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Capital Markets

Delphi protocol limits CDS turmoil

The procedure is an important step towards the cash settlement of the entire CDS market.

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.

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