Investors synthetically referencing the recently bankrupt U.S. auto parts manufacturer Dura Automotive Systems, for the first time this week, will use the International Swaps and Derivatives Association's (ISDA) revamped auction protocol. Tuesday will bring the first auction protocol that opens up the cash settlement option to a much wider range of derivative instruments - including single-name CDS, first-to-default baskets and constant maturity swaps - along with the traded indices. Cash settlement will take place on Dec.12.

The protocol allows protection buyers and sellers the option to change the terms of their contracts from physical to cash settlement. The switch toward cash settlement is becoming increasing necessary, as more and more investors have piled into the credit derivatives market. In many cases, their trades far outpace the supply of physical bonds they reference, making for a sticky, technical-driven, situation when a credit event comes around.

"By moving more toward a cash settlement procedure for single-name CDS and other structures, and assuming the procedure put in place is adequate, there is a lower likelihood that technicals will exert as much of an influence on the cash (deliverable) market," Derivative Fitch analysts wrote in a report last week. Of course, the rating agency pointed out, the number of investors that opt for cash settlement will ultimately determine the impact of the updated protocol. Some are speculating that investors could seek arbitrage opportunities between the two settlement options.

Last year's bankruptcies

Following last year's bankruptcy of the widely referenced U.S. auto parts manufacturer Delphi Corp., investors were scrambling to obtain Delphi bonds in order to satisfy the physical settlement portion of their CDS contract agreements. Exacerbating the situation, speculators also swooped in to pick up the bonds. Demand was so high that pricing skewed upward, effectively distorting the economics of the trade in the first place, Fitch has pointed out.

Physical settlement can also pose problems when contracts are unclear as to what constitutes a deliverable obligation. A question as to whether convertible notes would be an acceptable deliverable obligation in the aftermath of power producer Calpine Corp.'s bankruptcy last year prompted a move by ISDA to draw up a set of guidelines for dealing with such disagreements. Holding up implementation, the organization is in the process of seeking a group of unbiased experts that could serve in an advisory capacity.

Earlier this month, ISDA released the set of settlement protocols that include a cash settlement option for a wide range of derivative instruments. Previous protocols enabled cash settlement only of index trades. Eventually, the wider availability of cash settlement options will likely be incorporated in the organization's 2007 credit definitions.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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