CDS Auctions: An Overview
A credit default swap (CDS) is a credit derivative that can be used as insurance against a reference entity's credit risk, where a reference entity is either a government or corporation that has issued debt. If a party owns equal amounts of bonds and CDSs for a particular reference entity, then the party is completely insured against a negative credit event. However, unlike insurance, it is possible to own more of the CDS protection than of the underlying bond. In this way, CDS contracts make
... DS contracts make it possible to trade on an entity's credit risk without having exposure to the entity's actual bonds. Figure 1 summarizes how CDS contracts work. A CDS contract is a bilateral agreement between a protection seller and a protection buyer. The former is taking a short position in the CDS, while the latter is taking a long position. The protection seller compensates the protection buyer if there is a credit event with respect to any of the bonds issued by the contract's reference entity. Credit events include bankruptcy, failure to pay, and restructuring, among others. In exchange, the protection buyer makes periodic interest payments to the protection seller until the contract expires. CDS auctions are the main settlement mechanism for CDS contracts. The auction provides a unique price for the defaulted bond, which directly impacts the amount that the protection seller needs to pay the protection buyer if a credit event occurs. In this way, CDS auctions have direct in ‡uence on payouts in the CDS market, a market that had approximately $10 trillion in contracts outstanding by the end of 2007. 1 Considering the size of the CDS market, understanding how CDS auctions function is extremely important for CDS users and regulators. Any opinions expressed are those of the authors and do not necessarily re ‡ect those of the Federal Reserve Bank of Richmond or the Federal Reserve System.