Credit Events and Settlement

When a reference entity's debt goes into default, a holder who hedges bonds or loans with CDS protection checks whether the CDS pays and how it is settled.

Types of credit events

A credit event is an event that obliges the protection seller in a credit default swap (CDS) to pay the buyer. If no credit event occurs, the seller pays nothing. The contract sets which events count as credit events.

According to a report by a financial law study group of the Japanese Bankers Association, published in 2012, a typical CDS on a company as the reference entity uses three. They are bankruptcy, failure to pay, and restructuring¹. The basic payments of a CDS are covered in Credit Default Swaps (CDS).

In a sovereign CDS, which references a country, the buyer is paid if failure to pay, repudiation/moratorium, or restructuring (a change in the terms of the debt) occurs². Compared with the three events for companies, repudiation/moratorium takes the place of bankruptcy.

When a credit event occurs, the protection buyer sends the seller a notice that it has occurred and a notice of publicly available information that confirms it¹. Disputes over which facts amount to a credit event, or whether the notice was proper, can lead to legal disputes¹.

The default terms in a bond contract are generally not the same as the credit event terms of a CDS. Even bonds of the same issuer can define default differently depending on the series or the market where they were issued, and loan terms are set even more individually³. As a result, debts of the same company can differ by instrument in whether a default is recognized and when.

Determination by the DC

Whether a credit event has occurred is decided by the Credit Derivatives Determinations Committee (DC), organized under the International Swaps and Derivatives Association (ISDA). The procedure for DC determinations was put in place by the 2009 amendments to ISDA's CDS definitions⁴. The regional DCs decide whether a credit event has occurred and what type it is⁵.

In a document published in 2012 (describing the situation as of the end of October 2011), there were DCs for five regions: the Americas; Europe, the Middle East and Africa; Japan; Asia excluding Japan; and Australia and New Zealand. Each had 15 voting members: 8 global dealers, 2 dealers from the region, and 5 non-dealers⁴.

Under the procedure at that time, a determination starts with a question from a market participant to ISDA. If at least one member agrees to discuss it (two members for an anonymous question), the DC discusses it, and a credit event is recognized if 80% of the voting members vote in favor⁴. Besides credit events, the DC also decides questions about how CDS contracts should be interpreted⁴.

Physical settlement and cash settlement

After a credit event, a CDS can be settled by physical settlement, by cash settlement, or through an auction⁶. In physical settlement, the protection buyer delivers to the seller claims on the reference entity, such as bonds or loans, and the seller pays their face value. The contract sets which obligations can be delivered (the deliverable obligations)⁶. In cash settlement, nothing is delivered. The market value of the debt is set by polling dealers, and the seller pays the difference between the face value and the market value⁶.

Consider a hypothetical example in which a CDS on Company B has a notional amount of 1 billion yen. After the credit event, Company B's bonds trade at 25 per 100 of face value.

A buyer holding Company B bonds with a face value of 1 billion yen ends up with 1 billion yen in total under either method. With cash settlement, selling the bonds in the market for 250 million yen (a price of 25) gives the same result as physical settlement. The seller, on the other hand, loses 750 million yen under either method. In physical settlement, it pays 1 billion yen and receives bonds worth 250 million yen.

According to a 2009 Federal Reserve Bank of New York paper, both methods have weaknesses. In physical settlement, a buyer that bought protection without holding the bonds still has to get them in the market to settle. When the total notional amount of CDS exceeds the reference entity's debt outstanding, buyers scramble for the bonds and push their price up artificially. CDS on the same risk then settle at different prices. The rule that the physical settlement process must begin within 30 calendar days of the credit event also made such a squeeze more likely⁷. For the Lehman Brothers CDS, it is estimated that about one-third could have been hedges of bonds, and the rest were positions without bonds⁷. In cash settlement, it is hard to get a reliable price for the defaulted debt, all the more because corporate bonds and loans trade thinly⁸.

How the auction sets the final price

An auction sets a single price for the defaulted debt, and all CDS on the same reference entity are cash settled at that price. Participants who want physical settlement can buy or sell bonds within the auction and get the same result as physical settlement⁹. The procedure has two stages. The description of the procedure from here on is based on the 2009 Federal Reserve Bank of New York paper. Figure 1 shows the flow from the determination of a credit event to settlement.

Figure description

A market participant asks ISDA whether a credit event has occurred, and the DC determines whether one has occurred, which requires 80% of the voting members to vote in favor. These steps for the question and the determination follow a document describing the situation as of the end of October 2011. If no credit event is determined, no settlement takes place. If it does, the first stage of the auction collects dealer quotes and physical settlement requests. The second stage matches limit orders to set the final price, and market participants cash settle their CDS at that price.

In the first stage, the dealers taking part directly in the auction submit bids and offers to buy and sell a preset amount of the debt. The maximum gap between a bid and an offer is also preset. The midpoint calculated from the quotes serves as the initial estimate of the recovery rate. At the same time, participants who want physical settlement submit requests to sell or buy the debt at the final price. A request must be in the same direction as the participant's own CDS position and cannot exceed it¹⁰. The net of the sell and buy requests is called the open interest⁹.

In the second stage, dealers submit limit orders, which are matched against the open interest. If the open interest is to sell, buy orders are used from the highest price down, and the price of the last order needed to fill the full amount becomes the final price. If it is to buy, sell orders are used from the lowest price up. If the open interest is zero, the first-stage midpoint becomes the final price⁹. Second-stage prices are capped at a set distance from the midpoint so that the final price cannot be manipulated¹⁰.

Now take an auction for Company B's bonds. The first-stage midpoint is 26, and the open interest is 20 billion yen to sell. If the second-stage buy limit orders are as follows, the running total from the top reaches 20 billion yen at the order priced at 25, so the final price is 25.

With a final price of 25, the seller of a CDS with a notional amount of 1 billion yen pays the buyer 1 billion yen × (100 − 25) ÷ 100 = 750 million yen. A buyer that submitted a request in the auction to sell bonds with a face value of 1 billion yen also receives payment for the bonds, which gives the same result as physical settlement⁹.

As a real example, Lehman Brothers filed for Chapter 11 bankruptcy protection under the U.S. Bankruptcy Code on September 15, 2008, and the auction for its senior bonds was held on October 10 of that year. The 358 parties that adhered to the auction protocol took part through the 14 dealers that participated directly. The first-stage midpoint was 9.75, the open interest was USD 4.92 billion to sell, and the second-stage cap was 10.75. The final price was 8.625, and sellers paid 91.375% of the notional amount¹⁰.

Deep diveHow the first-stage midpoint is calculated

The paper's description of the Lehman Brothers auction calculates the midpoint as follows. First, the bids and offers are sorted, and if the highest bid is at or above the lowest offer, both are removed. This is repeated until every remaining bid is below every remaining offer. The midpoint is then the average of the higher half of the remaining bids and the lower half of the remaining offers, rounded to the nearest 1/8¹⁰.

A dealer also has to pay a penalty in some cases. This happens when its quote was removed for crossing other quotes, was a bid above the midpoint (or an offer below it), and was unreasonable given the direction of the open interest. In the Lehman Brothers auction, a dealer that bid above the midpoint paid the penalty¹⁰.

An auction treats all debt of the same seniority as the same security and sets a single recovery rate for that level of seniority. The auctions held up to 2009 covered loans, senior bonds, and subordinated bonds¹¹. The final price set in the second stage becomes the recovery rate used to settle the CDS⁹. The relationship between the recovery rate and the valuation of a CDS is covered in Pricing a CDS.

Standardization of auctions in 2009

Settlement through auctions came into use gradually from around 2005¹². The two-stage procedure described in the 2009 Federal Reserve Bank of New York paper had been in use since the 2005 auction for Delphi's CDS⁹. However, for each credit event, buyers and sellers that wanted to take part had to send a notice by a deadline that they would adhere to an agreement amending their existing contracts (a protocol). Also, auctions up to 2006 allowed only physical settlement, and participants could not choose cash settlement as they could by the time of the 2009 paper⁸.

The Japanese Bankers Association report published in 2012 gives three reasons why the 2009 amendments were needed. First, because a CDS is a bilateral trade between two parties, CDS on the same reference entity could differ trade by trade in when a credit event is recognized and in the settlement price. Second, the parties could disagree on how to interpret the contract at settlement. Third, there were concerns about the liquidity and transferability of the debt to be delivered¹².

In March and July 2009, the CDS definitions were substantially amended. The March amendments are called the Big Bang and the July amendments the Small Bang⁴. The Big Bang put in place the procedure for the DC to determine credit events⁴. The Big Bang took effect on April 8, 2009, and from that date auction settlement was built into the definitions and became the industry standard for settlement¹²¹³¹⁴. The Small Bang made auction settlement available for restructuring, which the Big Bang had left out¹⁵. So that the new arrangements could also apply to CDS already entered into, parties were allowed to adhere to an agreement, and more than 2,000 parties did so⁴.

Settling at a single price means that a position in single-name CDS on a reference entity, hedged with a CDS index, no longer produces gains or losses from differences in recovery rates. If each trade were physically settled, the bonds would be bought and sold at different times and prices, producing a loss or gain on a position that should have zero profit or loss⁹.

Hedge outcomes and hedge mismatches

An investor that holds Company B bonds with a face value of 1 billion yen and bought protection for the same amount covers the fall in the bond price with the CDS payment if the final price is 25. If the investor bought the bonds at face value, the combined gain or loss on the bonds and the CDS, excluding the premium, is zero.

When the default of a bond or loan and the credit event of the CDS diverge, however, the hedge no longer offsets the loss. The 2010 Bank of Japan report gives examples. If an out-of-court workout that covers only loans (such as a business turnaround ADR procedure) causes a loss on a loan, but no credit event is recognized for the CDS, the hedge on the loan does not work. Conversely, if a credit event is recognized in an out-of-court workout that does not include the bonds, someone who hedged bonds with CDS may make an unexpected gain³.

The amount recovered can also differ. Creditors of the same seniority can end up recovering very different amounts depending on whether they hold bonds or have made loans³. An auction, on the other hand, sets a single recovery rate for debt of the same seniority¹¹. As a result, the CDS payment may not match the amount actually recovered on a loan, so the CDS may over- or under-hedge the loan.

Notes

1. 森下哲朗, "クレジット・デフォルト・スワップ" (Credit default swaps), chapter 5 of the report "金融取引における信用補完に係る現代的展開" (Modern developments in credit enhancement in financial transactions) by the Japanese Bankers Association's 金融法務研究会 (financial law study group) (published September 2012, in Japanese), pages 45–46, "（５）クレジット・イベント" (5. Credit events). ↩ ↩² ↩³

2. Bank of Japan, "金融市場レポート" (Financial Markets Report, January 2010, in Japanese), page 17, "BOX３ ソブリン CDS 市場について" (Box 3: The sovereign CDS market). ↩

3. Bank of Japan, "金融市場レポート" (Financial Markets Report, January 2010, in Japanese), pages 37–38, "BOX６ デフォルト局面における信用リスク商品の連動性" (Box 6: How credit risk products move together around defaults). ↩ ↩² ↩³

4. 森下哲朗, "クレジット・デフォルト・スワップ" (published September 2012, in Japanese), page 45, "（４）契約" (4. Contracts) and note 18, and page 46, "（５）クレジット・イベント" (5. Credit events). The regions, the composition of the members, and the determination procedure are described as of the end of October 2011. ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶ ↩⁷

5. IHS Markit, "CDS Indices Primer" (November 2021), pages 11–12, "Credit event procedures." ↩

6. 森下哲朗, "クレジット・デフォルト・スワップ" (published September 2012, in Japanese), page 47, "（６）決済" (6. Settlement). ↩ ↩² ↩³

7. Federal Reserve Bank of New York, "Credit Default Swap Auctions" (Staff Report no. 372, May 2009), pages 3–4, "Why is an Auction Necessary to Settle CDS Contracts?" ↩ ↩²

8. Federal Reserve Bank of New York, "Credit Default Swap Auctions" (May 2009), page 5. ↩ ↩²

9. Federal Reserve Bank of New York, "Credit Default Swap Auctions" (May 2009), pages 5–8, "The Auction Mechanism." ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶ ↩⁷

10. Federal Reserve Bank of New York, "Credit Default Swap Auctions" (May 2009), pages 20–21, "Box 1: Lehman Brothers as an illustration of the CDS auction mechanism." ↩ ↩² ↩³ ↩⁴ ↩⁵

11. Federal Reserve Bank of New York, "Credit Default Swap Auctions" (May 2009), page 6. ↩ ↩²

12. 森下哲朗, "クレジット・デフォルト・スワップ" (published September 2012, in Japanese), page 48, "（６）決済" (6. Settlement). ↩ ↩² ↩³

13. 吉井一洋, "クレジット市場における検討課題" (Issues to consider in the credit market, in Japanese; Financial Research and Training Center, Financial Services Agency, July 2009), page 46, "５．１．１ ＣＤＳとは" (5.1.1 What is a CDS?). ↩

14. IHS Markit, "CDS Indices Primer" (November 2021), page 36, "Appendix 6: Credit Derivatives Glossary," "Big Bang Protocol." ↩

15. IHS Markit, "CDS Indices Primer" (November 2021), page 41, "Appendix 6: Credit Derivatives Glossary," "Small Bang Protocol." ↩

16. Federal Reserve Bank of New York, "Credit Default Swap Auctions" (May 2009), page 3. ↩