Comment: Europcar auction dented short-sellers but not CDS

By Dan Alderson

Far from showing the CDS market is not fit for purpose, last week's Europcar Mobility Group credit event auction was a lesson that speculative short selling is a dangerous ploy - especially when the trade is crowded.

The 100 cents final price of the Europcar auction on Wednesday caused a furore, since it meant a zero pay-out to buyers of protection on the company's debt. This was dramatically different to what Europcar five-year CDS contracts and bonds had indicated, as well as the 40% theoretical recovery modelled for constituents of the iTraxx Crossover index.

Cue a wave of commentary online and in the press about CDS being a faulty insurance product that had once again left hedgers short-changed. Such dismissals have become a running theme in some quarters as they make for enticing headlines, but they seldom stand up to informed analysis. Europcar's result was no different.

Firstly, it has gone unreferenced in the litany of complaints that credit event auction results will always jump to 100 or zero if limit orders run out - depending on whether the open interest to physically settle contracts with bonds is a bid or offer. Such outcomes are hard-baked into the auction rules, as those who understood the process or consulted auction administrator Creditex's website would know.

In that sense at least the auction worked as intended. There was no operational shortfall or glitch. Two dealers bid for a total of €43.3 million worth of bonds, none submitted offers and the sum of limit order trades failed to match the bids at just €39.5 million. This imbalance permeated through to the secondary market, with Europcar bonds rising above 80 cents on the day amid a hunt for paper.

A different question is why there weren't enough deliverables. Some commentators have blamed it on bonds being locked up by the Europcar restructuring agreement, or hinted that some kind of orchestration was at play. This is a commonplace insinuation whenever CDS auctions produce unexpected results - fitting neatly into the theme of activist investor manipulation and narrowly tailored credit events.

What does not fit neatly is that there is meagre evidence to support such accusations. A more prosaic explanation is that there had been a surge in Europcar CDS protection buying ahead of the auction, with shorters speculating on a low recovery. This dynamic can be evidenced in a big widening of the Europcar bond/CDS basis package in the second half of 2020, with a particular increase towards the end of the year.

Partially this derived from expectations regarding the overall trend for credit event settlement (numerous US high yield CDS pay outs last year were in the single digits). But also there was growing belief a term loan would be included in deliverables and prove even cheaper than bonds to deliver.

Fuelling such hopes in the auction run-up, the Emea Determinations Committee added a €50 million term loan facility agreement dated 27 December 2019, following a challenge to its initial list. This followed KSAC Europe Investments contacting the DC about the agreement between Europcar Mobility Group and Credit Suisse (as original lender, agent and calculation agent), which the DC noted was novated to KSAC among others on 15 October.

Here is not the place to debate the merits or morals of negative speculation, a facet of financial markets that many would say is vital to preserving competitive tension in pricing. But any number of things can stack against one's bet - be it fundamental, technical and interventional - so it is the shorter's funeral if they get it wrong.

French insolvency and restructuring situations are notoriously more challenging to navigate than credit events in some other jurisdictions. But betting on the impact of a small private instrument in any situation is inherently risky, especially if you don't own it. There was little certainty about the price of the Credit Suisse loan and no guarantee any participant would deliver it into the auction.

From all appearances the end result with Europcar was an outsize short position that simply fell foul of a classic squeeze, such as can be found in other asset classes. In the context of views aired online, the irony is that true CDS hedgers - those that protected their cash bond investment with protection or entered into a basis package - do not look to have lost out. Sources Creditflux spoke to report there had been plenty of opportunity to exit the trades at a lucrative level well before speculative shorting took the mismatch to extremes.   

But this does not detract from an essential message about CDS that is all too often ignored or misrepresented. The contracts should not be viewed only as 'a form of insurance' or 'hedging tool', but rather as a tradable investment instrument. Pricing and returns are subject to technical as well as fundamental dynamics, so identifying the interplay of both is essential to gainful use.

It is regrettable there is yet to be a public comment on the Europcar auction by Creditex, the Determinations Committee or IHS Markit. This would help explain what happened and head off negative headlines.

But confidence in CDS should sustain no damage from last week's result. In general the product only becomes more robust over time, as it always goes through a round of strengthening each time it is tested and found wanting. In this instance, however, it has stood up to examination - leaving short sellers to do the soul searching. 


TAGS: CDS Europe High yield bonds Distressed debt Credit derivatives Default