How does the CDS credit event auction work?

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AcadiFi · Accepted Answer

The credit event auction, run by ISDA and Markit/Creditex after a determinations committee (DC) declares a credit event, establishes a single final price for deliverable obligations, allowing cash settlement of all outstanding CDS contracts at a standardized recovery rate. It has two stages. Stage 1 collects dealer initial markets (bid/offer quotes on a fixed-size deliverable basket) and physical settlement requests — participants who want to physically deliver bonds in exchange for par. The initial market midpoint (IMM) is set as the average of non-crossed midpoints. Stage 2 holds a single Dutch auction: an open order book matches physical settlement requests against limit orders, and the final price is set at the level that clears all requested deliveries. The final price might be 37.25 cents on the dollar, meaning the recovery rate is 37.25% and the CDS payout is 62.75% of notional. For Borealis Shipping's default auction, if final price is 28.5, a protection buyer holding $100M notional receives $71.5M and the contract terminates. Why an auction? It avoids the mess of physical delivery when CDS notionals vastly exceed deliverable bond supply — a squeeze would distort recovery. The auction creates a clearing price reflecting true market value. FRM tests the mechanics and timing, and the recovery rate directly affects both pricing and risk calculations.

How does the CDS credit event auction work?

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