When you buy a credit default swap, you know what you’re getting: a derivative that pays out if the underlying instrument defaults. But one of the curious spillovers of the global financial crisis is a controversy about who decides whether or not something has defaulted, and how that is decided.
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. It also said 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 or not a bankruptcy credit event had happened at Aiful, and whether or not a restructuring credit event had taken place, two events that have different consequences for different derivatives.
