The International Swaps and Derivatives Association is leading an effort to find a permanent solution for the settlement of credit default swap trades for all future credit events. The association plans to send a draft proposal to members and non-members next week that will lay the groundwork for a formal procedure to physically settle index, tranche and single-name CDS. ISDA hopes to have a final document published and in place by June 20.
So far ISDA has developed cash settlement protocols to settle index CDS trades for individual credit events, such as the bankruptcies of Collins & Aikman, Delphi Corp. and most recently, Calpine Corp. But these procedures are not a good long-term solution, most notably because they have not included single-name CDS, according to market participants. In the case of Delphi, the exclusion of single-name CDS led to a short squeeze on bonds as dealers scrambled to collect bonds to deliver for single-name contracts. "People were happy with the protocols, but they are only a one-off solution. They are not the best way to handle settlements," said John Williams, a senior associate at law firm Allen & Overy.
As under the cash settlement protocols, the draft proposes an auction that would determine the settlement price of CDS trades. The main difference under the new proposal is that it would involve all market participants, not just dealers, and would include index, single-name and bespoke trades. Williams said the draft proposal is very important for the CDS market because it will tie together the settlement price for all CDS trades. "Even though there was a cash settlement protocol for index trades, single-name trades were not included so there was a mismatch between what the protocol trades settled at and the price of the deliverable obligations. Ideally, they should not be different," he said.
But he added that the proposal, if it were to be implemented, would be no easy undertaking. "It is difficult because it would involve a lot of different parties. There are a lot of technical issues to grapple with," Williams said. An ISDA spokeswoman said the implementation of the proposal is a difficult task because of the large amount of information that needs to be collected on all the positions for a particular credit event and cited the bankruptcy of Delphi as an example. She added that a third party vendor that will administer the settlement has not yet been selected.
The draft proposal is still in its early stages and a lot of details still need to be worked out, Williams said. Over the next couple of weeks, dealers will be able to comment on the proposal and it will be subject to further refining.