How does a CDS auction work and what's the difference vs physical settlement?

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AcadiFi · Accepted Answer

After a credit event, CDS contracts settle either through auction (cash settlement at an auction-determined price) or physical settlement (protection buyer delivers defaulted bonds in exchange for par). The 2009 Big Bang made auction settlement the default, though parties can still opt for physical.

Auction process (standard today):

(1) ISDA Determinations Committee confirms the credit event and sets the auction date (typically 30 days after trigger).

(2) First stage (inside market) — participating dealers submit bids and offers for a specified basket of deliverable obligations. This establishes the Initial Market Midpoint (IMM) and determines the net open interest (sum of physical settlement requests).

(3) Second stage (limit orders) — participants submit limit orders to buy or sell defaulted bonds. These orders are matched against the net open interest at a clearing price, establishing the Final Price.

(4) All CDS contracts cash-settle at (1 − Final Price) × notional. For example, if Meridiana Airlines defaults and the auction clears at 18.5, protection buyers receive 81.5% of notional.

Physical settlement (legacy and optional):

Protection buyer delivers deliverable obligations (specified bonds or loans) with face value equal to the notional, receiving par in return. Issues include: scramble for bonds among protection buyers, potential short squeeze if deliverable supply is scarce, and operational complexity. The 2002 Conseco CDS controversy — where buyers delivered restructured long-dated bonds at par despite their true value being much lower — was a key motivator for refining settlement mechanics.

The auction process ensures a transparent, market-wide single recovery price, avoiding distortions. CFA Level II tests understanding of both mechanisms.

How does a CDS auction work and what's the difference vs physical settlement?

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