Question

What is the Big Bang protocol?

how a credit event auction work?

Answer 1

BIG BANG PROTOCOL

The “Big Bang” protocol is an initiative launched on April 8, 2009, by the International Swaps and Derivatives Association Inc. to help strengthen the credit default swap market.

The protocol represents the final step in the process known as “hardwiring”, or the incorporation of auction settlement terms into standard CDS documentation. It is intended to make it easier for investors in the opaque credit derivatives market to know what will happen to their contracts if debt defaults occur.

More than 2000 market participants have signed on to the protocol.

Credit Default Swap (CDS)

A credit default swap (CDS) is essentially an insurance policy on corporate debt where the CDS buyer pays a quarterly premium and the CDS seller promises to cover the losses on the debt should it go into default.

Credit Event Auction Process

The auctions establish a market price of the defaulted bonds and thereby determining the payment from the CDS seller to the CDS buyer. To the extent that CDS contracts are settled through the auction, the auction makes it more likely that all CDS contracts will be settled at a single price.

The auction process has two stages.

1. In stage 1, dealers post bid and offer prices for the underlying debt for a predefined amount and a pre-defined spread resulting in an initial recovery rate. The initial rate is used to constrain the final auction price.

• Participants who wish to physically settle make a request to buy or sell debt at the final price. Then, open interest is calculated. If the open interest is to sell, then dealers place a new limit order to buy.

2. At the second stage Dutch auction, the open interest is matched to the limit orders to establish a price that eliminates the excess demand for or supply of bonds.

• If the open interest is to buy, the lowest ‘sell’ limit order submitted is matched to the amount of open interest equal to the size of the limit order.
• If the open interest is to sell, then the highest ‘buy’ limit orders are used.

3. The next step is to take the second-lowest sell order or the second-highest buy order and match these. The process continues until all the open interest is matched, or the limit orders are exhausted.

If the limit orders are exhausted, then the final price is the par when the open interest is to buy and zero when open interest is to sell.

The second stage auction price is the final recovery price.