Are CDS Auctions Biased and Inefficient?

Abstract

We study the design of credit default swaps (CDS) auctions, which determine the payments by CDS sellers to CDS buyers following defaults of bonds. Using a simple model, we find that the current design of CDS auctions leads to biased prices and inefficient allocations. This is because various restrictions imposed in CDS auctions prevent certain investors from participating in the price discovery and allocation process. The imposition of a price cap or floor also gives dealers large influence on the final auction price. We propose an alternative double auction design that delivers more efficient price discovery and allocations.

The Anatomy of the CDS Market

“…More broadly, our paper relates to a growing literature that investigates the effects of CDS markets on information transmission, risk transfer, and credit market outcomes(Acharya and Johnson (2007),Qiu and Yu (2012),Minton et al (2009),Ashcraft and Santos (2009),Hirtle (2009), and Saretto and Tookes (2013)), as well as a growing theory literature on the uses of CDSs(Duffee and Zhou (2001),Parlour and Plantin (2008),Thompson (2009),Parlour and Winton (2013),Bolton and Oehmke (2011), Zawadowski (2013),Atkeson et al (2015),Che and Sethi (2014),Fostel and Geanakoplos (2012), andOehmke and Zawadowski (2015)). Du and Zhu (2013),Gupta andSundaram (2012), andChernov et al (2013) investigate CDS settlement auctions.…”

Credit Default Swaps: A Primer and Some Recent Trends

“…Since 2009, an auction system has been in place with the purpose of obtaining a postdefault market price that determines the loss in default and that the contract holders have committed to use for cash settlement. Helwege et al (2009) focus on price discovery in these CDS auctions, whereas Chernov, Gorbenko & Makarov (2013); Gupta & Sundaram (2015); and Du & Zhu (2017) all raise concerns about the format of the auctions.…”

The Long and Short of It: The Post-Crisis Corporate CDS Market

“…The protection seller then pays the difference between the par value and this auction-identified price per unit of the contract notional to the protection buyer. Gupta and Sundaram (2015), Chernov et al (2013), and Du and Zhu (2017) study theoretically and empirically the auction mechanism to determine settlement price.…”

“…For a detailed discussion of the auction mechanism and its efficiency, seeHelwege et al (2009),Gupta and Sundaram (2015),Chernov et al (2013), andDu and Zhu (2017).…”