The Situation: Fears of a potential short-squeeze in the upcoming Sears CDS auction have kicked off disputes in a variety of venues.
The Result: One of these disputes caused the fourth-ever convening of an ISDA CDS Determinations Committee external review panel and another made its way before the Sears bankruptcy court.
Looking Ahead: The CDS industry is now grappling with questions regarding whether the CDS auction rules should be changed and, if so, whether those changes should be applied prospectively or retrospectively.
The credit derivatives industry underwent a massive overhaul in 2009 as the International Swaps and Derivatives Association ("ISDA") implemented the credit default swap ("CDS") "Big Bang" to increase certainty, efficiency and uniformity in the global CDS markets. Two of the Big Bang's hallmark innovations were the establishment of the Credit Derivatives Determinations Committees (the "DCs") and the specification of an auction process (the "Auction Process") to be the industry-standard settlement method for CDSs. ISDA formed the DCs to provide expeditious market-wide credit event determinations and the Auction Process to serve as a means of settling CDSs on a uniform market-wide basis.
Prior to the Big Bang, the default method for settling corporate and sovereign CDSs was physical settlement only, which meant buyers of protection had to procure physical "Deliverable Obligations" in order to be paid upon the occurrence of a credit event. This could be a challenge for protection buyers and it was exacerbated by the fact that protection sellers had the right to declare credit events and could do so opportunistically at times of low liquidity in the debt of the underlying "Reference Entity." The Big Bang introduced (or, more accurately, formalized) the Auction Process in part to address the problem of "short-squeezes" on Deliverable Obligations that had arisen or had threatened to arise on a number of occasions. Over the past decade, the DCs have resolved hundreds of important questions and over a hundred auctions have resulted in CDS trades settling at market-clearing prices. Concerns over a potential short-squeeze on Deliverable Obligations in the Sears bankruptcy, however, are now raising questions over the integrity of the Auction Process itself.
The Auction Process has two phases and, in addition to setting the price at which CDSs settle, involves cash purchases of Deliverable Obligations. In the first phase, parties submit orders to purchase or sell Deliverable Obligations at the auction clearing price (the "Auction Final Price"), and the net open interest (the "NOI") to buy or sell Deliverable Obligations is determined. In the second phase, parties place limit orders that are filled against the NOI (at increasing levels for NOI to buy and at decreasing levels for NOI to sell) until either the NOI or the limit orders have been exhausted. The Auction Final Price is typically set at the level of the last trade that fills, but it can result in a price of 100% (or 0%) if the NOI is not exhausted during the second phase. All sales of Deliverable Obligations clear at the Auction Final Price and all CDS trades pay out at 100% minus the Auction Final Price (with a floor of 0%).
The Sears auction is raising concerns that the buy orders submitted in the first phase will overwhelm the sell orders placed in the first and second phases, causing an Auction Final Price of 100% (and no CDS payouts) despite the fact that the Deliverable Obligations are expected to recover far less than 100%. The notional amount of orders a party can place in a CDS auction is technically capped by its own net exposure in the first phase and by the total NOI in the second phase. However, sell orders in practice are effectively capped by the available amount of Deliverable Obligations, while no similar limitation exists for buy orders. If the CDS exposure of a protection seller (or group of protection sellers, whether or not acting in concert), significantly exceeds the amount of Deliverable Obligations available to be delivered into the auction, that seller or group of sellers can profit by submitting buy orders that result in purchases at an over-value (e.g., 100 cents on the dollar) for a lesser face amount of Deliverable Obligations and avoiding payment altogether on a greater notional amount of CDSs.
The scarcity of Sears Deliverable Obligations relative to the net CDS exposure has led to unusually intense disputes over the scope of instruments that should be considered "Deliverable Obligations" for purposes of the Auction Process. In connection with certain second lien loans, the DC failed to achieve consensus and, for only the fourth time ever, an external review panel was convened in accordance with the DC rules to decide the question. On December 19, 2018 that panel unanimously concluded that each of the loans met the characteristics of a "Consent Required Loan" and therefore qualified as a Deliverable Obligation. While the DC was (barely) able to reach the requisite supermajority consensus to determine that certain medium terms notes qualified as Deliverable Obligations, the sale of some of those notes and the lock-up of others were challenged in the Sears bankruptcy court.  The DC rejected requests to add other bonds and loans to the auction despite the fact that they admittedly did not strictly qualify as Deliverable Obligations.
The DC has also rejected repeated requests  to (arguably retrospectively) amend the Credit Derivatives Auction Settlement Terms (the "Auction Terms") for Sears to limit the amount of buy orders a party can place, and it is now considering a request to postpone the CDS auction, currently scheduled for January 17th, until after a sale hearing takes place in the bankruptcy court when more Deliverable Obligations may be available to the market.
Regardless of how the Sears auction plays out, we may see increased market and regulatory pressure to mitigate short-squeeze risks going forward. Market participants, as encouraged by regulators, have already been working to amend the 2014 ISDA Credit Derivatives Definitions and the Credit Derivatives Determinations Committees Rules to address concerns regarding narrowly-tailored credit events. Consideration of modifications to the Auction Terms to address the risks of short-squeezes might be a good candidate to add to that agenda. It is quite possible that as the Big Bang's tenth anniversary approaches, the CDS industry will again be remade. In the meantime, it remains important for CDS market participants to be aware of the risks and opportunities presented by the relative size of the CDS and cash markets for a given credit as well as, if known, the identities and motives of the holders of the positions.
Three Key Takeaways
- While successful in many respects, the auction settlement process hardwired into CDS trades has apparently not yet entirely achieved one of its primary goals, which is to prevent short-squeezes.
- As a result of the tumultuous Sears CDS auction process, the industry may face increased market and regulatory pressures to amend the CDS auction terms to address this issue.
- In the meantime, market participants should make efforts to educate themselves as to situations in which CDS exposures exceed the amount of debt instruments that would be practicably deliverable into a future CDS auction.
For further information on complex international disputes in front of the NCC and NCCA, please contact your principal Firm representative or the lawyers listed below. General email messages may be sent using our "Contact Us" form, which can be found at www.jonesday.com/contactus/.
George J. Cahill
Locke R. McMurray
Jayant W. Tambe
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