Streetwise Professor

June 11, 2007

More on Credit Derivatives Cash Settlement

Filed under: Derivatives — The Professor @ 2:57 am

Former FRBNY President Gerald Corrigan made a call for cash settlement of credit derivatives in the event of a default. This WSJ article doesn’t state whether one of Corrigan’s rationales was that cash settlement would make credit derivatives less vulnerable to manipulation. (Nor did any of the other press coverage that I found via Google.) I hope not, as I blogged last year this is NOT a reason to adopt cash settlement. A cash settled contract is as vulnerable, and perhaps more vulnerable, to a market power manipulation as a delivery settled one. I would also note that cash settlement is viable only to the extent that there is a reliable, independent price discovery mechanism that can be used to determine the settlement price. An auction of defaulted securities, combined with cash settlement, will provide the price discovery mechanism, but will not reduce the frequency or severity of manipulation (of the corner/squeeze variety) of these instruments.

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