties to “swap” or transfer the risk that a third-party borrowing reference entity (i.e. a corporation, bank, or sovereign entity) defaults on an obligation, such as a bond payment. The buyer of the CDS needs to make a series of payments to the protection seller until the maturity date of the financial instrument, while the seller of the CDS is contractually held to pay the buyer a compensation in the event of, for example, a debt default of the reference entity. Determination Committees (DCs), which comprise nine voting dealer members (members who are active participants in derivative markets), three non-dealer members (other institutions that are not primarily engaged in dealing derivatives but can be significant end-users ) and two non-voting central counterparties (such as ICE Clear Credit LLC and LCH.Clearnet SA), make major decisions on whether credit events took place based on the contractual terms of the CDSs. This is not only for CDSs referring to corporations but also sovereign nations. DCs oversee 90% of the nearly four trillion-dollar CDS market in the United States.
Criticisms of the functioning of DCs
The DCs currently have a number of measures to avoid and manage conflicts of interest. Examples include the fact that all votes are public, the secretary (i.e. DC Administration Services Inc; a Delaware-incorporated subsidiary of the International Swaps and Derivatives Association (ISDA) that is responsible for, among other duties, providing administrative support, record-keeping, and ensuring compliance with procedures and regulations) cannot vote itself, and that DCs make decisions with a supermajority voting (i.e. 80%) or otherwise the question proceeds to an external review panel of legal experts for its final decision.
Yet, DCs still have been subject to criticism over the last few years. DCs are composed of major market participants who help write the rules of the game and are responsible for interpreting and enforcing them. According to some scholars, like Nathaniel Dutt and Dan Awrey, DCs promote the interest of only the few major participants in the CDS market. Criticisms about transparency and conflicts of interests have also appeared in the media. One Bloomberg article depicted DCs as a “secret circle.” For instance, in one controversial case in which the Italian company Seat Pagine Gialle defaulted on a payment, some market participants claimed that several DC members initially voted that the event did trigger the CDS agreement not on legal merit but based on their trading positions in these derivatives or in the underlying bond.
Irrespective of whether the criticism that current conflicts of interest measures are inadequate, the ISDA reviewed the structure and governance of DCs in 2023 with a law firm as an independent assessor. On May 13, ISDA published that report with several recommendations. These included: a) DCs should appoint up to three independent members with one acting as the chairperson, b) rules should enhance the minimum requirements on DC members’ compliance procedures, and c) DCs should be permitted by a simple majority to refer DC questions to an independent panel for a decision. The report further proposed that a separate governance body be established with the responsibility for overseeing the operation of the DCs and making changes to the DC rules from time to time. The governance body should be able to appoint independent auditors to audit DC members’ compliance procedures under the DC rules.
Suggestions to further reduce conflicts of interest
The report’s proposals make a good first effort at reforming DCs and are now under public consultation. I offer here a few more recommendations to improve DCs’ independent functioning.
First, additional conflicts of interest requirements could be installed to alleviate the risk that parties coerce or manipulate DC members to provide favorable rulings. The European Benchmark Regulation, which works to prevent panel banks from manipulating benchmarks rates with contributions, can be used as a model. Although DC members typically have conflicts of interest measures in place, the standards currently required under the DC rules might have limitations. Currently, DC decisionmakers must be sufficiently independent of the relevant business line but are permitted to know the economic position of the DC participant. Any individual who is involved in a DC member’s decision about how to vote should not be aware of either party’s net position in CDSs concerning the relevant reference entity or other information that would lead a reasonable person to believe that there is a real possibility of bias. It could also be the task of the DC secretary or an independent governance body (similar to the oversight committee foreseen in the European benchmark regulation) to check whether all conflicts of interest procedures are observed in practice and has a process for enforcing a breach. This could be in the form of the DC participants providing an internal audit report on their governance regularly.
An alternative is that there could be a policy in which DC participants who have a conflict of interest abstain from voting in case they have business relationships with the reference entity or when the outcome of the vote would have financial implications for them. In that way, the credit event decision is separate from any part of a DC member’s business that may create an actual or potential conflict of interest. A counterargument would be, however, that larger investment banks or major asset managers active in the CDS market would never be able to participate, making this an intrusive solution. One could therefore claim that the mere fact of a conflict of interest should not lead to an automatic disqualification of the voting member but that it should depend on the intensity of the relationship between the DC member and the reference entity. In any case, if we consider the DCs as arbitral bodies, the International Bar Association (IBA) guidelines on conflicts of interest in international arbitration prescribe that an arbitrator—in this case, a DC member— should decline an appointment or refuse to act as an arbitrator if there is doubt as to its ability to be impartial or independent.
In addition, DC members should disclose the financial interest of their firm in the reference entity, whether they had an actual or potential conflict of interest, and their final votes so that the market can also observe whether they vote against their positions or not. Considering DCs as arbitral bodies, one has to take into consideration that it is a universally accepted principle of international arbitration that the arbitrator has to be, and remain, impartial and independent and disclose all relevant circumstances. For instance, according to the IBA guidelines, the fact that the arbitrator holds shares, either directly or indirectly, in one of the parties or an affiliate of one of the parties that is publicly listed, is a situation that needs to be disclosed. If DC members do vote against their position, it is not a strict proof of them having a conflict of interest but at least it would allow external parties to explore further to determine whether they objectively have justifiable doubts as to the DC member’s impartiality or independence.
Another suggestion could be that not only the most active dealers in the market can be part of the DC but that the opportunity is open to also less active institutions, under the condition that they can illustrate that they have the necessary time, expertise, and experience. The ISDA report proposed the appointment of up to three independent members with one acting as DC chairperson. These should be legally qualified and have sufficient experience in derivatives or financial markets. This proposal has advantages in terms of independence but one could argue that also smaller dealers should be allowed to join the DCs as they could have expertise but less exposure in absolute terms to reference entities. A counterargument is that smaller dealers are more susceptible to conflicts of interest as they may be less able to maintain separation of decisionmakers or may be exposed to relatively more concentrated positions. It is thus still important that these smaller dealers being active adhere to the same strict conflict of interest requirements as the bigger ones.
Alternatively, the regional committees could require decisionmakers coming from another region. ISDA suggests that a non-dealer should be able to put itself forward for membership of individual DCs rather than having to join all the DCs. That is, an entity based in New York with no international operations may prefer to join the Americas DC only. This might be attractive for smaller entities as it would require fewer resources. One can also argue that conflicts of interest are lower for DC members having to decide on credit events for reference entities in other jurisdictions in which they would have marginal or no activities.
Another alternative is that more (than three) independent voting members become part of the DC, such as regulatory authorities. Instead of having a private regulator—and thus complete self-regulation—a public-private collaboration where public regulators enforce the principles and guidelines that have been implemented by the intervention of private actors is a possibility. In addition, coerced self-regulation could be an option where private actors self-regulate but with the oversight of a public authority. This can be legitimate when the government guarantees the achievement of public goals by creating and implementing monitoring mechanisms and procedures. Having a regulator involved might be stricter than having a legislative solution imposing a minimum standard, as there is direct supervision. On the question of which regulatory authorities could become part of the DCs, one can make arguments that, given the large importance of CDSs for financial stability purposes, these should be financial stability authorities with a global mandate, such as the Federal Stability Board. Alternatively, local financial stability authorities could be present in the regional DCs, such as the European Systemic Risk Board for the European DC.
Furthermore, the role of the secretary is rather extensive and a secretary not representing the industry or being related to ISDA could lead to a higher level of independence. Note that there was already an attempt to transfer the secretariat to the Intercontinental Exchange (ICE) Benchmark Administration. ICE was selected for the role of secretary following a public tender in May 2016 but a transfer required changes to the DC rules, which must be passed by a super-majority vote comprising 12 out of the 15 committee members. A final agreement could not be reached and ICE dropped out of the DC role.
Finally, one can argue that a central counterparty clearing house (CCP) should be able to obtain voting powers and not simply have an observer role. Nowadays, the DC can only use publicly available information in deciding whether to accept a credit event request but CCPs could have more information about a clearing member’s financial condition, as well as in a faster manner, compared to the DCs. The primary role of CCPs is to act as intermediaries in clearing trades and managing counterparty risk, their risk management insights could be valuable in assessing credit events and their potential impact on the market. Because they typically do not take a directional exposure due to the novation process, they could be considered more independent than buyers and sellers. Their involvement in the voting could thus contribute to a more robust and resilient decision-making process.
Conclusion
The single-name CDS market is subject to a considerable degree of uncertainty, such as whether an event can legally be considered a credit event triggering a payout. These are decisions made by the determinations committees. DCs currently suffer from criticism pointing to a lack of independence, jeopardizing trust in their oversight of the four-trillion-dollar single-name CDS market. The governance of DCs can be further improved by including conflicts of interest and transparency requirements for voting members in the DCs’ rules, making sure that not all voting members represent the largest buy- or sell-side market participants, giving central counterparties voting rights, and having an independent secretariat.
Author Disclosure: The author is the coordinator of the markets and post-trading unit at the Belgian Financial Services and Markets Authority (FSMA), a member of the IOSCO CDS task force and a finance professor for UBI Business School and Antwerp Management School. Views expressed in this article are those of the author and do not necessarily reflect the views of the FSMA or any other institution with which the author is affiliated. The author has no other conflicts of interest to disclose. Please read ProMarket’s disclosure policy here.
