The deterioration in the credit markets over the past year has caused investors to focus on the operational and counterparty risks embedded in the closely-related credit derivatives market. In particular, buyers of credit default protection increasingly worry about their ability to realize the "recovery value" of the assets underlying the derivative transaction from their counterparty promptly after a credit default.
Investors in the U.S. derivatives market recently have begun to purchase and sell protection against the default of leveraged loans using: (i) the single-name syndicated secured loan credit default swap (LCDS), (ii) the index form of LCDS (LCDX), or (iii) the tranched version of LCDX (Tranched LCDX). Investors in the LCDS/LCDX family of products may sleep more soundly than investors in other derivative transactions due to a key design feature hard-wired into the products: prompt cash settlement through a binding, marketwide auction capable of generating trusted recovery values.
The same auction technology is currently being adapted for use in Europe in connection with cash settlement of the European family of leveraged loan credit default swap and index products. Once finalized, the European loan credit default swap and index will be the first European derivative products to use a market-wide auction to set recovery values for cash settlement. This reflects the markets desire for a more efficient determination of recovery values, -- one that overcomes the difficulties in valuing the deliverable loans and physically settling multiple loan transactions.
This memorandum explains why traditional "physical settlement" of LCDS/LCDX presents intractable difficulties, and why cash settlement is the desired alternative for a majority of derivative counterparties. In addition, the memorandum outlines the complex methodology used for LCDS/LCDX auctions, referencing the actual procedures used in the recent auction held for Movie Gallery, Inc. first lien loans as an example.
After a credit event occurs under a credit default swap, protection buyers traditionally receive the benefit of their credit protection through physical settlement of the swap. This means that a protection buyer delivers an eligible debt obligation to, and receives a par payment from, its protection seller. But physical settlement raises a number of issues, some of which are exacerbated by the complex nature of the underlying loans referenced in the LCDS/LCDX products.
First, physical delivery of a loan can be cumbersome and time-consuming. While the "Physical Settlement Rider" published by The Loan Syndications and Trading Association, Inc. attempts to ameliorate these problems by codifying standards and conventions used to physically settle LCDS and LCDX transactions, the process will still strain operational resources at institutions with a large number of LCDS/LCDX transactions. Second, since the aggregate notional amounts of LCDS/LCDX transactions will likely exceed the outstanding principal amounts of the underlying loans, a short squeeze?in the loans may occur, when many protection buyers have the simultaneous need to purchase the loan in the cash market in order to physically settle their swap transactions. A short squeeze produces artificial inflation and increased volatility of the price of the deliverable loan after a credit event, and may also prolong market-wide settlement timeframes in LCDS/LCDX transactions.
Cash settlement, on the other hand, enables derivative counterparties to settle LCDS/LCDX transactions without the delivery of a loan: instead, protection seller pays to protection buyer the difference between par and the market price, or recovery value, of the loan. The critical difficulty in cash settlement is finding a trusted market price in a potentially illiquid market. A bilateral price-discovery mechanism agreed on between two swap counterparties may be capable of generating a trusted price, but it still exposes the counterparties to basis risk if they are unable to settle offsetting trades with all other market participants at the same price. Therefore, the key to a successful cash settlement mechanism is the ability to find a trusted market price to clear all LCDS/LCDX trades.
Application of Cash Settlement to LCDS/LCDX
In May 2007, the LCDS standard terms supplement was amended by the International Swaps and Derivatives Association, Inc. to provide for cash settlement at an auction-generated price to the extent a successful auction occurs with respect to the relevant reference entity and its loans of the relevant lien.1 In addition, the standard terms governing both the LCDX product and the Tranched LCDX product, published by ISDA in May and September 2007, respectively, contain the same cash settlement requirement for all component transactions in the index.
The auction mechanism devised for LCDS/LCDX is based squarely on the ISDAsponsored CDS auction mechanism, which was first used in June 2005 to cash settle outstanding CDS contracts after the bankruptcy of Collins & Aikman Products Co., and has been tested and refined in connection with its use following credit events in the CDS market involving Delta Air Lines, Inc., Northwest Airlines, Inc., Delphi Corporation, Calpine Corporation, Dana Corporation, Dura Operating Corp. and, most recently in February 2008, Quebecor World Inc. The Dura CDS auction methodology, published in November 2006, was modified to create a mechanism that could be used to determine the price of a secured loan, and the resulting LCDS/LCDX auction mechanism was published by ISDA in September 2007. The LCDS/LCDX auction mechanism was first used in October 2007 to cash settle LCDS and LCDX contracts referencing Movie Gallery first lien loans.
The remainder of this memorandum outlines the basic terms of LCDS/LCDX auction settlement terms, and explains how those terms were customized for the Movie Gallery auction.
LCDS/LCDX Auction Methodology
The goal of the auction methodology is three-fold: to (i) determine a Final Price of the underlying loan that can be used by the market to settle all LCDS/LCDX transactions covered by the auction, (ii) enable parties voluntarily to physically settle LCDS transactions through the auction at the Final Price, and (iii) dictate the terms of any such physical settlement.
After a credit event, at the request of two eligible LCDS/LCDX dealers, the auction administrator, Markit Group Limited, will poll all eligible dealers to determine whether an auction should be held with respect to the defaulted reference entity. If a majority of eligible dealers vote for an auction, Markit will promptly announce that an auction will be conducted. Markit will then convene dealers to determine (i) the specific terms of the auction, based on ISDA-approved template auction documentation,2 and (ii) the eligible deliverable obligations for that reference entity and lien priority.3
- The Auction
The price-finding process is designed to create price tension, thereby enhance trust in the integrity of the outcome, by blending traditional Dutch auction bidding methodology with the ability to physically transact through the auction at the Final Price. The Auction occurs in two stages, as described below.
- Morning: Markit determines the inside market midpoint and the open interest
On the morning of the auction date, each participating dealer submits (i) an inside market bid/offer pair, representing a bid and an offer price for the eligible deliverable obligations identified in the relevant auction terms, and (ii) physical settlement requests on its own behalf and on behalf of its customers, reflecting requests to physically transact through the auction. Each dealers inside market bid/offer pair must be in a specific lot size and cannot differ in price by more than a maximum spread, each as reflected in the relevant auction settlement terms.4
Markit sorts the inside market bids received from each dealer in descending order and the inside market offers in ascending order. Markit ignores bids and offers that cross or touch (i.e., tradeable markets), and identifies the best half of quotes received in the non-tradable markets, meaning those with the smallest bid/offer spreads. The arithmetic mean of that best half of quotes is the inside market midpoint. This preliminary price will be announced by Markit and will serve as an important reference point for purposes of determining the Final Price, as discussed below.5
Physical settlement requests submitted by a dealer are limited in size and direction by (i) the net market position of all of the dealers LCDS/LCDX transactions, or (ii) the net market position of the customers LCDS/LCDX transactions with the submitting dealer, as applicable. Physical settlement requests to buy will be matched against physical settlement requests to sell, resulting in a market-wide open interest that quantifies the unfilled physical settlement requests and indicates the direction of additional orders (to buy or to sell) that are needed to fill all unmatched physical settlement requests.6
Once the morning session has been completed, Markit will publish the inside market midpoint and the size and direction of the open interest on its website.
- Afternoon: Markit determines the Final Price and the open interest is matched with limit orders
In the afternoon of the auction date, dealers submit limit orders on their own behalf and on behalf of their customers. Unlike physical settlement requests, limit orders are not limited by the net position of LCDS/LCDX transactions of the submitting dealer or customer. Limit orders must be in the direction opposite to the open interest, and will be matched against the open interest in the order of best price to worst price. If the limit orders do not satisfy the open interest, the inside market quotes submitted by dealers in the morning will be used to fill the open interest.7 Once all of the open interest has been matched, the last limit order or inside market quote that is used to match the open interest (i.e., the highest offer in the case of open interest to buy or the lowest bid in the case of open interest to sell will be the Final Price, subject to a cap.8
- Settlement After Auction
LCDS/LCDX transactions governed by the auction will be cash settled at the Final Price. The cash settlement date is prescribed in the auction settlement terms.9
Physical Settlement through the auction is governed by the auction settlement terms as well as the Physical Settlement Rider. Every matched physical settlement request pair, matched physical settlement request/limit order pair, and matched physical settlement request/inside market quote pair will form a matched trade. Parties to a matched trade will be deemed to have entered into an LCDS/LCDX transaction with hard-wired terms provided in the auction settlement terms, for which a Credit Event Notice and Notice of Publicly Available Information are deemed to have been delivered.10 Protection buyer in that transaction must deliver the notice of physical settlement (NOPS) by the second business day after the auction date. If it fails to do so, protection seller then has 15 days to deliver a NOPS and demand delivery of the loan. In lieu of par payment for the loan, protection seller will pay the Final Price to protection buyer.
Failed or Abandoned Auction
If an auction fails or is abandoned, the LCDS/LCDX transactions will be subject to physical settlement pursuant to their own terms, which include the Physical Settlement Rider.
The auction methodology that has evolved through eight CDS credit events and one LCDS/LCDX credit event has successfully generated reliable recovery values of assets underlying the CDS and LCDS/LCDX products in the U.S. Adapting the auction to the European loan credit default swap products will require modifications necessary to suit the underlying European loan market, in which investors face issues such as access to information concerning loans and credit events. The resolution of these issues and a successful auction will initially require unprecedented cooperation among dealers. When these issues are resolved to the markets satisfaction, the European loan credit default swap and index products will benefit from a price discovery mechanism that enables prompt and efficient settlement of the derivatives transactions.