Streetwise Professor

Thinking about credit derivatives makes my head hurt–and I get the feeling that goes double or triple for most central bankers, who view them as the nitroglycerine of modern finance, powerful, useful, and highly unstable (and destabilizing). I am less concerned than they about the adverse consequences of the CD market, although the well-documented shoddy back office practices are worrisome. I have not made a detailed study of the implications of CDs for the stability of the financial system, but they are facing one problem that I do know a lot about.

Specifically, some of the recent credit blowups (e.g., Delphi, Calpine) created a situation where the supply of bonds deliverable against credit derivatives contracts was far smaller than the open interest in these contracts. This has caused disruptions in the market, and raised the specter of squeezes–and squeezes are my meat.

Here’s the basic issue. Many credit derivatives call for the bonds of a bankrupt firm to be delivered to settle the contract. For instance, if I sell default protection against company X’s bonds, if X goes belly up I have to settle my credit derivative position by delivering X’s bonds. Well, what happens when there are $10bn of CDs outstanding, but there are only $1 bn of bonds available to be delivered against them? In the case of Delphi, things were even more extreme–the open interest in Delphi CDs totaled $25 billion, but there were only $2 billion of Delphi bonds available for delivery against the CDs in the event of a default. (There is some uncertainty over what goes into this $25 billion. It may be all in single name Delphi credit default swaps. It may include, however, Delphi notionals included in collateralized default obligations and default index swaps, both of which are written on multiple names.)

If the market is competitive, that isn’t an issue. It happens in futures markets all the time. It is not unusual for the maximum open interest in a futures contract to exceed the deliverable supply by orders of magnitude. A competitive futures market can liquidate quite nicely under those conditions as long as there isn’t too much concentration in long positions. The futures contract will settle at the marginal cost of delivery/marginal value of the deliverable asset with few deliveries being made. (The lack of a centralized market mechanism for trading credit derivatives may make the liquidation process somewhat more cumbersome, but the main parties all have each others’ phone numbers, so liquidation of a large open interest under competitive conditions still shouldn’t be that challenging.)

The problem arises when one firm or colluding group of firms obtains a long position that is bigger than the supply that can be delivered at the competitive price. Under those conditions, the long can squeeze the shorts, and refuse to liquidate unless the shorts pay a supracompetitive price to settle their positions.

This could happen in the CD market. Somebody goes way long in a CD and demands delivery of more bonds than are available at the competitive price. Or goes “Texas”–i.e., goes way long the CD and the deliverables–and demands delivery of more of the remaining float. Could happen. May have already happened–It’s an issue that’s worth looking into.

Squeezes like this are an exercise of market power. In several articles and my manipulation book, I refer to them as “market power manipulations.” They might actually be more of a concern in CD markets as compared to futures markets because in the latter, when delivery will occur is known and hence market participants can mitigate (though not eliminate) market power by preparing to make delivery in advance. However, in CD markets, the timing of delivery is random–it depends on when the credit event occurs, and credit events arrive randomly. Thus, there may be a possibility of a mad scramble if a credit event occurs earlier than market participants had expected.

Many major CD players think they have come up with a solution to this problem–have an auction for the deliverable bonds, and use the auction price to settle the contract. That is, make CDs cash settled, rather than delivery settled. Working through ISDA, parties to CDs tied to Delphi that should have been settled by physical delivery agreed to implement a cash settlement mechanism instead. The cash settlement prices were based on auctions of the bonds underlying the CDs.

The conventional wisdom in derivatives markets (and not just CD markets) is that cash settlement can eliminate the possibility of a squeeze. Sorry to break it to you folks, but as usual the CW is wrong. A paper I published in the Journal of Business in 2001 shows that I can always design a delivery settled contract that is less susceptible (or at least no more susceptible) to a squeeze by large longs than any cash settled contract you design.

The intuition is pretty straightforward. A corner in a delivery settled contract works by the long demanding too many deliveries. This forces shorts to bid up the price of the deliverable above the competitive level in order to satisfy the long’s excessive demands. Similarly, somebody long a cash settled contract can force up the spot price against which the contract is settled by buying too much of the reference instrument(s) in the cash market himself. Either way, the long can liquidate the futures position at a higher price.

If there is one instrument deliverable against the delivery settled contract, and the price of the same instrument is used to settle the cash settled contract, the contracts are equally manipulable. However, if there are multiple reference issues used to determine the price of the cash settled instrument, I can design a delivery settled contract allowing delivery of these same reference issues that is less subject to manipulation.

Why? The delivery settled contract usually gives the shorts the choice of what to deliver. They will deliver the instruments whose prices are least responsive to additional buying pressure. In contrast, somebody long a cash settled contract can concentrate their buying activity on the instruments whose prices are most responsive to buying pressure in order to maximize the price impact. Put differently, when there are multiple deliverables/reference issues, cash settlement gives more power to the longs, but delivery settlement gives more power to the shorts. Since it is long market power that is the danger in most circumstances, it’s pretty obvious that delivery settlement is preferable.

As I demonstrate in my JOB piece, to be less susceptible to manipulation, the delivery settled contract must have price differentials (delivery premia and discounts) that reflect competitive price differentials. For instance, if value of deliverable A is $.10 greater in a competitive market than deliverable B, the delivery settled contract should give a $.10 premium to delivery of A. Otherwise, B is the “cheapest to deliver” and all of the large long’s delivery pressure is concentrated on that deliverable until its price is distorted by $.10. Nonetheless, a judicious choice of delivery premia/discounts results in a delivery settled contract that is less susceptible to a squeeze than a cash settled one. Put differently, the supply of bonds is more elastic in a delivery settled contract with appropriately chosen delivery differentials than is the case with a cash settled contract.

Thus, the CD fix isn’t a panacea. Indeed, it could make things worse! The next time somebody goes way long CDs on a name that defaults, the fact that the issue is cash settled will not reduce the susceptibility to the squeeze. The large long can buy a lot at the auction, drive up the price, and enhance the value of the long position. So much the better (for him) if he’s already gone Texas and can withhold securities from the auction.

Now I understand that setting delivery differentials on a CD may present some challenges. The difficulty of setting delivery differentials on government bond futures contracts has created the potential for squeezes in those markets. (Merrick, Naik & Yadav’s RFS paper “Anatomy of a Squeeze” illustrates how this happened in the UK Gilt futures market.) Nonetheless, this analysis suggests that it would be better to devote resources to specifying appropriate delivery differentials than to creating a cash settlement mechanism.

There is some information that is consistent with the hypothesis that Delphi CDs were squeezed in spite of (or because of!) the auction. According to a Nomura Fixed Income Research report, immediately after the auction the price of Delphi bonds fell from 68 to 64. This is consistent with a “burying the corpse” effect that is characteristic of a squeeze.

If squeezes like this are perceived to be a problem, deterring them will require doing something else other than cash settlement. I don’t know what legal options are available here. Would the Commodity Exchange Act’s or Securities Act’s anti-manipulation provisions apply to credit derivatives? Are CDs “commodities” under the terms of the CEA? Does the fact that a manipulation in the CD market would induce “artificial” movements in the prices of registered securities bring such conduct under the aegis of the Securities Acts? Would large market participants have recourse to lawsuits–individual or class action? Any legal eagles have any answers?