by Simon Boughey
The innovative and much-hailed protocol governing the settlement of Delphi CDS positions was in fact a compromise solution between the banks on the one side and end-users on the other, according to well-placed sources in New York.
The 14 dealers, who were the same ones called to the summit meeting with the Federal Reserve Bank of New York in September to discuss trade confirmations and novation, wanted a cash settlement process for all index, tranche and single-name trades. But end-users and customers resisted this initiative as they had often bought cash bonds against CDS positions. Consequently, cash settlement of all single CDS positions but not the defaulted bonds would have exposed them to basis risk.
The banks, however, wanted cash settlement as they had often hedged index and correlation trades with single-name trades. So cash settlement of index and tranche positions, allied to physical settlement of single-name trades, exposed the banks to basis risk. “You’ve got basis between single names and correlation and index trades. The larger correlation desks were clamouring for cash settlement,” says a senior banker at one of the banks involved in the process.
Markit and Creditex, which ran the auctions and developed the algorithm that governed the intricate auction process, have said that single names were not included in the cash settlement process as it would have added an extra layer of unmanageable complexity. In fact, it seems that it was because it was not possible to get both sides of the market to agree.
A creative answer
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The ingenious solution developed by the banks was to allow those signatories to the protocol to buy and sell bonds at the price determined by the auction for cash settlement, and then use these bonds for physical settlement of the single-name trades.
Through the use of market orders and limit orders, the auction process was also designed to reflect accurately the true open interest in the market so that the final cash settlement price was based upon dealers’ positions. If all the buy orders had equalled all the sell orders, then the market would have cash settled at the mid-point of that price.
In fact, the sum of bids was $186 million and the sum of sells was $285 million, leaving an imbalance, or open interest, of $99 million. This amount was matched off against the best limit bids, working from the best down, to arrive at a final cash price of 63.375 cents on the dollar for Delphi bonds.
Bonds could be then bought and sold at this price for physical settlement, so that there was no basis risk. “The methodology was developed so that people can settle their index trades and single-name trades at the same price all in one go,” explains Nishul Saperia, vice-president of analytics at Markit.
The process was both more comprehensive and more complex than the earlier auctions to deal with the settlement of CDS positions in auto parts dealer Collins & Aikman and the failed airlines, Delta and Northwest. There were a lot more outstanding Delphi trades and, as it had been investment grade until the end of last year, it was a reference entity in hundreds of structured trades.
Delphi declared bankruptcy on October 9, which gave the banks a month to work out the methodology and secure market support for it. However, as Tom Benison, head of North American credit product management at JPMorgan in New York, points out, this event had been on the cards for some time.
“People had been thinking about this for a long time. It was not as if it came out of the blue,” he says. The discussions were led by senior people in the industry, said one source. “An awful lot of time has been spent on this. Some of the phone discussions would go on for three or four hours. It was not practical to have traders away from the desk for that long,” he says.
Sleepless nights
The protocol was enforced by the programme developed by Markit and Creditex. Development of this interface under a very tight deadline required a few sleepless nights from application developers at Creditex.
According to Sunil Hirani, chief executive officer of Creditex, the Delphi protocol is “a giant step towards the eventual cash settlement of indices and single names in the CDS market.” Others agree, and cite the fluctuations of the price of Delphi cash bonds in the days before the settlement of CDS positions as evidence of the market distortions than physical settlement precipitates.
According to some reports, a conservative estimate of where Delphi bonds should be trading at this time was 40 cents on the dollar. In fact, they rallied to almost 70 cents on the dollar as the date of settlement neared.
“There were only a small amount of bonds and distressed debt desks were scooping them up as they knew CDS desks would be needing them for settlement,” says one trader. Buyers of protection thus receive a much thinner margin for the bonds delivered for settlement than would otherwise be the case. “Cash settlement would alleviate a lot of problems,” says another New York banker.
Approval
Cash settlement has been distrusted by banks in the past as they feared that the dealers would manipulate the price. The success of the last three auctions has erased some of these concerns, say dealers. The migration of the market to universal cash settlement of CDS positions will not meet universal approval.