Abstract:
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.

Description:
The present application claims priority under 35 U.S.C. §119 to U.S. Provisional Application No. 60/834,654, filed Aug. 1, 2006, the entire disclosure of which is herein expressly incorporated by reference. 
    
    
     BACKGROUND OF THE INVENTION 
     Exemplary embodiments of the present invention are directed to credit default swap contracts (CDS). Credit default swap contracts involve one party (referred to as the protection buyer) buying protection from another party (referred to as the protection seller) in case of a credit event, such as the issuer of the debt instrument declaring bankruptcy, failing to pay an amount due on a debt instrument or restructuring a debt instrument. When a credit event occurs, the contract requires the protection seller to make a payment to the protection buyer in the course of physical or cash settlement of the credit default swap. 
     Physical settlement involves a protection buyer delivering one or more debt instruments to the protection seller, and the protection seller paying the protection buyer the face value of each debt instrument delivered. The protection seller can then proceed to collect on the debt instrument from the issuer of the debt instrument for an amount referred to as the recovery value of the debt instrument, which has likely been diminished due to the credit event. For example, assume that after a credit event occurs the recovery value of the debt instrument is 70% of its face value (i.e., there is a 70 cents on the dollar recovery rate). The protection seller pays the protection buyer 100 cents on the dollar (i.e., face value of the debt instrument), and the protection buyer physically delivers the debt instrument. The protection seller can then collect the 70 cents on the dollar recovery value from the issuer of the debt instrument or the issuer&#39;s successor-in-interest. Alternatively, the protection seller can attempt to sell the debt instrument in the open market. 
     Cash settlement involves the protection seller paying the difference between the expected recovery value and face value of the debt instrument to the protection buyer. If the protection buyer owns the debt instrument, the protection buyer can then proceed to collect from the debt instrument issuer for the recovery value of the debt instrument. Assuming, that the expected recovery value of the debt instrument is 70% of its face value (i.e., a 70 cents on the dollar recovery rate), the protection seller pays the protection buyer 30 cents on the dollar, and the protection buyer does not hand-over the debt instrument, but instead proceeds to collect the recovery value (i.e., the remaining 70 cents on the dollar if the actual recovery value is equal to the expected recovery value) from the debt issuer or the issuer&#39;s successor-in-interest. Alternatively, the protection buyer can attempt to sell the debt instrument in the open market. 
     SUMMARY OF THE INVENTION 
     The popularity of credit derivatives has made physical settlement very complicated due to the large imbalance between the notional outstanding of credit default swaps contracts and the underlying debt instruments. This imbalance is caused by protection buyers who do not actually hold a nominal amount of the instrument equal to the amount of protection purchased. For example, a protection buyer, who does not actually hold the debt instrument, can buy protection on the debt instrument from a protection seller. Accordingly, when a credit event occurs, this protection buyer must purchase the relevant nominal amount of the debt instrument in order to physically settle the credit default swap contract. This can cause a run-up in the price of the underlying debt instrument as protection buyers must purchase the underlying debt instrument in order to deliver the instrument to the protection seller. In addition, if a third party holds a significant amount of the debt instrument, it may not be possible for a protection buyer to locate and purchase the relevant nominal amount of the debt instrument in the open market. 
     Moreover, the imbalance also causes problems for physical settlement by parties acting as both protection buyers and protection sellers in a debt instrument. For example, a first party may be a protection buyer with respect to a second party and a protection seller with respect to a third party. When the first party&#39;s position is as a net protection buyer (i.e., more protection is purchased than is sold) or when the first party does not hold any of the debt instrument, if the first party had to deliver debt instruments to the second party before being able to obtain debt instruments from the third party, the first party would have to purchase debt instruments on the open market. Due to the run-up in price of the underlying debt instrument discussed above, the first party may have to purchase the underlying debt instrument at an inflated price in order to physically settle with the second party. 
     Although some parties to credit default swap contracts prefer cash settlement, there has not been an efficient mechanism to determine the expected recovery value (i.e., the recovery rate) for the debt instrument. One valuation technique that has been attempted is for the protection buyer to poll a number of dealers for a recovery rate, and then submit that recovery rate to the protection seller. This technique, however, is open to manipulation by dealers because these dealers are not contractually obligated to actually purchase the debt instruments at this price. Accordingly, this amount may not reflect the actual recovery rate that should be accorded to the debt instrument. Therefore, credit default swap contracts have generally involved only physical settlement. 
     Exemplary embodiments of the present invention overcome the above-identified and other deficiencies of settling credit default swap contracts. In accordance with exemplary embodiments of the present invention, a two stage process is provided. The first stage determines an inside market midpoint and the second stage determines a final price for settling imbalances between buy and sell orders from the first stage. In the first stage, participants submit inside market orders, that include a price and are for a pre-determined quantity, and/or market orders/requests for physical settlement, which specify a quantity but not a price. The inside market midpoint can be calculated using the inside market orders. In the second stage, limit orders, which specify a price and a quantity, are received, which are used to calculate the final price. All orders for the second stage are settled at the final price. 
     Other objects, advantages and novel features of the present invention will become apparent from the following detailed description of the invention when considered in conjunction with the accompanying drawings. 
    
    
     
       BRIEF DESCRIPTION OF THE DRAWING FIGURES 
         FIG. 1  is a block diagram of an exemplary system in accordance with the present invention; 
         FIGS. 2A and 2B  are flow diagrams of an exemplary method for selecting deliverable obligations for an auction in accordance with the present invention; 
         FIGS. 3A and 3B  are flow diagrams of an exemplary auction method in accordance with the present invention; 
         FIGS. 4A-4C  illustrate exemplary bids and offers which are contributed, sorted and used to determine an inside market midpoint; 
         FIGS. 5A and 5B  are tables illustrating exemplary adjustment amounts in accordance with the present invention; and 
         FIG. 6  is a table illustrating the matching of limit bids submitted to the open interest. 
     
    
    
     DETAILED DESCRIPTION OF THE PREFERRED EMBODIMENTS 
       FIG. 1  is a block diagram of an exemplary system in accordance with the present invention. The system includes a number of participants  105   a - 105   d  and an administrator  150 . One or more of the participants can be, for example, a computer, telephone, or a human participant operating a computer and/or telephone. These participants can be broker/dealers acting on their own behalf and/or acting on behalf of other persons, such as their customers. 
     Administrator  150  includes a participant interface  155 , memory  160  and processor  165 . Participant interface  155  can be any type of interface that is suitable for interacting with participants  105   a - 105   d . For ease of explanation, and not limitation, the central entity is described as a single administrator  150 , however, the administrator can be more than one entity. For example, various functions and processes can be divided between a trade organization such as the International Swaps and Derivatives Association, Inc. (ISDA) and an auction administrator. 
     Processor  165  includes logic  170 - 182 , which will be described in more detail below in connection with  FIGS. 2 and 3 . Processor  165  can be any type of processor, such as a microprocessor, field programmable gate array (FPGA) and/or an application specific integrated circuit (ASIC). When processor  165  is a microprocessor then logic  170 - 182  can be processor-executable code loaded from memory  160 . 
       FIGS. 2A and 2B  are flow diagrams of an exemplary method for selecting deliverable obligations (i.e., debt instruments) for an auction in accordance with the present invention. The method of  FIG. 2  is performed by deliverable obligation list preparation and publishing logic  182 , which can include logic for performing the acts of this method. Initially, requests for hosting an auction are received, and notice of the auction is posted (step  205 ). A decision of whether to host an auction can be performed by a committee of administrator  150 , and the committee can select a protocol for the auction that sets forth the auction rules and delivery requirements. 
     Next, one or more requests to post a deliverable obligation are received (step  210 ), and after a predetermined period of time a list of deliverable obligations is published (step  215 ). Deliverable obligations are one or more different types of debt instruments that meet pre-determined criteria. Participants  105   a - 105   d  can request that a listing of one or more of the deliverable obligations be reviewed, and these requests are received by administrator  150  (step  220 ). This request can be provided at any point after administrator  150  posts the details of the proposed deliverable obligations, until a predetermined time, such as two business days before an auction cut-off date, and the request can be in writing. An arbiter, such as a law firm, can be appointed to review the deliverable obligation for inclusion in the auction, and once that review is complete, the analysis is shared with all participants (step  225 ). This initial review replaces the conventional dealer poll approach with one that provides any market participant the ability to have a voice in what should be subject to the auction, and also to flag any possible issues with deliverability under the terms of the auction protocols. 
     Referring now to  FIG. 2B , if a participant is not satisfied with the results of this analysis, objections can be provided to the administrator (step  230 ). When one or more objections are received, a list of parties favoring and opposing removal of the objected to deliverable obligations is published (step  235 ). A list of experts and advocates for the favoring and opposing sides are received and published by administrator  150  (step  240 ). Each of the opposing sides can object to the experts, and as appropriate the experts can be stricken (step  245 ). Administrator  150  then receives a nomination of a third expert from the two appointed experts (step  250 ). After receiving advocate arguments and publishing the decision of the panel of experts (step  255 ), an amended list of deliverable obligations is published (step  260 ). The amended list includes all of the deliverable obligations that are subject to the auction. 
       FIGS. 3A and 3B  are flow diagrams of an exemplary auction method in accordance with the present invention. This method can be performed separately for each class of deliverable obligation from the final amended list. When it is determined that a credit event has occurred, the protocol for the credit event is published (step  305 ), and bidding agreement letters from participants  105   a - 105   d  are received (step  310 ). After a predetermined period of time, a list of participating bidders is published (step  315 ). Logic  170  then receives inside market orders and market orders/requests for physical settlement from participating bidders (step  320 ). The participating bidders are one or more of participants  105   a - 105   d , acting on their own behalf or on behalf of their clients. 
     Inside market orders are matched pairs of bids and offers in a pre-determined size, for example, $10 million, and the matched pairs are not more than two percent of par apart from each other (these matched pairs are commonly referred to as 10×10&#39;s). Market orders/requests for physical settlement are orders to buy or sell debt instruments, which do not include a price, and instead are executed at the final price determined by the auction. In the method of  FIG. 3 , a participant that wants to physically settle its credit derivative trades submits a market order/request for physical settlement equal to its net position, whereas a participant that only wants to cash settle its position would not submit such a market order/request for physical settlement. This approach is an “open system” because the submission of market orders/requests for physical settlement is voluntary. Each non-participating bidder&#39;s market order/request for physical settlement may be any size up to its actual market position, and its market position is equal to the size of deliverable obligation purchases or sales that would cause the participant&#39;s risk position, after cash settlement of all of its credit default swap contracts with respect to the defaulted reference entity, to be the same as its position would have been had such swaps been physically settled. 
     For example, if a participant&#39;s net credit default swap position was as a protection buyer of $10 million in credit protection on the defaulted reference entity, the participant&#39;s market position would be as a seller of $10 million in deliverable obligations of the defaulted reference entity. This is because, without the cash settlement of its trades under the auction, the participant would have had to have been holding $10 million in deliverable obligations to be delivered to settle its positions. As those positions will now be cash settled, that participant must now sell those $10 million in deliverable obligations in order to maintain the same risk position. 
     If the participant is a net protection seller, the participant will be on the buy side because buying the debt instrument and paying a loss amount in cash settlement will be economically equivalent to receiving the debt instrument and paying the par value. For example, if a debt instrument that defaults is now worth 40 cents on the dollar, that debt instrument would be purchased for 40 cents on the dollar. When combined with the settlement amount of 60 cents on the dollar, the participant is in the equivalent position of being delivered the debt instrument and paying 100 cents on the dollar. 
     Returning to  FIG. 3A , logic  172  then matches offers to sell that are lower than or equal to another bid to buy and categorizes these matches as tradable markets (step  325 ).  FIG. 4A  illustrates the inside market orders received from participating bidders, and  FIG. 4B  illustrates the order sorted such that the tradable markets are identified. Logic  172  then determines the inside market midpoint by excluding the tradable markets and averaging the best half of the remaining bids and offers (step  330 ).  FIG. 4B  also illustrates the best half of the remaining bids and offers that are used to calculate the inside market midpoint, and this calculation is illustrated in  FIG. 4C . Logic  174  then determines the open interest, i.e., the imbalance between net sell and net buy positions of the market orders/requests for physical settlement (step  335 ), and any adjustment amount payable in respect of a tradable market is determined by logic  176  (step  340 ). 
       FIGS. 5A and 5B  are tables illustrating the calculation of any adjustment amount payable in respect of a tradable market. Specifically,  FIG. 5A  illustrates the adjustment amount when the open interest is an offer to buy deliverable obligations, and  FIG. 5B  illustrates the adjustment amount when the open interest is an offer to sell deliverable obligations. When the open interest is an offer to sell deliverable obligations, logic  176  determines the adjustment amount as the greater of (a) zero and (b) the inside market bid forming part of the tradable market minus the inside market midpoint, multiplied by the inside market quotation amount, and determines that such amount will be payable by the participant who submitted the inside market bid forming part of the tradable market. When the open interest is a bid to purchase deliverable obligations, logic  176  determines the adjustment amount as the greater of (a) zero and (b) the inside market midpoint minus the inside market offer forming the tradable market, multiplied by the inside market quotation amount, and determines that such amount will be payable by the participant who submitted the inside market offer forming part of the tradable market. 
     Logic  174  publishes the size and direction of the open interest, as well as the adjustment amount (step  345 ). The size of the open interest is the difference between market orders/requests for physical settlement to buy and market orders/requests for physical settlement to sell. The direction of the open interest indicates whether the open interest is a net buy or net sell. If all market participants submit their precise market positions as market orders/requests for physical settlement, these positions would net to zero and the auction would settle at the inside market midpoint, which is essentially a dealer poll of the market prior to the publication of the open interest. However; it is likely that participants may submit market orders/requests for physical settlement for less than their market position, and the market orders/requests for physical settlement will likely not net to zero and additional limit bids and offers are necessary to fill the open interest. 
     When there is an imbalance between net buy and net sell positions, the second stage of the auction is performed. Specifically, for a predetermined period of time limit orders are received (step  350 ), and the open interest is matched to the received limit orders (step  355 ). Depending upon whether all of the open interest has been matched (step  360 ), one of two techniques are used to calculate the final price (steps  365  or  370 ). When all of the open interest has been matched (“Yes” path out of decision step  360 ), then logic  180  calculates the final price by finding the highest bid or lowest offer among limit orders of which the entire open interest is fulfilled (step  365 ). When there are two or more highest bids or lowest offers of which the entire open interest is fulfilled, these bids or offers are fulfilled on a pro rata basis. Referring now to  FIG. 6 , an example is illustrated in which the open interest is an offer to sell of 75 and the final price is 35% because that is the last highest bid among the limit order of which the entire open interest is fulfilled, and because there are two bids at this percentage they are fulfilled on a pro rata basis from the remaining open interest after all of the other orders are fulfilled. 
     When not all of the open interest has been matched (“No” path out of decision step  360 ), then logic  180  calculates the final price using the second technique (step  370 ). In the second technique, if the open interest is a bid to purchase deliverable obligations, then the final price is set equal to the face value of the deliverable obligation, and if the open interest is an offer to sell deliverable obligations, then the final price is set equal to zero. 
     Logic  180  then publishes the final price (step  375 ), and administrator  150  requires the participating bidders to deliver notice of settlement (step  380 ). Logic  178  matches participating bidders to deliver to relevant buyers the deliverable obligations specified in the notice of physical settlement in exchange for payment of the final price (step  385 ). In other words, the limit orders that are matched with the open interest are executed at the final price, and not the price specified in the limit order. 
     The foregoing disclosure has been set forth merely to illustrate the invention and is not intended to be limiting. Since modifications of the disclosed embodiments incorporating the spirit and substance of the invention may occur to persons skilled in the art, the invention should be construed to include everything within the scope of the appended claims and equivalents thereof.