Market participants are voicing concerns about the imbalance between credit default swaps on certain credits and the bonds that are deliverable to settle those CDS contracts. Speaking at an II Events conference on CDS & LCDS in New York last week, Mark Delaney, senior portfolio manager at GE Asset Management, said it is difficult to quantify the risk of an imbalance if it exists, but the market should be aware of the problem. This imbalance comes about because market participants do not necessarily have to hold bonds to buy protection against securities. And with no official figures, it is virtually impossible to tell how large the imbalance is.
Delphi Corp. demonstrated that risk of imbalance when it saw a short squeeze on its bonds after it filed for bankruptcy in October last year. Delphi bonds climbed 10 points after buyers of single-name CDS scrambled to buy bonds to physically deliver into CDS contracts. The market fears a much greater short squeeze could happen if there were a default of a larger credit, such as General Motors Corp. or Ford Motor Co., which are both said to have a large imbalance between CDS written on the name and the securities that can be delivered to settle the CDS.
The International Swaps and Derivative Association's CDS cash settlement protocol is designed to solve this problem by creating a cash settlement procedure that includes single-name, index and tranche CDS. The inclusion of single names is designed to prevent a short squeeze on bonds by preventing buyers of protection from having to physically deliver bonds to CDS contracts (CIN, 9/11). An ISDA spokesman said, "The protocol is designed to address any potential imbalance in the amount of available paper and the amount of protection written by offering the cash settlement option."
However, the protocol has yet to be tested and some say it is unknown as to what extent it will prevent a short squeeze. Gerald Corrigan, managing director at Goldman Sachs, called ISDA's protocol a giant step forward, but that it is not the end game. The next step, he said, is a universal system of cash settlement and he cited efforts to create a warehouse facility that would include information on all CDS trades. The Depository Trust and Clearing Corp. is working on such a system.
Another source familiar with the protocol said he thinks the risk of a short squeeze on bonds should be reduced through ISDA's cash settlement protocol, but it will be difficult to predict how effective it will be until an auction occurs. He predicted most people will want to cash settle to avoid the risk the bonds will be bid up, but he said the risk exists that some may choose to physically settle if they think they can buy the bonds cheaper than the price determined through the auction under cash settlement. The option to physically settle was added to the protocol to appease those who own bonds and want to make sure they are physically deliverable (9/11). The ISDA spokesman said the main rationale of signing up to the protocol is to cash settle. The association believes it is likely a small portion of the market may always want the option to physically settle, but not a majority.
One dealer predicted, that despite the ISDA protocol, many market players will still choose to physically settle CDS and that there could still be a squeeze on bonds when there is a perceived imbalance between the CDS and the securities available for physical settlement. He also pointed out that cash settlement is open to manipulation, explaining that because cash settlement is based on the price that bonds are trading at when the auction takes place, the market can easily manipulate the price. "People will go along with cash settlement, but it is still open to manipulation by the market," he said.
The ISDA spokesman said the auction process, as successfully executed in the last six credit events, is a good faith effort to establish a market price.
