Credit Event Auctions

A credit default swap pays out if a company defaults, but a default doesn't come with an obvious payout number attached — bonds from the same defaulted company can trade at different prices depending on which bond it is. Before 2009 this meant every CDS holder had to physically deliver a bond to their counterparty to settle, which caused a scramble: far more CDS contracts existed than deliverable bonds, so demand for bonds to hand over could spike, distorting the very recovery price the swap was supposed to be based on.

The industry's fix is a credit event auction, run by ISDA-appointed dealers shortly after a determinations committee confirms a default has occurred. Dealers submit bid and offer quotes on the defaulted company's bonds; those are used to set an initial price, and then market participants submit further orders to buy or sell at that price, which the auction uses to true it up into a single final number. Every CDS contract on that name then cash-settles at the same recovery price, regardless of which specific bond a holder might have owned.

The auction price also becomes the reference recovery rate quoted in the news and used in post-mortem analyses of the default, making the process transparent as well as orderly — a marked improvement over the ad hoc scrambles that preceded it.