Dealers in the credit default swap market are working on an alternative to the net physical settlement procedure that the International Swaps and Derivatives Association is spearheading to cash settle credit default swap trades. A source familiar with the talks said the alternative measure would be similar to protocols established to cash settle index trades for individual credit events.
A source on the buyside said the alternative has been put forward to satisfy those who want to be able to cash settle CDS instead of physically settle CDS. "Customers who want to cash settle do not have the right to do so. This new proposal gives them an option to cash settle," said the source. He added that those who want to physically settle CDS would still be able to do so. The new proposal would allow people to choose either option. Cash settlement is unpopular with some because investors who have large CDS exposure can influence the price of the cash settlement through trading. But others prefer cash settlement because buyers of protection do not have to buy bonds to deliver into contracts. "Cash settlement is a much easier process," said the source.
He said details of the alternative procedure are still in the early stages, but there is talk of creating a protocol procedure similar to those created to cash settle CDS trades for bankrupt companies such as Delphi Corp., Dana Corp. and Calpine Corp. The difference is that future protocols would include single-name trades. These types of trades have been left out of previous protocols, partly because of the difficulty of including them within the 30-day time frame that buyers and sellers of CDS have to settle trades after a credit event. But the source said there is now a strong effort to include them because the market is comfortable with how protocols work. Observers say the CDS protocol for Dana, for example, went off without a hitch.
The net physical settlement procedure that ISDA has spearheaded to physically settle single name, index and tranche trades for all credit events, is still the market's ultimate goal, said another source close to the talks. Some worry that the net physical settlement will not be ready in the near future. ISDA will not commit to a time frame when it anticipates the settlement will be completed. "I would be very surprised if anything is achieved before the end of the year," said the buysider. An ISDA spokeswoman confirmed that the market is considering a variety of different options, but would not comment specifically on alternatives. "Talks are in flux," she said. "There could be a net physical settlement or there could be a cash settlement. There are various possible outcomes." She added that the various viewpoints in the market on what a final solution should be have resulted in a variety of options being considered. Dealers and buysiders are meeting once a week now to discuss a solution, she said.
