Reviewing Auction Protocols for the Settlement of Credit Default Swaps

The Situation

A derivatives trade association needed analysis of  the underlying economics of auction procedures used to determine the final price for the settlement of credit default swaps (CDS) after a credit event.

NERA's Role

NERA analyzed the function and efficiency of the auction methodology, its ability to clear excess supply or demand for deliverable obligations, and its susceptibility to manipulation. We also analyzed and explained the economic implications of the auction protocol, and the potential costs and benefits of procedures and constraints built into the auction. We prepared memoranda and made presentations explaining our analysis and findings for the staff, participating firms, and regulatory authorities. Later, we were asked to evaluate the implications for pricing, liquidity, and efficiency as the auction became accepted and as various indices and contract markets sought to reference the auction final price.

The Result

Using simulation and other empirical methods, NERA performed a preliminary analysis of CDS prices, bond prices, and related markets leading up to and following a default, and evaluated the pricing and efficiency characteristics.