What constitutes a 'credit event' under ISDA definitions, and how does the determination process work for CDS contracts?

Question

AcadiFi · Accepted Answer

Under ISDA (International Swaps and Derivatives Association) definitions, a **credit event** is a predefined occurrence that triggers settlement of a credit default swap. The 2014 ISDA Credit Derivatives Definitions (as amended) recognize six categories.

**Six ISDA Credit Events**

| Event | Description | Common For |
|---|---|---|
| **Bankruptcy** | Legal insolvency filing (Chapter 11, administration) | Corporates |
| **Failure to Pay** | Missing a scheduled payment beyond any grace period | Corporates, Sovereigns |
| **Restructuring** | Changes to debt terms that disadvantage creditors | European corporates |
| **Obligation Acceleration** | Debt becomes due before maturity due to covenant breach | Less common |
| **Obligation Default** | Technical default that has not yet accelerated | Rare |
| **Repudiation/Moratorium** | Government refuses to honor obligations | Sovereigns |

**The Determination Process**

CDS contracts do not trigger automatically. The process works through the **ISDA Credit Determinations Committee (DC)**:

```mermaid
flowchart TD
    A["Potential Credit Event Occurs"] --> B["Market Participant Submits Question to ISDA DC"]
    B --> C["DC Deliberates — 15 voting members"]
    C --> D{"Supermajority (12/15) agrees?"}
    D -->|Yes| E["Credit Event Declared"]
    D -->|No| F["External Review Panel"]
    E --> G["Auction Held to Determine Recovery Rate"]
    G --> H["CDS Contracts Settle"]
    F --> I["Panel Rules: Event or No Event"]
```

**Restructuring Controversy**

Restructuring is the most debated credit event because it exists on a spectrum:

- **Full Restructuring (CR)** — any material change to terms (old standard)
- **Modified Restructuring (MR)** — restructuring triggers CDS but limits deliverable obligations to maturities under 30 months
- **Modified-Modified Restructuring (MMR)** — European standard, extends deliverable maturity limit to 60 months
- **No Restructuring (XR)** — North American standard for investment-grade names since 2009

**Practical Example**

In 2024, Terraforge Industries missed a $45 million bond coupon. After the 30-day grace period expired, a CDS market participant submitted the failure-to-pay question to the ISDA DC. The committee voted 14-1 to declare a credit event. An auction was held, and the final recovery price was set at 32 cents on the dollar. Protection buyers received (100 - 32) = **68 cents per dollar of notional** from protection sellers.

**Key Exam Points:**
- Bankruptcy is the "cleanest" trigger — no ambiguity
- North American CDS trade with no restructuring (XR)
- Sovereign CDS include repudiation/moratorium
- The ISDA auction process ensures standardized settlement across thousands of contracts

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What constitutes a 'credit event' under ISDA definitions, and how does the determination process work for CDS contracts?

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