Category: General Finance

Designing More Efficient CDS Auctions

Professor Haoxiang Zhu

Credit default swaps (CDS) are an important derivative class. According to the Bank for International Settlements, as of June 2013, CDS contracts have $24 trillion notional amount outstanding and $725 billion market value globally.

A CDS contract is a default insurance contract written on a firm, loan or sovereign country. Buyers of protection (CDS buyers) pay periodic premiums on a notional amount of debt to sellers of protection (CDS sellers), until the contract expires or default occurs, whichever is earlier. For example, if a bond investor wishes to insure against the default of $100 million corporate bonds, and a five-year CDS contract on that bond is quoted at 500 basis points (5%) per year, then the CDS buyer pays $5 million per year to the CDS seller for five years. If the bond defaults within five years, the CDS seller pays the CDS buyer the loss given default. The question is: What are the recovery value and default compensation?

The market uses CDS auctions to determine the recovery value of a defaulted bond. For example, the auction-determined recovery rate of Greece debt is 21.5 cents per euro. So, CDS sellers pay CDS buyers 78.5 (=100-21.5) cents per euro of debt insured. In addition to settling CDS contracts, CDS auctions also give investors an opportunity to trade defaulted bonds at zero bid-ask spread. Given the sheer size of CDS markets and high-profile defaults in the recent recession, it is important that CDS auctions deliver unbiased prices and efficient allocations. But do they?

In a recent research paper with Professor Songzi Du of Simon Fraser University, we find that the current design of CDS auctions leads to systematically biased prices and inefficient allocations.

To understand why the auction design is biased and inefficient, we need to understand the auction procedure itself. A CDS auction consists of two stages. In the first stage, investors who have CDS positions submit market orders (called “physical requests”) to buy or sell the defaulted bonds. An investor’s market order on the bond must be in the opposite direction of his CDS position, and no larger in magnitude. The sum of these market orders, called “open interest,” is sold in the second stage, which is a uniform-price auction. Importantly, only one-sided limit orders are allowed in the second stage. If the open interest is to buy, only limit sell orders are allowed; if the open interest is to sell, only limit buy orders are allowed. The market-clearing price in the second stage is the “official” recovery rate of the defaulted bond for settling CDS.

From 2006 to November 2013, this auction procedure has settled more than 140 defaults, including those of Lehman Brothers, Fannie Mae, General Motors, and Greece, among others.

Through a formal auction model, we show that the biased design comes from the restrictions imposed on the two stages of CDS auctions. To get the intuition, consider a CDS buyer. A CDS buyer naturally wishes to sell the defaulted bonds to minimize the uncertainty in the auction final price; he can eliminate this price risk by selling an amount equal to his CDS position. If this CDS buyer also has a low value for owning the bonds (for information or hedging motives), he would want to sell more. But the auction procedure forbids him from selling these additional quantities. A supply to sell is therefore suppressed in the first stage. In the second stage, this supply is suppressed again if the open interest is to sell (as only buy limit orders are allowed). Information from a suppressed demand cannot come into the price. Therefore, price is systematically biased, and allocations of bonds are inefficient.

This is not the end of the story. In an earlier version of the same research paper, we show that, if CDS traders are large, they also have a strong incentive to manipulate the final price auction price—to get favorable settlement payments on their CDS positions. Manipulation also leads to price biases.

The administrators of CDS auctions are aware of the biased prices; as a remedy, they impose a price cap or a price floor, depending on dealers’ quotes and the direction of the open interests. But this measure is imperfect and can backfire. We find that although a price cap or floor can correct price biases, it can also make bond allocations even less efficient.

What is a better solution then? We show that a simple, unconstrained double auction delivers better price discovery and allocative efficiency. A double auction for settling CDS is similar to the open and close auctions on stock exchanges. Since double auctions have done well in equity markets, why not consider it for CDS auctions?

For details of this research, see Songzi Du and Haoxiang Zhu, “Are CDS Auctions Biased and Inefficient?”. An earlier version of this paper is summarized by FT Alphaville (part 1, part 2).

Haoxiang  Zhu is Assistant Professor of Finance at the MIT Sloan School of Management

Stress test scenarios miss the boat

Professor Jonathan Parker

The Dodd-Frank act requires that large financial institutions be more closely monitored for exposure to systematic risks.  A key part of this monitoring is stress testing.  Regulators announce a set of adverse scenarios, and financial institutions calculate and report their losses in each scenario.  Regulators get to see how exposed the institutions are.

The OCC has now released the scenarios for 2014.  You can easily download and look at them here.  The scenarios detail lots of economic outcomes: each scenario has 28 variables that mostly turn bad.  But I am really disappointed – this regulatory approach is not addressing the financial-crisis type exposures at all.

There are only three scenarios, one of which is the baseline scenario. The other two are really two typical recessions – one bad, one worse.  What use is this?  Where are those once a century scenarios, like a house price collapse?  Where are the unlikely but possible bad scenarios like a run on the US dollar or US debt?  How about a large fiscal inflation?  In none of the adverse scenarios do long interest rates.  My suggestion: reverse the detail – more scenarios, each with fewer variables.  There are many factors in asset pricing for a reason – there are many sources of risk.  Regulators seem to think there is only one.  Be more creative. Think about unlikely bad outcomes  That’s the entire benefit of the exercise.  Make banks think about these scenarios; make regulators aware of how bad (or not) the unlikely scenarios would be.

Large financial institutions do not have to evaluate their losses in the scenarios that keep me up at night.  I hope the regulators also do not sleep so well.

Jonathan A. Parker is the International Programs Professor in Management and a Professor of Finance at the MIT Sloan School of Management.

Optimal Contracting and the Securitization of Human Capital

Professor Jonathan Parker

An interesting new company, Fantex, is securitizing human capital.  They are offering assets whose payouts are determined by a given athlete’s future earnings, in this case both Arian Foster and Vernon Davis, players in the National Football League.  Here is a New York Times article from today, and here is a more complete description from former Goldman Sachs employee and current Grantland writer Katie Baker.  (Before heading out to buy, note that the convertible bonds that the story describes are pretty complex and not just a bond backed by a share-of income.)

This financial innovation could be bad thing, and I expect that sports leagues make this illegal, or at least a violation of the terms of contracts.

Why?  Because private contracts like NFL contracts are typically carefully structured by employers and employees to balance risk-sharing and incentives (and to be consistent with salary cap rules).  On the one hand, employees do not want lots of income volatility.  For a given expected income, people prefer to be paid a certain amount, rather than having to bear uncertainty due to variations in future performance, particularly due to factors that are beyond their control.  On the other hand, employees that get paid more if they do better have an incentive to do better, to train harder, eat right, etc.  Would someone work as hard if they were only getting fifty percent of the money they earned?   In general, economists think not.   This dis-incentive is the source of the economic cost of taxes, why higher taxes mean lower output.  So contracts provide insurance and a safe payment where the effects of monetary incentives are weak or the effects of forces beyond the employee control are large (such as for injuries).  Similarly, contracts provide incentives and a variable payment where the effects of incentives are large and mostly controlled by the employee (such as attendance at practice or weight gain).

The central lesson of this theory is that incentives are costly.  Because employees dislike risk, a contract involving more incentives has to pay more on average to the employee to compensate for bearing the additional risks.

Now suppose that an optimal contract is agreed to by both parties.  But now a new securitization market opens, and the employee takes the incentives part of the contract, for which they are on average being paid more, and securitizes it so as to insure the risk away (at least partly).  The employee has just re-written the contract in a way that is disadvantageous to the employer who now no longer has an employee with (as strong) incentives to perform well.  Anticipating this possibility undermines the writing of the original contract.

An analogy might help.  Imagine a CEO who was highly incentivized by company stock and as a result highly paid securitizing his human capital.  Securitization the CEO’s human capital would look like the CEO shorting the company stock – turning the expected high income into a sure thing, unaffected by company performance.  Thus CEO contracts and US regulations prohibit this.  And this is socially optimal (at least the bit about prohibiting shorting own-company stock).

So, while, the general idea of securitizing human capital seems great, it can undermine incentives.  For contractual relationships (rather than spot labor markets), it opens the possibility for employees to change incentives after contracts have been written.  In the case of Arian Foster, we are only talking about 5 percent of earnings.   But if I were the NFL, I would be quite concerned about my employees using financial instruments to weaken the strength of incentives.

Jonathan A. Parker is the International Programs Professor in Management and a Professor of Finance at the MIT Sloan School of Management.