At Germany's insistence, any new European rescue plan will likely involve stiff losses for private holders of Greek debt, perhaps as much as 60 percent. Greece is insisting that any such "haircut" for bondholders be voluntary, but many see the losses as little more than a dressed-up default. And that in turn is turning the spotlight on an obscure committee of a little-known industry association whose job it is to determine whether countries have actually defaulted on their debt.
There's plenty riding on whether losses incurred by bondholders can be described as voluntary and whether they constitute a default or restructuring. A formal finding that a Greece has defaulted on or restructured its debt--a "credit event," in the industry's parlance--would trigger credit default swaps, the risk-management instruments that played such a central role in the 2008 financial crisis. Senior European policymakers are reportedly spooked by the possibility of a replay. Via the Financial Times:
“You don’t need to be paranoid to be terrified,” said the person familiar with the talks. “They need to find a fine line where they don’t create a credit event but where the effect is significant enough so the [Greek] debt is sustainable over the long term.”
A senior German official said: “We are trying to avoid a credit event.”
Not everyone agrees that a Greek credit event would have disastrous consequences in this case. While the precise size of the CDS market for Greek debt isn't known, some observers argue that it's a very small percentage of Greece's overall debt load and that major banks are well prepared to pay on outstanding swaps. Triggering CDS provisions could even have benefits by exposing existing swaps and mitigating uncertainty.
But assuming that there is a substantial danger of contagion from CDS activations, the question of whether the likely write-down of Greek debt constitutes a credit event looms large. So who exactly determines whether a credit event has occurred? Enter the International Swaps and Derivatives Association (ISDA).
The ISDA is comprised of banks and firms that buy and sell derivatives. Founded in 1985, it claims more than 800 members from 57 different countries. Like most industry associations, it does all manner of lobbying. But it also plays a quasi-regulatory role. It hosts several "determinations committees" (DCs) whose job it is to determine whether and when a credit event has occurred. The ISDA describes the process this way:
The process begins when a market participant puts a question to the DC for the relevant region. Any market participant (who need not be an ISDA member) with one or more CDS transactions can raise a question. A question is raised by submitting it, along with publicly-available information evidencing the event, using an online form on the ISDA website. After a question is submitted, it must be accepted by one of the members of the appropriate DC. This step is included in order to filter out frivolous questions. Once a question is accepted, the DC will meet within a defined timeframe to consider it. The DC will weigh the publicly-available evidence and vote on whether a Credit Event has occurred within the terms of the CDS Definitions.
It should be noted that the DC simply applies the Definitions to the public facts; it is not empowered to decide whether, as a matter of policy, a Credit Event should or should not occur in particular circumstances.
As soon as a vote has occurred, the determination is posted on the ISDA website. Each DC member’s vote is made public.
The ISDA website reports that the members of the determinations committee for Europe include most major banks that issue credit default swaps, including Bank of America/Merrill Lynch, Barclays, BNP Paribas, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase Bank, N.A., Morgan Stanley, Société Générale, and UBS. The committee also includes a smaller number of players active in buying CDS instruments.
While the ISDA insists that determinations are made solely on the merits, committee members face an array of competing pressures. Plenty of the banks that committee members represent have chunks of Greek and other European sovereign debt on their balance books. But they also have complex financial, advisory, and regulatory relations with sovereign governments themselves, including Greece. One hedge fund manager told me that several banks represented on the committee are simultaneously advising Greece:
BNP, Deutsche Bank, and HSBC are all apparently serving an advisory role to the Greek Government. BNP was recently visiting investors to try to 'persuade' them to take a haircut. At the same time, everybody knows BNP has a seat on the determinations committee, and one wonders how independent that BNP representative is.
Even leaving aside direct linkages to Greece, committee members have to consider the wishes of Europe's most powerful governments, which appear determined to avoid a credit event. If Europe does manage to assemble a new package for Greece that includes a haircut for bondholders, the ISDA's determinations committee will face some tough decisions--and more scrutiny than it is accustomed to receiving.