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Market Paves Way For New CDS Settlement Process

International Swaps and Derivatives Association committee has drafed a net physical settlement supplement for the ISDA Credit Derivatives Definitions, the first step in cementing a market standard process for settling credit events.

International Swaps and Derivatives Association committee has drafed a net physical settlement supplement for the ISDA Credit Derivatives Definitions, the first step in cementing a market standard process for settling credit events. The supplement which was created by a new ISDA committee has been circulated to the market for feedback. Once the market has consulted on the draft, ISDA will refine the supplement as needed to make sure that end result will work long-term. ISDA is looking to have the legal documents on the new supplement ready for a June rollout date pending on market feedback and momentum, said Karel Engelen, policy director and head of FpML at ISDA.

ISDA was hosting a conference call to discuss the net physical settlement proposal as Operations Management went to press last Thursday. The preliminary draft of the supplement provides a number of new definitions ranging from "auction administration agreement" to "net physical settlement transaction" and amendments that outline procedures. The proposed net physical settlement mechanism is outlined, including the auction procedures for credit event notices--the auction triggering and netting of auction-settled transactions, the process to determine the final price and multiple auctions for a single reference entity. Following the consultation period, ISDA will begin the process of refining the details of the proposal.

"The market is certain about one thing: we need to find a solution for the way we settle the credit events. We cannot keep on doing it with the protocols that we have, so we have to find a better way to deal with it," Engelen said at a recent OM sponsored roundtable (see supplement). "I think the challenge now is to make sure that we can transform that into a process that will work going forward because we are in a way changing the way this market is settling its trades so that's a fairly significant change." Until now, credit events were settled through protocols market participants signed up to. Those protocols only applied to index trades and settlement prices were set by an auction. The new supplement, and its clarification of the procedures, will allow the market to do cash settlement without doing a protocol each time and it will apply to both single name and index trades.

The focus on credit event settlement follows the ongoing market efforts to reduce the confirmations backlog in response to concern voiced by the Federal Reserve Bank last year. The major market players met with the Fed in February to discuss their progress on tackling confirmations--reducing the backlog by 54% rather than the projected 30%. "The next step is for the industry to submit additional goals," said Linda Ricci, spokeswoman for the Fed. Market officials anticipate the next goals will be defined and submitted to the Fed within the coming weeks.

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