Big Bang and Small Bang

After the creation of Credit Derivatives from the 90s there were a number of standardisations introduced to try and help investors get comfortable with the product which, when not standardised introduced some very minor, but potentially unpleasant risks.

The Big Bang Protocol happened in April 2009 and covered a lot of different topics and then a Small Bang came into effect in October 2009 which had a lesser effect.

Big Bang: Standard Coupon Rates

Unlike Cash Bonds if you buy protection at 90bps, and then sell protection at 92bps you still have risk to the Credit Event the reason being if you look at the cashflows you are net long 2bps running. This could carry on for 1 month or 5 years depending on when or if the default happened. Investors wanted to be out of the risk totally and just take an upfront payment.

The solution was to set all CDS to have the same coupons, so when you bought protection at 90bps, you actually bought protection at 100bps and then received a payment equal to the PV of 10bps to make the economic position the same as had you bought protection at 90bps. So when you then sell protection at 92bps you sell at 100bps and pay the PV of 8bps to make it equal. Now the net resulting position has no residual cashflows and you are totally out of your risk having received the PV of 10bps and paid the PV of 8bps.

The coupons were set roughly around the level of the underlying CDS, so for any credit trading below about 250bps the coupon was set at 100bps, anything above that was set at 500bps, some very tight names traded at 25bps. The reason for this was to make sure that the upfront payments weren't too large. When a 100bp name widened significantly, the dealing community would start trading with a 250bp coupon but you can always ask for a price with 100bps coupon if that's the position you were unwinding, for example.

Big Bang: Full First Coupons

Once you have standardised the coupons, you want one single calculator to give you the price of a CDS, you don't want to say "no that's not right I need the contract to start from 29th December", therefore much like bonds all CDS began trading with a Full First Coupon so that if you bought protection on the 20th Jan and then unwound on the 22nd Jan you didn't have to worry about that 2 days accrued being removed from your P&L, both contracts would have started accruing from the 20th December. CDS pay quarterly a/360 regardless of currency so accrual dates are always 20th March, 20th June, 20th September and 20th December.

Big Bang: Standard Effective Dates

Now that the coupons rates and accrual dates are all synchronised it's also very important to make sure the Effective Dates are the same. What this means in practice is that if you buy protection on the 20th Jan and then sell protection on the 22nd Jan there is the potential for a credit event to occur in the 21st which will generate a windfall gain for the buy of protection but won't trigger the sell, so to avoid dealers having to ask when the trade was initiated and look for random credit events on specific dates all CDS were determined to have effective dates backdated 60 days for Credit Events and 90 days for Successtion Events.

Big Bang: Determinations Committee

Instead of individual legal teams at various institutions going through and trying to work out if there had been a Succession event or a Credit Event it was decided that all determinations would be made by a CDS Determinations Committee where firms could submit evidence and the Committee would publish a decision on that basis.

Big Bang: Auctions Protocol

As the Credit Derivatives markets grew the Auction Process became more cumbersome and there were instances where the amount of bonds to be delivered into outstanding CDS contracts exceeded the amount of bonds outstanding. To avoid this a standardised auction would be run and the final price determined and everyone who did not want to be part of the Auction Process would be cash settled to the final price which would be published on CreditFixings.com.

Small Bang: Mod-Mod Restructuring

The nuances of the Restructuring process in Europe meant that the Restructuring mechanism in contracts didn't completely work, so a modified version of the already modified restructuring language (Mod-R) was introduced with added maturity buckets for reference obligations and a couple of other tweaks.