The recent Delphi settlement auction once again raised the issue of how to settle a credit-default swap contract once a default has occurred. As the market seeks a solution to the current settlement process that is not subject to the negative aspects of cash or physical settlement, it seems appropriate to review the benefits and drawbacks of the two methods and analyze how these affect final price determination.
Physical Settlement
The current market standard is to settle contracts physically. Once the notice of default--accompanied by two pieces of publicly available information--has been served, the buyer of protection has up to 30 days to select the individual deliverable obligation for settlement of the contract. Once the notification has occurred, the buyer has a further 30 days from that date to deliver the chosen obligation, against which the buyer receives the notional of the CDS contract.
By delivering an asset worth the recovery value, the buyer of protection has removed the need to wait until the final legal recovery value is determined in order to receive the compensation due from the seller of protection. By taking delivery of the defaulted bonds, however, the seller of protection is left with a residual exposure to the defaulted entity, creating a position which must be managed. This process has to be carried out for each trade individually, including the notification process, and can be extremely time and resource intensive. It does ensure, however, the final price is truly reflective of the recovery level.
Cash Settlement
Cash settlement works by agreeing to a value of the individual bond that would have been delivered for physical settlement, and paying the compensation net of this amount. The International Swaps and Derivatives Association 2003 documentation specifies a number of ways to cash settle. Probably the most common is a single valuation date, using a dealer poll of at least five dealers. The valuation date is agreed at the time of executing the contract, but could be up to 122 days after the credit event. The final price would be determined by the highest bid price for a specified notional of bonds, and this price is used to determine the compensation amount. It is also possible to use multiple valuation dates. This final amount is paid five days after the dealer poll. The advantages to this method are that cash settlement 1) does not leave the seller of protection with a residual exposure to the defaulted entity and 2) one dealer poll can be used to agree on the settlement values of all relevant contracts with agreement between the counterparties, thus reducing operational loads at a busy time.
Settlement Methods Affect Price Determination
In the physical settlement process, the need for the 30 day notification and delivery windows occurs when the total notional of deliverable obligations is less than the total notional of CDS of the reference entity. If all contracts had to settle physically on the same day, there would be insufficient bonds to meet demand. The windows allow settlement of different contracts on the defaulted reference entity to occur on different days, making it possible for the same notional of bonds to be used to settle contracts repeatedly. This is possible because not all sellers of protection want to run recovery risk after being delivered the bonds and, consequently, sell them. The difficulty with this auction approach is that it cannot guarantee a result that exactly reflects the market at the time of the poll. In addition, the price of the defaulted bonds can vary significantly during the 60 days following a default event, thereby resulting in a material difference in the settlement values determined through the two processes.
During physical settlement, if there are offsetting CDS positions, it is important to ensure that the contracts on which protection were sold are triggered no later than the date for the purchases of protection. This ensures that the market participant knows which bonds will be delivered before having to declare which ones to deliver. In the event that there are multiple deliverable obligations trading at different prices, then careful monitoring is necessary to ensure that one will not be delivered the cheapest bond while having purchased a more expensive one to deliver.
In theory, this concern about the differing prices of the deliverable obligations should be irrelevant because all bonds ranked pari-passu at a given point in the capital structure should trade at the same implied recovery level. Historically, this has not always been the case, and technical factors in the market such as short squeezes owing to significant short selling of a particular issue before the default occurred can create differences of one or two percentage points in the bond price with an identical claim to the defaulted company's assets.
The elimination of the price basis between cash and physical settlement would allow the entire market to agree on a single price for settling all CDS contracts on a defaulted reference entity. This would result in a significant reduction in operational and settlement risk as well as significant savings in resources for the front- and middle-office.
Auction System: A Possible Solution?
One solution to the basis issue is cash settlement using procedures that create an offsetting basis. Recent market developments in North America lead to one solution based around the separation of the bond trade from the process of physical settlement. This approach leaves a cash-settled contract that requires a trade of equal notional of deliverable obligations to be executed at the same time. In this case, the bond trade executed is used to create the same position that each counterparty would have had after standard physical settlement. A seller of protection would have expected delivery of bonds upon settlement and they are required to purchase bonds in the auction. By executing this trade at the same price that is used to cash settle the CDS contract, the counterparties are indifferent as to the final settlement price as any excessive gain or loss on the CDS settlement is offset by the bond trade. This auction system provides further benefits in that it allows for the settlement of a portion of trades not covered by the auction. As described in the previous example, the bonds purchased in the auction could be used to settle another contract where protection had been purchased.
It appears that the market is moving toward a solution that allows bulk settlement of CDS trades while leaving a residual and much smaller number of related trades for execution. This minimizes the operational risk created by physical settlement while eliminating the pricing issues linked to cash settlement. A big step forward would be adoption of a market-wide practice even if this approach is initially imperfect. This solution will eliminate several of the challenges that can occur when attempting to offset the basis between cash and physical settlement.
This week's Learning Curve was written by Chris Crowley, strategy and business development manager, at Creditex and Nishul Saperia, associate director, at Markit.
