The CDS Auction Process – Not So Scary

Posted by on Mar 19, 2012 in Uncategorized | No Comments

First, I believe that the regulators should be forcing CDS to be cleared if not exchange traded.  But in any case, there are once again concerns about the “auction” process and what it means.

Yes, it is slightly weird to settle a contract based on an “auction” but it is actually both a useful step and was necessary for the growth of the market.

In the old days, each counterparty had to send Credit Event Notices describing the Credit Event with their sources of Publicly Available Information, to anyone who had sold protection to them (Seller of protection could also trigger).  The receiver of the Credit Event Notice could dispute the notice.  It was awkward and in the end came down to a matter of a day here or there, which did cause some settlement issues, as settlement was based on the time a valid Credit Event Notice has been delivered.   It was messy, and there were potential issues with the chain of paperwork.  That led to the creation of the Credit Event Determination Committee and the auction process.

The Credit Event Determination Committee allowed one group to declare a Credit Event for all contracts and establish one time for all deals to be settled.  People can still dispute the Committee’s determination, but as far as I know, no one has, and I haven’t seen a decision that didn’t follow the documents.

Another legacy of the old days, was Physical Settlement.  The Buyer of protection would deliver Deliverable Obligations to the Seller of protection.  That Seller would get bonds and then have to sell them in the open market if they wanted out of the position entirely.  There were always concerns about short squeezes – or lack of Deliverable Obligations.  That is one reason Buyers and Sellers might wait to trigger a Credit Event, in order to take advantage of potential squeezes.  The street, purely out of self-interest in an effort to let the product grow in size, wanted to get rid of the Physical Settlement constraint.  So long as there was a Physical Settlement, there was risk of short squeeze.  SNAC finally ensured that every trade is cash settled, meaning there is no risk of a squeeze and the amount outstanding on CDS is not at all constrained by amount of bonds a given issuer has.

In theory, cash settlement is great.  It works for most futures contracts and single stock options, etc., but there is a “market” for the underlying asset.  The problem with credit, is there is no real market.  A bunch of dealers send around messages with indicative prices, trying to induce a trade, or better yet, an order from a client.  Trying to rely on prices over the course of a day in a “market” where no price is live, and it could be easily pushed in one direction or another wouldn’t work. No one would take comfort in that.  A true “market” clearing price had to be determined for the cheapest to deliver bond.

So that is why there is an auction.  The first step is to have market makers make live prices on the bond.  Any trades that can be crossed, are crossed and the dealers who were off on the price, lose money.  That sets an initial “mid market”.  Then anyone can participate in the actual auction.  It allows people who need to buy or sell the bonds to cover that risk.  By bringing the buyers and sellers together at one point in time, around the mid-market of executable prices, a fair price for the recovery is determined.

This auction came up with 21.5% of par as the recovery value.  Since the 2042 Greek bonds were quoted as 22.5 – 23.5 as of Friday, that seems a reasonable recovery/settlement level.  I wouldn’t be surprised to see bonds move back up a bit from here, as the auction often cleans up weak long positions, and it is easier to lean on bond prices until after the auction.

The process worked well, basis holders have done well, since they own the full “strip” of new bonds and some EFSF bonds, that have a total value of more than this recovery value.

I’m assuming the markets are bouncing a bit on the successful completion of the auction, although it shouldn’t be a surprise to anyone.