• Home
• Daily
• Newsletter
• Data
• Events
• Resources
• About us

Glossary | Essentials | Round tables You are here: Home > Public zone > Resources

Problems with physical settlement

Following a credit event, the seller of protection under a credit default swap needs to pay the protection buyer an amount reflecting the extent of losses lenders to that credit have suffered. This process is known as credit event settlement.

At the time of publication, physical is the most common form of settlement for single name credit default swaps.

However, as the credit derivative market has grown, several big problems with physical settlement have emerged. One is the practical issue of acquiring and delivering bonds for each contract a counterparty has outstanding on a defaulted name. For active counterparties in the credit derivatives market, the administrative burden of physically settling hundreds or even thousands of individual contracts can be very large.

Another problem is that some protection sellers are not permitted to buy distressed bonds and so are not able to settle credit default swaps physically.

A third problem is that the very process of settling credit derivatives tends to distort the price of a recently defaulted debt obligation. Traders who have bought protection need to go into the market and acquire obligations to deliver to their counterparties. And this causes the value of the defaulted debt to rise. The extent of this technical ‘squeeze’ depends largely on the ratio of credit default swap contracts outstanding to deliverable obligations for the defaulted reference entity.

In an extreme case, where there are many more credit derivative contracts than physical debt obligations, the price of the defaulted bonds and loans could theoretically be pushed up to par. This would make credit default swap protection worthless.

Short squeezes have occurred since the earliest days of the credit derivatives market, for example, after Russia’s default in 1998. However, as the ratio of credit derivatives to cash credit instruments has grown, the tendency for defaulted bonds and loans to be squeezed has increased.

Following the bankruptcy by Delphi in October 2005, the short squeeze is said to have increased the value of the US car parts maker’s bonds by between 10 and 15 percentage points. Dealers were nervous that an artificially high settlement on Delphi – one of the most widely referenced names in the credit derivatives market – would undermine confidence in the product altogether. Some large market participants privately expressed the view that if Delphi settled around 70 cents in the dollar, it would spell the end of the credit derivatives market.

As a result of these problems, and inspired by the success of cash settlement for index credit derivatives, there is a move to create a system of cash settlement for single name credit default swaps. Talks on this issues were continuing at the time of publication.