On September 29, 2008, ISDA published a final settlement protocol for the Fannie Mae and Freddie Mac Credit Event under ISDA-documented credit default swaps (excluding referenceobligation- only, fixed-recovery, loan-only and preferred credit default swaps). The protocol is typical of previous settlement protocols, except that it includes all of Fannie Mae’s and Freddie Mac’s eligible deliverable obligations, rather than only selected deliverable obligations.

Background

Credit default swaps under which a Credit Event has occurred are settled in one of two ways: by physical settlement (i.e., the exchange of debt obligations for their outstanding principal balance) or by cash settlement (i.e., the payment to the protection buyer of the difference between an agreedupon reference market value of those obligations—typically, 100%—and their estimated market value at the time of settlement). While physical settlement avoids the uncertainties of the estimation process, it can both cause and become impaired by market illiquidity—most notably the “short squeeze” condition that constrains supply and increases prices as protection buyers all simultaneously seek to buy the same debt obligations for use in settling their credit default swaps. As the credit default swap market has grown, it has, with the help of ISDA, moved toward a hybrid form of settlement, in which the parties cash settle their transactions using a market-value that is not merely estimated, but generated by a carefully choreographed set of market transactions. The combination of parties’ agreement to cash-settle their trades using this special market value and their potential participation in the value-generating market transactions together constitute a “CDS protocol.” These protocols have been tested by the credit default swap market, and their parameters improved, over the course of a number of major Credit Events, including the Dura bankruptcy and the current Fannie/Freddie events.

The Protocol

Each CDS protocol consists of two price-generating auctions (we will refer to them here as a “Preliminary Auction” and a “Main Auction”), separated by an “Open-Interest Determination” process in which the unsatisfied, or “open,” buy- or sell-side interest in the deliverable obligations (“DOs”) is determined.

Preliminary Auction

Only dealers participate in the Preliminary Auction, in which they each submit a bid and an offer for a predetermined quantity (i.e., outstanding principal amount) of the DOs designated as eligible for purposes of the protocol. Each dealer’s bid and offer may differ by no more than a predetermined spread, and dealers whose respective bids and offers touch or cross (i.e., where the bid is equal to or higher than the offer) are each penalized by being required to pay a penalty amount to ISDA that is used to defray the costs of administering the protocol. Of the non-touching and non-crossing bids and offers, the half that exhibit the narrowest bid-offer spreads are used to calculate a midmarket price called the Inside Market Midpoint, which is used as a constraint on the Final Price that will be determined in the Main Auction.

Open-Interest Determination

The participants in the protocol will cash settle all their credit default swaps at the Final Price determined by the protocol. However, some of them nonetheless may want, in addition, to sell DOs (for example, those who already hold “cheap” DOs) or receive DOs (for example, those who need to acquire DOs to deliver under physically settled transactions with parties who did not adhere to the protocol). The protocol allows these parties to buy or sell DOs by means of bids or offers they place in the Open-Interest Determination and the Main Auction. For the Open-Interest Determination, each dealer (directly) and any customer of a dealer (through that dealer) may submit to the protocol administrator a Physical Settlement Request specifying how much of the DOs it wants to buy or sell (it may not specify more than its aggregate net position under all its credit default swaps that will settle at the protocol’s Final Price). These Physical Settlement Requests specify a quantity, but not a price, and they will be settled at the Final Price that will be determined by the Main Auction. The administrator then compares the respective sums of the Physical Settlement Requests to buy and sell DOs; the excess demand to buy or sell constitutes the market “open interest,” for which participants will bid or offer in the Main Auction, which is essentially a modified Dutch auction.

Main Auction

After the direction (buy or sell) and quantity of the open interest is determined and announced, anyone (regardless whether or not an adherent to the protocol or a party to a credit default swap) who desires to bid or offer for a portion of that interest may submit a limit order (specifying a quantity and limit price) to buy or sell DOs, depending on whether the open interest is to sell or to buy. These limit orders will be matched against the open interest in the Main Auction. The market-clearing price in that auction becomes the Final Price for use in the physical settlement of all the Physical Settlement Requests, limit orders and inside market quotes (either bids or offers, depending on the direction of the open interest) and the cash settlement of all the credit default swaps covered by the protocol. Now, if the open interest is small relative to a party’s net long or short exposure under its credit default swaps that are covered by the protocol, it might be worthwhile for such a party to place an unrealistically-priced limit order in order to produce a Final Price that would earn it more on its cash settlements than it would lose on its limit order. This brings us to the value of the Inside Market Midpoint: it serves as an important item of information that may inform the bids/offers of those who participate in the Main Auction, it serves to limit the aforementioned potential price manipulation in that the protocol constrains how far the Final Price may be above or below (depending on the direction of the open interest) the Inside Market Midpoint and it serves as the Final Price itself in the event that the Open-Interest Determination determines that there is no open interest.

A Special Case: the Fannie/Freddie protocol

Past protocols have concerned Bankruptcy Credit Events in which all obligations of the Reference Entities had been presumed to have been accelerated and to be trading at essentially the same price—namely, their recovery value. Since none of such obligations was trading at a discount to others, none of them was cheaper to deliver than the others. Accordingly, the protocols designated only a few of these as deliverable under the protocols, since it was assumed that doing so would not prejudice any of the parties. The obligations of Fannie Mae and Freddie Mac, however, will not be accelerated, and thus those that have either a lower coupon or longer maturity (other things being equal and presuming long-term rates exceed short-term rates) will trade at a lower price and be cheap to purchase for delivery under the Fannie/Freddie protocol. In order to preserve this cheapest-to-deliver option (which the credit default parties are presumed to have priced into their credit default swap transactions), the Fannie/Freddie protocol designates as DOs all the Fannie Mae and Freddie Mac DOs that are eligible DOs under the 2003 Credit Derivatives Definitions, rather than only a few of them. The only issue raised as to DOs in the Fannie/Freddie protocol has been the eligibility as DOs under the 2003 Credit Derivatives Definitions of certain STRIPS (i.e, principal-only products issued in the secondary market in respect of Fannie/Freddie bonds— products that would inherently be cheap to deliver because they trade at a deep discount to par). ISDA has received a legal opinion that these are not valid DOs.