FT Alphaville " A necessary condition for growth Credit event auctions determine what the ultimate payout is when credit default swap contracts are triggered by a "credit event" such as bankruptcy. In a previous post, FT Alphaville explained why such auctions came to exist. Here we discuss why auctions were so important in helping the market grow to astronomical heights, particularly with regards to index trading, a segment that continues to boom. Auctions do a lot with a little Bonds change hands in the credit event auctions. The goal is to figure out the fair price of the debt of the defaulted entity in order to settle the CDS. A large amount of bonds (or loans) could change hands in the auction, but you only need enough for price discovery, so the amount can be relatively small in practice. In cases where the amount of bonds is several orders of magnitude smaller than the total CDS positions outstanding, it is evident how the auction process can solve the short squeeze issue that Delphi experienced, as described in the first post in this series. The "final price" discovered for the debt in the auction is applied across all CDS trades, determining their cash settlement amounts. Cash = no bonds involved, really just cash Now, it used to be that auctions physically settled and it looked like this, with bonds and cash moving to close out the trade: Cash settlement is set at one minus the recovery amount - that is, one minus the final price of the bonds as determined in the auction. In the above diagramme, this would amount to a single transfer from protection seller to protection buyer of $6m. So again, in the auction, bonds are bought and sold. The price at which they trade hands will determine the size of the cash payouts for all CDS. All stages of the auction are publicly available. Defining success If the auction has gone well, in the general and theoretical sense, then the price discovered by the auction will be close to the price at which the same bonds were trading in the open debt market. For example, if the bonds had been trading at 40 cents, then the auction should see them also price at 40 cents. Keep in mind though that these are bonds of defaulted companies, they may not be all that liquid, hence part of the motive to outline a process like an auction for price discovery. Logically, an investor that holds CDS is hoping that the debt traded in the auction will also have been representative of the debt that the same investor used the CDS to hedge against (or, if the investor is a speculator, to bet against). In other words, headlines like this from Debtwire in 2009 are scary: "BTA Bank CDS deliverables list leaves some market participants fretting over recoveries and KYC tests." Index trading on the rise Regardless of their annoying tendency to sometimes deviate from their expected results, auctions were vital in making the explosive growth in CDS possible, particularly when it comes to credit indices. A graph on that point using statistics from the Bank of International Settlements shows this growth: Note that the subsequent decline after late 2007 owes as much to the portfolio compression process - the tearing up of redundant contracts - as to a general post-crisis decline in the market. The blue dashed line shows the percentage of credit derivatives (of the total) that reference more than one company or sovereign. These can be basket trades (a tailor-made collection of credits), structured credit products (like synthetic CDOs and tranches thereof), or index trades (standardised baskets of credits). They were on the rise before and they are on the rise again. Here is more recent data that looks at pure weekly activity, rather than total positions outstanding (using DTCC, Section 4 data): This further supports the notion that indices are a big part of the market, especially when looking at sheer notional sizes. Enabling index trading In the example we used in the previous post, it was evident that auctions addressed the problem that can arise when more CDS contracts exist than actual bonds outstanding, thereby avoiding a short squeeze on the bonds. For index trading to truly take off, settlement amounts in the case of default needed to be the same for single-name and index trades, where the single-name was also referenced by the index. Though of course single-name trading got a huge boost too, as the auction process eliminated the possibility of settlements for different amounts, varying by counterparty, on identical trades. In this way, auctions were a necessary, though not sufficient, condition for credit derivative activity to become what it is today. Necessary but not sufficient because the contracts also needed to standardise in other ways, the documentation needed improvements, and so on. If you want to look more closely at the importance of uniform settlements across counterparties and instruments, we've provided a simplified scenario below. Warning: lots of numbers lurking in there, and non-uber-nerds can feel free to skip... FT Alphaville Detailed Example Box A positive number for the notional amount signifies protection bought, and negative is protection sold. The table shows you a dealer with five trades: four on a single-name (three buys, one sell) and a big protection sold trade on the index. That is, the first trade means the dealer has a $5m bought position, the second $4m, and so on. Assume further that the index references 125 names, one of which is the single-name in the other four trades. The five trades in total could be with five different counterparties. Now, it could be that under the old physical settlement regime, the bonds that exchange hands to close out the trades could all be worth slightly different amounts. From the above, the dealer was clearly aiming for a perfect notional hedge (delta hedging is more likely, but again, we're simplifying). The dealer's single-name position is that of a $7m buyer (5+4+2-4), and the portion of the index notional sold that relates to the same single-name is, correspondingly, also $7m (875 notional divided by 125 names in the index). The table then also lists some theoretical recoveries, or the amount that the defaulted bonds might be trading/valued at. If the recoveries across the contracts turn out to be even a bit different, as they are in the above table, the potential loss (the failure of the hedge) can be sizeable. In this case, the loss is $400,000 ($4.4m that had to be paid on the index trade minus the $4m net recovery received in total on the single-name trades. As a percentage of the original gross position of $14m ($7m bought plus $7m sold), that's a loss of 2.8 per cent. That may not seem like much, but only because our example was small. Consider that a bank engaged in the same series of trades, but with notional exposure of, say, $500m instead of $7m, would stand to lose $14m on a trade that was supposed to be entirely hedged. Why do recoveries differ? For a start, debts have a lot of different features, including but not limited to maturity, coupons, currency, embedded derivatives, and rankings. Credit 101. The industry that writes derivatives on debt has sought to fit all the variation into a neat standardised box. Most derivatives, in general, do this to a greater or lesser degree, but with credit, the emphasis should be on "greater." Without the standardisation by way of contracts, conventions, and auctions, they just don't work that well. And without the standardisation, this would still be a small, bespoke market. Mind you, it would probably also be one that better resembled the underlying debt. Physical settlement was more respectful of what a hedge was, and more closely resembled what we think of as insurance. That is, "here's the thing (debt) that is now busted. There's some recovery in it. Take the debt, and give us full compensation for the loss experienced. Having a single settlement price for triggered CDS contracts has made this market what it is today - something less loyal to that which it was meant to hedge. It's moved beyond that - so far beyond as to be effectively redefined. In our next installment, we'll trade some bonds and discuss auction mechanics. Related links: Debt and CDS: It's complicated - FT Alphaville CDS fight of the day, Seat edition - Felix Salmon, Reuters The conflicted Isda committee - FT Alphaville Critics of credit default swaps have got it wrong - Conrad Voldstad, chief executive of Isda, writing in the FT This entry was posted by Lisa Pollack on Monday, January 9th, 2012 at 20:18 and is filed under Capital markets. Tagged with CDS, credit derivatives, credit event, credit event auction, credit indices.