Euromoney, December 2009

When you buy a credit default swap, you know what you’re getting: a derivative where you get paid if the underlying instrument defaults. Fine. But one of the curious spillovers of the global financial crisis is a controversy about who decides whether something has defaulted or not, and how they decide it.

This came to the fore in Japan in October over the fate of the Japanese consumer finance house Aiful. In September, Aiful said it would suspend loan payments and apply for alternative dispute resolution, and that it was in negotiations with creditors. This was enough for Standard & Poor’s to declare a selective default on Aiful, which naturally caught the attention of the many hedge funds and other holders who had credit default swaps with Aiful debt underpinning them.

On October 2, one of Aiful’s creditors, Aozora Bank, wrote to the determinations committee of the International Swaps and Derivatives Association. The determinations committee was set up to make binding decisions on issues such as whether or not a credit event (such as a default) has happened, and what obligations are deliverable. Aozora wanted the committee to decide whether a bankruptcy credit event had happened at Aiful, and also whether a restructuring credit event had taken place. (These events have different consequences for various different derivatives.)

ISDA’s Japan determinations committee came together on October 5, and dismissed both questions: the first because there wasn’t enough publicly available information to consider it, and the second because not enough committee voting members had agreed to deliberate the question. “This,” says one hedge fund manager, “is like saying that the committee decided not to answer it on the grounds that the committee decided not to answer it.”

Not deterred, another request came in to ISDA on October 15, again believed to be from Aozora, although this has not been confirmed.  This time, the request asked whether another type of default, called a failure to pay credit event, had occurred; the request was backed it up with supporting evidence suggesting that it had.

At this point, things started to get a little odd. Members following the ISDA web site saw two pages of Japanese text appear on the site, only for them to disappear shortly afterwards. The text, seen by Euromoney, gives details of repayments by Aiful, and appears to support the contention that it had failed to pay due debts.

So why was it taken down? Euromoney understands that ISDA put the documents on its site in good faith, only to receive a complaint from Aiful saying that the information was confidential and should not be published. ISDA duly took it down. But the real twist in the tale was that because that information had been declared confidential, ISDA’s determination committee refused to accept it. Consequently it rejected the question about whether Aiful was in default, despite the fact that it had already inadvertently published information appearing to suggest clearly that it was.

Those on the other end of the derivatives are furious – and there’s a lot of money at stake. According to data from the Depository Trust & Clearing Corp, contracts protecting $1.36 billion of Aiful’s debt were outstanding as of November 6, with as much as $238 million more protected through credit swaps based on indices that feature Aiful as a member, according to Bloomberg. Hedge funds and others who will get paid in the event of a formal default are furious. They want to know why it is that ISDA’s committee, having not only had evidence of a failure to pay waved in front of them but having published it online themselves, can then refuse to consider that information or even deliberate a question relating to it. They also wonder how ISDA can argue there is insufficient public information when Aiful itself put out a press release on September 18 – in English – saying it wanted to change the principal repayment schedules to its creditors.

At stake, hedge funds argue, is the credibility of the whole CDS industry, particularly in Japan. And that’s big business: Bank of Japan data shows that at the end of June, the notional outstanding of credit default swaps was US$887.3 billion.

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