CDS Auction

[Jaskarn]

Hi @David Harper CFA FRM ,

Gregory, Chapter 12: Default Probabilities, Credit Spreads, Funding Costs

In your notes under the above topic, there is a sub-topic "Describe credit default swaps (CDS) and their general underlying mechanics" in this there you explained about how in recent times auctions are done, namely Big Bang Protocol, to solve earlier problems of CDS settlement. can you please explain a bit how this auction helps in solving the issue?

Also, what the meaning of delivery squeeze? In the below image you have written that the impact of delivery squeeze can be seen .....

Thanks in advance.

 

[David Harper CFA FRM]

Hi @Jaskarn The auction was part of the CDS Big Bang Protocol, and it was needed to solve the problem of a delivery squeeze. The squeeze problem here is similar to the squeeze problem thwarted by the the use of the cheapest-to-deliver (CTD) option in U.S. Treasury futures contracts. The problem arises because many CDS derivative contracts can reference a single bond (this is a big reason that credit default swaps have remained controversial since the crisis). If I write you credit protection on a reference bond (that is, say I am the writer and you are the CDS/protection buyer), and subsequently the bond defaults (ie., credit event triggers), then I owe you a contingent payoff. You need to be made whole. In physical settlement, you transfer the defaulted bond to me, and I pay you the face value of the bond (say, $100); you are made whole by my full face value payment, and I can work on recovering as much as possible on the defaulted bond. However, there is a huge problem that is common to any derivative: neither of us needs to even own the bond. There could be 10 or 20 or 50 such contracts between pairs of counterparties, all referencing the same bond! If physical delivery were the only way to settle, a terrible "squeeze" on the bond would ensue as all the protection buyers suddenly need the bond (in this case, then, I would define a squeeze as a disruptive surge in demand). Worse, speculators can buy the bond (and hold it hostage, so to speak) to bid up the price to profit, knowing it will be needed for delivery.

The auction solves this by making even more smooth the alternative settlement, cash settlement, where the key and non-trivial problem is the determination of the recovery value on the defaulted bond. Using the same prior example, if the recovery value of the bond is 30%, then upon default, instead of delivering me the bond, I simply pay you $100 * (1-30% recover) = $70 in cash, because that is the "loss given default." If we settle in cash and we want to do it quickly, then we probably need to estimate the recovery before experiencing the actual recover which can be time consuming. The auction is a method to determine this value and you can read more about it http://creditfixings.com/CreditEventAuctions/fixings.jsp, specifically http://creditfixings.com/informatio...auctions/docs/credit_event_auction_primer.pdf. I hope that's helpful!

 

[Jaskarn]

Hi @David Harper CFA FRM ,

Thanks a lot for your clarification.

In the same topic under sub-topic "Describe index tranches, super senior risk, and collateralized debt obligations (CDO)" you have mentioned

"Therefore, issuers of CDOs are super senior protection buyers, not necessarily
because they think super senior tranches have value but rather because

They need to buy protection or place the super senior risk in order to have efficiently
distributed the risk. Failure to do this may mean holding onto a very large super
senior piece and potentially not being able to recognize P&L on a transaction.
OR
Buying super senior protection is required as a hedge for other tranche positions.
Without going into too much detail, we note that structured product traders may buy a
product such as an option or tranche, not because they think it is undervalued, but
rather because it allows them to hedge. In options terminology they may pay for the
“gamma” (the convexity of the price with respect to market movements). In this case,
a CDO correlation trader may buy protection on a super senior tranche, not because
he thinks it will have a payoff (losses hitting the tranche), but rather because it
provides positive gamma."

What I understand in CDO market is that: Bank will transfer underlying to an investment bank and investment bank will transform a pool of loan into CDOs which they will slice into various tranches and sell to an investor like a menu in a restaurant. So according to your above statement investment bank will sell CDO on one hand and buy protection on another hand in case the underlying loan goes bad, just like 2008, they will get payment from protection seller and same money they will pay to the investors. Correct?

If my above interpretation is correct, they do investment bank buy protection on the same CDO issued by them? and from whom they buy this protection?
And your above statement means that issuer is protection buyer for super senior tranche because they are selling that tranche by saying it will never fail so they will buy protection ONLY for that tranche. Correct?

 

[Jaskarn]

Hi @Jaskarn The auction was part of the CDS Big Bang Protocol, and it was needed to solve the problem of a delivery squeeze. The squeeze problem here is similar to the squeeze problem thwarted by the the use of the cheapest-to-deliver (CTD) option in U.S. Treasury futures contracts. The problem arises because many CDS derivative contracts can reference a single bond (this is a big reason that credit default swaps have remained controversial since the crisis). If I write you credit protection on a reference bond (that is, say I am the writer and you are the CDS/protection buyer), and subsequently the bond defaults (ie., credit event triggers), then I owe you a contingent payoff. You need to be made whole. In physical settlement, you transfer the defaulted bond to me, and I pay you the face value of the bond (say, $100); you are made whole by my full face value payment, and I can work on recovering as much as possible on the defaulted bond. However, there is a huge problem that is common to any derivative: neither of us needs to even own the bond. There could be 10 or 20 or 50 such contracts between pairs of counterparties, all referencing the same bond! If physical delivery were the only way to settle, a terrible "squeeze" on the bond would ensue as all the protection buyers suddenly need the bond (in this case, then, a squeeze is a disruptive surge in demand).

The auction solves this by making even more smooth the alternative settlement, cash settlement, where the key and non-trivial problem is the determination of the recovery value on the defaulted bond. Using the same prior example, if the recovery value of the bond is 30%, then upon default, instead of delivering me the bond, I simply pay you $100 * (1-30% recover) = $70 in cash, because that is the "loss given default." The auction is a method to determine this value and you can read more about it http://creditfixings.com/CreditEventAuctions/fixings.jsp, specifically http://creditfixings.com/informatio...auctions/docs/credit_event_auction_primer.pdf. I hope that's helpful!

I Swear to god, you are such an awesome teacher. You have made my life so simple like seriously. Thanks a ton again.

 

[Jaskarn]

Hi @David Harper CFA FRM

Under this topic in your notes subtopic "Contingent credit default swaps"

You have mentioned the normal CDS has the disadvantage that "a key aspect of counterparty risk is that the loss as determined by the credit exposure at the credit event time is usually unknown." Can you please elaborate this statement a bit? I mean how is the loss unknown at the time of default? Is this something related to how CDS are sold in the market?

Thanks a lot

 

[David Harper CFA FRM]

Hi @Jaskarn That's Jon Gregory, as you surely know. I *think* (but am not certain) based on the context that he means the loss on a (bilateral) OTC derivative contract (e.g., interest rate swap), not necessarily, is not necessarily known at time of counterparty default, such that CCDS are a remedy for this problem. My interpretation is based on:

"In the event of a bankruptcy, the holders of OTC derivatives contracts with the counterparty in default would generally be pari passu9 with the senior bondholders. OTC derivatives, bonds and CDSs generally reference senior unsecured credit risk and may appear to relate to the same LGD. However, there are timing issues: when a bond issuer defaults, LGD is realised immediately, since the bond can be sold in the market. CDS contracts are also settled within days of the defined “credit event” via the CDS auction that likewise defines the LGD. However, OTC derivatives cannot be freely traded or sold, especially when the counterparty to the derivative is in default. This essentially leads to a potentially different LGD for derivatives. These aspects, which were very important in the Lehman Brothers bankruptcy of 2008 (see Figure 3.3 in the previous chapter), are discussed in more detail in Section 12.2.5." -- Gregory, Jon. The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital (The Wiley Finance Series) (p. 36). Wiley. Kindle Edition.

... notice the point is about the difficulty of quantifying LGD for certain OTC contracts? and then jumping to the referenced 12.25:

"A final point on recovery is related to the timing. CDSs are settled quickly following a default and bondholders can settle their bonds in the same process (the CDS auction) or simply sell them in the market. However, bilateral OTC derivatives cannot be settled in a timely manner. This is partly due to their bespoke nature and partly due to netting (and collateral), which means that many transactions are essentially aggregated into a single claim and cannot be traded individually. The net claim (less any collateral) is then often quite difficult to define for the portfolio of trades (see Figure 3.3 in Chapter 3). This creates two different recovery values:

• Settled recovery. This is the recovery that could be achieved following the credit event by trading out of a claim; for example, by selling a defaulted bond.
• Actual recovery. This is the actual recovery received on a derivative following a bankruptcy or similar process.

In theory, settled and actual recoveries should be very similar, but in reality – since bankruptcy processes can take many years – they may differ materially. This is illustrated in Figure 12.5. It should be possible to agree on the claim with the bankruptcy administrators prior to the actual recovery, although this process may take many months. This would allow an institution to sell the claim and monetise the recovery value as early as possible. In the case of the Lehman Brothers bankruptcy, the settled recovery was around 9%, whereas some actual recoveries received since have been substantially higher (in the region of 30– 40%)." -- Gregory, Jon. The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital (The Wiley Finance Series) (p. 274). Wiley. Kindle Edition.

... so my hunch (without certainty) is that the language is a bit confusing (it reads as if he's only talking about the loss on a CDS but I think he is referring generally to OTC derivatives credit exposure when he writes "However a key aspect of counterparty risk ...") but I think that: he is not referring to the loss on a vanilla CDS, but rather the loss due to a counterparty default (in the context of a derivative contract, perhaps including CDS) which itself is likely to be vague at the time of the credit event (trigger) and that a possible remedy to this specific problem is the contingent CDS (CCDS) because the CCDS directly references a (flexible) derivative notional amount. So the CCDS is not just a more specific type of CDS, it's a different (broader) animal, can reference many different types; e.g., the CCDS can reference a CDS, IRS, etc. I think that's what Gregory means.

 

[Jaskarn]

Hi @Jaskarn That's Jon Gregory, as you surely know. I *think* (but am not certain) based on the context that he means the loss on a (bilateral) OTC derivative contract (e.g., interest rate swap), not necessarily, is not necessarily known at time of counterparty default, such that CCDS are a remedy for this problem. My interpretation is based on:

... notice the point is about the difficulty of quantifying LGD for certain OTC contracts? and then jumping to the referenced 12.25:


... so my hunch (without certainty) is that the language is a bit confusing (it reads as if he's only talking about the loss on a CDS but I think he is referring generally to OTC derivatives credit exposure when he writes "However a key aspect of counterparty risk ...") but I think that: he is not referring to the loss on a vanilla CDS, but rather the loss due to a counterparty default (in the context of a derivative contract, perhaps including CDS) which itself is likely to be vague at the time of the credit event (trigger) and that a possible remedy to this specific problem is the contingent CDS (CCDS) because the CCDS directly references a (flexible) derivative notional amount. So the CCDS is not just a more specific type of CDS, it's a different (broader) animal, can reference many different types; e.g., the CCDS can reference a CDS, IRS, etc. I think that's what Gregory means.

Jon Gregory is a difficult read i guess... Most of the reading assigned in course are difficult to interpret.
Thanks a lot for your clarification David.