A failed attempt to get debt insurance from a struggling French car rental company is the final blow to the $ 9 trillion credit derivatives market, but this time the focus is on speculators.
Protection buyers who did not own any of Europcar Mobility Group's underlying debt were left with nothing due to a shortage of bonds to settle contracts at auction on Wednesday.
Weaknesses in the instruments' ability to protect against losses have undermined confidence in the credit derivatives market in recent years. The problem with Europcar, which defaulted last month, was that the bids exceeded the available collateral, driven both by bondholders who already had a lock-up agreement and traders who outsized bets on a lucrative swap payout.
"In this particular case, it is simply because of the positioning of market participants," said Jochen Felsenheimer, managing director at XAIA Investment in Munich, who trades both markets but had no position in Europcar. "If you speculate, you can lose money."
Dealers began holding auctions in 2005 to avoid such shortages following Delphi Corp.'s bankruptcy, when the amount of protection was about 10 times higher than the underlying debt.
Was a trial standardized in 2009 to settle swaps at the cash price set at auction rather than by delivering physical debt guaranteed by the instruments, although traders still have the option to sell bonds and loans at auction. The market was overhauled in 2014 to fix glitches.
While there were enough bonds outstanding to settle Europcar's swaps, about 7 million euros ($ 8.5 million) more bonds were demanded than offered, according to Creditex and Markit. data.
The mismatch resulted in an automatic recovery value of 100% on approximately $ 100 million in swaps. Net holders of protection received nothing, but bondholders who had covered themselves with credit default swaps and delivered notes at auction were compensated for their holdings.
The Europcar mismatch
“Ever since we designed the auction, we told participants that they couldn't rely on anyone else to provide liquidity to the auction, otherwise we would end one day with an auction ending at zero or 100,” said Athanassios Diplas, former senior adviser to the board of the International Swaps and Derivatives Association.
“ Buyers of protection really didn't have any bonds to offer or were sleeping behind the wheel in this case. & # 39; & # 39;
A settlement auction in 2019 found a rare final value of zero, with buyers of protection on New Look Retail Group Ltd.'s latest bonds. were paid in full.
For the most part, auctions have operated, with 19 settlements last year alone. And credit swaps, which fell out of favor after the financial crisis, have come back in fashion as defaults rise and a string of high-profile failures pays off for short sellers.
Nevertheless, Europcar reminds that the market does not always function as expected.
"Some people will look at it and say it doesn't work," said Julien Petit, a portfolio manager at Ostrum Asset Management who had no position at Europcar. "The lesson is that people playing in the CDS market need to pay attention to what is happening in the situation they are trying to cover."
–With the help of Jack Pitcher.
Photo above: the logo of the car rental company Europcar. Photographer: Loic Venance / AFP / Getty Images
Copyright 2021 Bloomberg.
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