Credit Default Swap Auction Settlement Mechanism
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Solution Overview
Problem
The complexity in physical settlement of credit default swap contracts due to a large imbalance between notional outstanding contracts and underlying debt instruments, and the lack of an efficient mechanism for determining the expected recovery value for cash settlement, lead to inefficiencies and potential manipulation in the credit derivatives market.
Innovation Solution
A two-stage process is introduced, where the first stage determines the inside market midpoint through submission of inside market orders and market orders for physical settlement, and the second stage calculates a final price for settling imbalances using limit orders, ensuring fair and efficient settlement of credit default swap contracts.
Engineering Contradictions & Design Principles
Engineering Contradiction Analysis
1Reliability
If physical settlement is used for credit default swap contracts, then protection buyers can deliver debt instruments to protection sellers, but the large imbalance between notional outstanding contracts and underlying debt instruments causes price run-up and settlement inefficiency
Solution Approach 1:
The patent segments the settlement process into two distinct stages: (1) determination of the inside market midpoint through polling dealers, and (2) a two-part auction process that separately handles physical settlement and cash settlement. This segmentation allows the system to manage the imbalance between contract notional amounts and actual debt instruments by directing participants to appropriate settlement channels based on their positions and abilities.
Solution Approach 2:
The patent introduces an intermediary auction mechanism that mediates between protection buyers who need to deliver debt instruments and protection sellers who need to receive them. The auction system acts as a central clearinghouse that matches orders, determines prices through competitive bidding, and facilitates settlement without requiring direct bilateral negotiations, thereby improving efficiency and reducing market disruption.
2Ease of operation
If protection buyers purchase debt instruments in the open market for physical settlement, then they can fulfill delivery obligations, but the price of underlying debt instruments runs up due to concentrated purchasing
Solution Approach 1:
The patent implements preliminary actions by requiring protection buyers to submit their settlement intentions and available resources before the settlement date. The auction process is conducted in advance of actual delivery, allowing participants to express their willingness to buy or sell at various price levels. This preliminary expression of intent enables the system to allocate debt instruments efficiently before concentrated purchasing occurs in the open market, thereby mitigating price run-up.
Solution Approach 2:
The patent changes the pricing parameter from market-determined prices to auction-determined prices. Instead of protection buyers purchasing debt instruments at prevailing market prices (which causes price run-up), the system establishes an auction mechanism where prices are determined through competitive bidding. This parameter change transforms the pricing mechanism from passive market acceptance to active auction determination, allowing the system to find equilibrium prices that reflect true supply and demand while preventing artificial price inflation.
3Reliability
If a two-stage process is implemented to determine settlement prices, then market manipulation is reduced and fairness is improved, but the settlement process complexity increases
Solution Approach 1:
The patent segments the complex pricing determination into two distinct stages with clearly defined functions: Stage 1 determines the inside market midpoint through dealer polling, providing a reference price level. Stage 2 conducts a two-part auction that separately processes physical settlement orders and cash settlement orders. This segmentation simplifies the overall complexity by breaking down the monolithic pricing process into manageable, well-defined stages with specific objectives, making the system more transparent and easier to understand despite the increased procedural steps.
Solution Approach 2:
The patent introduces an intermediary auction administrator that manages the complex two-stage process. This intermediary entity coordinates dealer polling, receives and processes auction orders, determines the inside market midpoint, conducts the two-part auction, and facilitates settlement. By centralizing these complex functions in a neutral intermediary, the system reduces manipulation risks while maintaining procedural transparency. The intermediary acts as a trusted third party that follows predetermined rules, reducing the need for participants to directly manage the complexity themselves.
Data Source
AI summary
Systems and methods for settling credit default swap contracts upon occurrence of a credit event are provided. In the first stage an inside market price and imbalance between net sell and buy positions are determined. When there is an imbalance between net sell and buy positions, a second stage is employed to determine a final price for settling the imbalance.