IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Credit default swaps (CDS)

Ahmad Peivandi, Northwestern University

March 6, 2013

1 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Credit default swaps (CDS)

Ahmad Peivandi, Northwestern University

March 6, 2013

2 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Table of contents

1 Introduction

2 Current settlement mechanism in use

3 Goals of a mechanism

4 Results

3 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

What is a credit default swap?

Think of a �rm (R) that has issued bonds.

Assume agent B has purchased a number of bonds from �rm

R.

There is a risk that �rm R will go bankrupt and defaults.

Because of this risk �rm B purchases insurance from another

agent (S).

For an agreed period of time B pays a fee to agent S and in

return receives insurance against default risk.

If default happens �rm S compensate B for his loss.

(Numerical example) Amount of outstanding CDSs is more

than 30 trillion USD!

4 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

What is a credit default swap?

Think of a �rm (R) that has issued bonds.

Assume agent B has purchased a number of bonds from �rm

R.

There is a risk that �rm R will go bankrupt and defaults.

Because of this risk �rm B purchases insurance from another

agent (S).

For an agreed period of time B pays a fee to agent S and in

return receives insurance against default risk.

If default happens �rm S compensate B for his loss.

(Numerical example) Amount of outstanding CDSs is more

than 30 trillion USD!

4 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

What is a credit default swap?

Think of a �rm (R) that has issued bonds.

Assume agent B has purchased a number of bonds from �rm

R.

There is a risk that �rm R will go bankrupt and defaults.

Because of this risk �rm B purchases insurance from another

agent (S).

For an agreed period of time B pays a fee to agent S and in

return receives insurance against default risk.

If default happens �rm S compensate B for his loss.

(Numerical example) Amount of outstanding CDSs is more

than 30 trillion USD!

4 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

What is a credit default swap?

Think of a �rm (R) that has issued bonds.

Assume agent B has purchased a number of bonds from �rm

R.

There is a risk that �rm R will go bankrupt and defaults.

Because of this risk �rm B purchases insurance from another

agent (S).

For an agreed period of time B pays a fee to agent S and in

return receives insurance against default risk.

If default happens �rm S compensate B for his loss.

(Numerical example) Amount of outstanding CDSs is more

than 30 trillion USD!

4 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

What is a credit default swap?

Think of a �rm (R) that has issued bonds.

Assume agent B has purchased a number of bonds from �rm

R.

There is a risk that �rm R will go bankrupt and defaults.

Because of this risk �rm B purchases insurance from another

agent (S).

For an agreed period of time B pays a fee to agent S and in

return receives insurance against default risk.

If default happens �rm S compensate B for his loss.

(Numerical example) Amount of outstanding CDSs is more

than 30 trillion USD!

4 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

What is a credit default swap?

Think of a �rm (R) that has issued bonds.

Assume agent B has purchased a number of bonds from �rm

R.

There is a risk that �rm R will go bankrupt and defaults.

Because of this risk �rm B purchases insurance from another

agent (S).

For an agreed period of time B pays a fee to agent S and in

return receives insurance against default risk.

If default happens �rm S compensate B for his loss.

(Numerical example) Amount of outstanding CDSs is more

than 30 trillion USD!

4 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

What is a credit default swap?

Think of a �rm (R) that has issued bonds.

Assume agent B has purchased a number of bonds from �rm

R.

There is a risk that �rm R will go bankrupt and defaults.

Because of this risk �rm B purchases insurance from another

agent (S).

For an agreed period of time B pays a fee to agent S and in

return receives insurance against default risk.

If default happens �rm S compensate B for his loss.

(Numerical example) Amount of outstanding CDSs is more

than 30 trillion USD!

4 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

CDS settlement

From now on assume that the default has happened.

The question is how to settle these contracts?

Agent B hands his defaulted bonds to S and gets the face

value. This is called physical settlement.

Assume the face value is 100. If the defaulted bond price in

the market was p, S has to pay B 100− p. This is called cash

settlement.

5 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

CDS settlement

From now on assume that the default has happened.

The question is how to settle these contracts?

Agent B hands his defaulted bonds to S and gets the face

value. This is called physical settlement.

Assume the face value is 100. If the defaulted bond price in

the market was p, S has to pay B 100− p. This is called cash

settlement.

5 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

CDS settlement

From now on assume that the default has happened.

The question is how to settle these contracts?

Agent B hands his defaulted bonds to S and gets the face

value. This is called physical settlement.

Assume the face value is 100. If the defaulted bond price in

the market was p, S has to pay B 100− p. This is called cash

settlement.

5 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

CDS settlement

From now on assume that the default has happened.

The question is how to settle these contracts?

Agent B hands his defaulted bonds to S and gets the face

value. This is called physical settlement.

Assume the face value is 100. If the defaulted bond price in

the market was p, S has to pay B 100− p. This is called cash

settlement.

5 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Physicall settlement vs cash settlment

Physical settlement seems to be natural solution for

settlement. However, number of issues that may arise.

1) It constrain the number of CDS contracts to number of

defaulted bonds. There maybe naked CDS.

2) Even if agents could purchase defaulted bonds it would

arti�cially raise the price of bonds.

3) Short-selling is impossible or very hard.

For these reasons cash settlement has merged.

These defaulted bonds are not traded in a liquid market,

therefore, value of these defaulted bonds are not known.

The challenge is to determine a price for the defaulted bond.

6 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Physicall settlement vs cash settlment

Physical settlement seems to be natural solution for

settlement. However, number of issues that may arise.

1) It constrain the number of CDS contracts to number of

defaulted bonds. There maybe naked CDS.

2) Even if agents could purchase defaulted bonds it would

arti�cially raise the price of bonds.

3) Short-selling is impossible or very hard.

For these reasons cash settlement has merged.

These defaulted bonds are not traded in a liquid market,

therefore, value of these defaulted bonds are not known.

The challenge is to determine a price for the defaulted bond.

6 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Physicall settlement vs cash settlment

Physical settlement seems to be natural solution for

settlement. However, number of issues that may arise.

1) It constrain the number of CDS contracts to number of

defaulted bonds. There maybe naked CDS.

2) Even if agents could purchase defaulted bonds it would

arti�cially raise the price of bonds.

3) Short-selling is impossible or very hard.

For these reasons cash settlement has merged.

These defaulted bonds are not traded in a liquid market,

therefore, value of these defaulted bonds are not known.

The challenge is to determine a price for the defaulted bond.

6 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Physicall settlement vs cash settlment

Physical settlement seems to be natural solution for

settlement. However, number of issues that may arise.

1) It constrain the number of CDS contracts to number of

defaulted bonds. There maybe naked CDS.

2) Even if agents could purchase defaulted bonds it would

arti�cially raise the price of bonds.

3) Short-selling is impossible or very hard.

For these reasons cash settlement has merged.

These defaulted bonds are not traded in a liquid market,

therefore, value of these defaulted bonds are not known.

The challenge is to determine a price for the defaulted bond.

6 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Physicall settlement vs cash settlment

Physical settlement seems to be natural solution for

settlement. However, number of issues that may arise.

1) It constrain the number of CDS contracts to number of

defaulted bonds. There maybe naked CDS.

2) Even if agents could purchase defaulted bonds it would

arti�cially raise the price of bonds.

3) Short-selling is impossible or very hard.

For these reasons cash settlement has merged.

These defaulted bonds are not traded in a liquid market,

therefore, value of these defaulted bonds are not known.

The challenge is to determine a price for the defaulted bond.

6 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Physicall settlement vs cash settlment

Physical settlement seems to be natural solution for

settlement. However, number of issues that may arise.

1) It constrain the number of CDS contracts to number of

defaulted bonds. There maybe naked CDS.

2) Even if agents could purchase defaulted bonds it would

arti�cially raise the price of bonds.

3) Short-selling is impossible or very hard.

For these reasons cash settlement has merged.

These defaulted bonds are not traded in a liquid market,

therefore, value of these defaulted bonds are not known.

The challenge is to determine a price for the defaulted bond.

6 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Physicall settlement vs cash settlment

Physical settlement seems to be natural solution for

settlement. However, number of issues that may arise.

1) It constrain the number of CDS contracts to number of

defaulted bonds. There maybe naked CDS.

2) Even if agents could purchase defaulted bonds it would

arti�cially raise the price of bonds.

3) Short-selling is impossible or very hard.

For these reasons cash settlement has merged.

These defaulted bonds are not traded in a liquid market,

therefore, value of these defaulted bonds are not known.

The challenge is to determine a price for the defaulted bond.

6 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

How does it work?

The mechanism determines a price and quantities for cash

settlement.

Ex: p = 70 and q = 5. If he has 8 CDSs contracts 5 of them

will be settled via cash settlement and the rest, 8− 5, via

physical settlement.

The current mechanism in use is a two stage mechanism.

In the �rst stage the mechanism determines a price �oor or

ceiling and also determines the number of defaulted bonds for

buy or sell.

In the second period a uniform price auction determines the

price of the defaulted bond.

7 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

How does it work?

The mechanism determines a price and quantities for cash

settlement.

Ex: p = 70 and q = 5. If he has 8 CDSs contracts 5 of them

will be settled via cash settlement and the rest, 8− 5, via

physical settlement.

The current mechanism in use is a two stage mechanism.

In the �rst stage the mechanism determines a price �oor or

ceiling and also determines the number of defaulted bonds for

buy or sell.

In the second period a uniform price auction determines the

price of the defaulted bond.

7 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

How does it work?

The mechanism determines a price and quantities for cash

settlement.

Ex: p = 70 and q = 5. If he has 8 CDSs contracts 5 of them

will be settled via cash settlement and the rest, 8− 5, via

physical settlement.

The current mechanism in use is a two stage mechanism.

In the �rst stage the mechanism determines a price �oor or

ceiling and also determines the number of defaulted bonds for

buy or sell.

In the second period a uniform price auction determines the

price of the defaulted bond.

7 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

How does it work?

The mechanism determines a price and quantities for cash

settlement.

Ex: p = 70 and q = 5. If he has 8 CDSs contracts 5 of them

will be settled via cash settlement and the rest, 8− 5, via

physical settlement.

The current mechanism in use is a two stage mechanism.

In the �rst stage the mechanism determines a price �oor or

ceiling and also determines the number of defaulted bonds for

buy or sell.

In the second period a uniform price auction determines the

price of the defaulted bond.

7 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

How does it work?

The mechanism determines a price and quantities for cash

settlement.

Ex: p = 70 and q = 5. If he has 8 CDSs contracts 5 of them

will be settled via cash settlement and the rest, 8− 5, via

physical settlement.

The current mechanism in use is a two stage mechanism.

In the �rst stage the mechanism determines a price �oor or

ceiling and also determines the number of defaulted bonds for

buy or sell.

In the second period a uniform price auction determines the

price of the defaulted bond.

7 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Comments on the existing mechanism

Rigged in the favor of artitechts who make money from this

mechanism.

Gupta et al, (2012) have observed that the defaulted bonds in

this mechanism are under priced in the vast majority of

auctions.

Underpricing implies that the protection buyer cannot fully

insure against the risk of default by the reference asset.

This comes at the cost of e�ciency loss.

In an e�cient allocation risk neutral agents (protection sellers)

should provide full insurance for risk averse agents (protection

buyers) against the default risk.

8 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Comments on the existing mechanism

Rigged in the favor of artitechts who make money from this

mechanism.

Gupta et al, (2012) have observed that the defaulted bonds in

this mechanism are under priced in the vast majority of

auctions.

Underpricing implies that the protection buyer cannot fully

insure against the risk of default by the reference asset.

This comes at the cost of e�ciency loss.

In an e�cient allocation risk neutral agents (protection sellers)

should provide full insurance for risk averse agents (protection

buyers) against the default risk.

8 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Comments on the existing mechanism

Rigged in the favor of artitechts who make money from this

mechanism.

Gupta et al, (2012) have observed that the defaulted bonds in

this mechanism are under priced in the vast majority of

auctions.

Underpricing implies that the protection buyer cannot fully

insure against the risk of default by the reference asset.

This comes at the cost of e�ciency loss.

In an e�cient allocation risk neutral agents (protection sellers)

should provide full insurance for risk averse agents (protection

buyers) against the default risk.

8 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Comments on the existing mechanism

Rigged in the favor of artitechts who make money from this

mechanism.

Gupta et al, (2012) have observed that the defaulted bonds in

this mechanism are under priced in the vast majority of

auctions.

Underpricing implies that the protection buyer cannot fully

insure against the risk of default by the reference asset.

This comes at the cost of e�ciency loss.

In an e�cient allocation risk neutral agents (protection sellers)

should provide full insurance for risk averse agents (protection

buyers) against the default risk.

8 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Comments on the existing mechanism

Rigged in the favor of artitechts who make money from this

mechanism.

Gupta et al, (2012) have observed that the defaulted bonds in

this mechanism are under priced in the vast majority of

auctions.

Underpricing implies that the protection buyer cannot fully

insure against the risk of default by the reference asset.

This comes at the cost of e�ciency loss.

In an e�cient allocation risk neutral agents (protection sellers)

should provide full insurance for risk averse agents (protection

buyers) against the default risk.

8 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Incentives and detail free

1 Ex-post incentive compatible, this means that the

mechanism is incentive compatible for all possible agents'

belief.

2 Detail free, which means that the settlement mechanism does

not depend on the functional form of the agents' valuation of

the defaulted bond.

9 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Budget balanced and Unbiased

1 Weakly budget balanced, which means that the designer

does not have to incur a monetary cost to run this settlement

mechanism.

2 Unbiased, this means that from the designer's view point.

The expected pay-o� induced by this mechanism is equal to

that of a mechanism that sets the cash settlement price equal

to the value of the defaulted bond.

10 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Main result

A �xed price mechanism satis�es all four properties.

price=the expected value of price.

Almost surely, these are the only mechanisms with these

properties.

Intuitively, this result suggests that auctions or any mechanism

that depends on agents' information can not achieve those

four goals.

11 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Main result

A �xed price mechanism satis�es all four properties.

price=the expected value of price.

Almost surely, these are the only mechanisms with these

properties.

Intuitively, this result suggests that auctions or any mechanism

that depends on agents' information can not achieve those

four goals.

11 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Main result

A �xed price mechanism satis�es all four properties.

price=the expected value of price.

Almost surely, these are the only mechanisms with these

properties.

Intuitively, this result suggests that auctions or any mechanism

that depends on agents' information can not achieve those

four goals.

11 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Participation

ISDA does not force participation in this mechanism. If both

parties of a CDS contract agree, they can settle their contracts

using another mechanism.

This mechanism leaves no incentive for agents to not

participate in the mechanism.

12 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

Participation

ISDA does not force participation in this mechanism. If both

parties of a CDS contract agree, they can settle their contracts

using another mechanism.

This mechanism leaves no incentive for agents to not

participate in the mechanism.

12 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

suggestion

Use rating agencies or other �nancial institutions to price the

auction.

13 / 14

IntroductionCurrent settlement mechanism in use

Goals of a mechanismResults

References

Participation and unbiased pricing in CDS settlement

mechanisms. Ahmad Peivandi.

M. Chernov, A.S. Gorbenko, and I. Makarov, CDS Auctions,

working paper 2012.

V. Coudert, M. Gex, The Credit Default Swap Market and the

Settlement of Large Defaults, working paper no. 2010-17,

CEPII.

S. Du, H. Zhu, Are CDS Auctions Biased? working paper,

Stanford GSB, 2010.

S. Gupta, R.K. Sundaram, CDS Credit-Event Auctions,

working paper 2012.

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