imposing a uniform procedure for settling CDS contracts when a company goes into default

TO BE NOTED: From Alea:

"Hazards of the Flat Hazard Rate

I missed that one early, but it’s a good read.
This paper is not meant as a criticism of the proposed standardization of the conversion method but as a warning on the confusion this may generate when the method is not used carefully.
Charting a Course Through the CDS Big Bang, from Fitch:

The proposed flat hazard rate (FHR) conversion method is to be understood as a rule-of-thumb single-contract quoting mechanism rather than as a modelling device.
For example, an hypothetical investor who would put the FHR converted running spreads into her old running CDS library would strip wrong hazard rates, inconsistent with those coming directly from the quoted term structure of upfronts.
This new methodology appears mostly as a device to transit the market towards adoption of the new upfront CDS as direct trading products while maintaining a semblance of running quotes for investors who may be suffering the transition. We caution though that:

• the conversion done with proper hazard rates consistent across term would produce different results;
• the quantities involved in the conversion should not be used as modelling tools anywhere;
• for highly distressed names with a high upfront paid by the protection buyer, the conversion to running spreads fails unless, as we propose, a third recovery scenario of 0% is added to the suggested 20% and 40%.

When the upfront is very high, the conversion method fails to produce a corresponding positive running spread if ( upfront + fixed recovery ) is larger than 1. The only possibility to get a positive flat hazard rate to do the conversion is to lower the recovery rate.

You can test that for yourself here, enter an upfront > (1-R) i.e 61 for Snr with R= 40%, and there is no (positive) running spread with FHR.

Related:
The CDS Big Bang"

The CDS Big Bang

Key changes:
1) Restructuring credit event: out
2) Standardised fixed coupons 100/500
3) Standard coupon dates
4) Effective dates: t minus 60 for credit events or t minus 90 for succession events
5) Accrual dates, trade with full coupon, protection seller will pay accrued from previous coupon date
6) Hardwired auction settlement

Markit has the best explainer so far.
The CDS Big Bang: Understanding the Changes to the Global CDS Contract and North American Conventions

And:

"CDS market’s Big Bang arrives

By Nicole Bullock and Michael Mackenzie in New York and Gillian Tett in London.

Published: April 7 2009 19:05 | Last updated: April 7 2009 19:05

The credit derivatives industry faces a Big Bang on Wednesday and on Tuesday participants were rushing to sign up to a new protocol designed to counter the intense criticism that has emanated from political and regulatory quarters over the industry’s alleged role in contributing to the market crisis.

At the 11th hour, dealers and investors besieged the International Swaps and Derivatives Association ahead of implementing a self-styled “Big Bang” protocol.

This protocol, which has been adopted by some 1,500 players – mostly in recent days, if not hours – aims to introduce more consistency into the credit default swaps market by imposing a uniform procedure for settling CDS contracts when a company goes into default (see box). It also tries to impose more standardisation by introducing set coupons for contracts – a measure that will initially be limited to the US, but could later spread into Europe.

“The benefit of the Big Bang is to facilitate the migration of trades to a central clearing counterparty (CCP),” said Brian Yelvington, senior macro strategist at CreditSights. “Every change made to the contracts makes them more suitable for a CCP – so broadly, the market should benefit from having that risk mutualised and having a central repository for trade data.”

Jason Quinn, a director in credit trading at Barclays Capital, said there was some trepidation in the industry about the mechanics of changing the way the CDS contracts are traded in the US. He added that the industry has automated some key components of the switch and firms like Barclays have been working with investors for months to help them prepare for the changes.

In the wake of last year’s brutal financial turmoil, the protocol will reorganise how credit derivatives contracts work around the world. And while the details of these measures are highly complex and technical, the essential aim is to put the industry on a more robust footing – and show that the scale of outstanding risk is far smaller than politicians initially thought.

Efforts are also intensifying to put CDS trades through a centralised platform in a bid to reduce counterparty risk – an endeavour which becomes much easier once standardised contracts are in place. The Intercontinental Exchange, for example, is running one clearing system in tandem with other banking groups, and has already managed to clear over $60bn worth of contracts.

Last, but not least, initiatives are intensifying to “tear up” (or cancel) outstanding CDS contracts which offset each other. This week Trioptima, for example, will announce that it has “netted” another $5,500bn contracts in the first quarter. As a result, the outstanding size of the market currently appears to be shrinking in size (see chart) - a trend industry leaders hope will, in itself, help allay political concern.

Raf Pritchard, chief executive officer at TriOptima North America said: “The big bang protocol is compelling the compression of a variety of different instruments as banks look to reduce their risk.”

Whereas dealers were somewhat reluctant in the past to reduce their outstanding derivatives exposure, the increased attention by regulators and balance sheet constraints at banks has heralded a big change in attitudes.

Optimists in the industry insist that these measures should calm the critics of the CDS world. Last year fears were rife that the CDS sphere could pose a systemic threat. In the event, however, the CDS market continued trading during the financial crisis – and contracts written on Lehman Brothers and other bankrupt groups have hitherto settled smoothly. Pessimists, however, say that it is still far from clear that the measures are dramatic or speedy enough to allay all attack.

One key reason why the industry has been so slow to adopt infrastructure changes until now is that ISDA has traditionally tended to be dominated by bankers who work on the trading side of the business.

Dealers had every incentive to keep the market opaque and bespoke, which boosted margins – and profits, while downplaying infrastructure issues. Thus, when groups such as BlueMountain Capital, a large hedge fund, have campaigned for change in the past, they have encountered resistance.

“The buyside will be a very significant part of what we do going forward in a more formalised manner,” says Robert Pickel, chief executive officer at ISDA.

The US Federal Reserve also seems determined to hand more power to investors. At a meeting of the key CDS players last week, for example, New York Fed officials insisted on including non-bankers .

As the industry becomes more commoditised, it could well slash margins for the banks. The transformation of contracts to meet the new standards, or to simply “tear up” deals, will generate additional costs, which some banks have not budgeted properly for.

If the CDS sector continues to expand, that decline in margins might be offset by a rise in volumes. The interest rate swaps business, for example, continues to generate healthy profits for some banks, even though it has become commoditised in recent years.

But judging whether the market will continue to expand remains extremely hard – not least because the politics of regulation remain wildly volatile, in the CDS sphere as everywhere else."