There are events that do not capture headlines but can turn into a major market catalyst. Call it the twig snapping in the savannah. One event and the herd starts to move which may begin the stampede. Recent events in the credit default swap market could be one of these catalyst events. The herd may not react right away and this could turn out to be nothing, but we believe this is the type of catalyst that can change market perceptions.

First, a little background on the current CDS market is necessary. One of the major problems in the Great Financial Crisis was the credit default swap market which grew to a huge size but was lightly regulated. When major players were facing loses, the market moved to liquidity failure. One to the key causes for the market failure was the issue of what represented a credit default. The swap contracts were not perfectly clear on how to handle all contingencies. There was a degree of market uncertainty on what constituted a payout event.

Moving forward in the post-crisis period, there was a change in rules with ISDA having a determination committee to decide default events. The uncertainty was supposes to be resolved and thus allow for a better functioning market. This should lead to more liquid trading and allow for better protection for those using CDS markets as a mechanism for hedging. All players could further invest in credit products and debt instruments because the credit derivatives markets offered a means of protection and liquidity.

Now we come to the Noble Group events which have been kicking around this summer. There has been a restructuring of some debt contracts given the firm’s ongoing financial difficulties. Some players who own CDS on Noble Group say this is a default event which should trigger payment on the swaps. Others, on the opposite side of the trade, say this is not the case. ISDA through its determination committee is supposed to resolve this issue by being the body to decide this event. The committee has stated it cannot make the determination. There is a difference between a hard credit event like a default and restructuring which makes this tricky. Some CDS contracts make this distinction others do not. Hence, we return to pre-financial crisis bilateral behavior which is distributive for the integrity of the credit markets.

If the structural process does not work, get out of your contracts, sell credit, and head for the sidelines. This is a serious breach of the integrity of the market. Dealers who may be hedging inventory with swaps should unload risks. Hedge funds who are speculators in this market should exit if the criteria of a credit event is in question. This sell-off does not have to be done immediately and there may be some resolution with the next ISDA determination meeting on Wednesday which could nullify some of this discussion. However, if the integrity of the process is questions, we know that liquidity will disappear when the markets are further challenged. An investor should not want to over-exposure in credit at that time.