Credit Default Swap auctions

Here's a summary of CDS auctions I've incorporated into my yet-(never?)to-be-released book on Financial Risk Management. Nice to know how they work.


CDS Auctions[1]

A method for gauging an official price at which to settle CDS contracts is not the only rationale for an auction. There are a number of credit market indexes that are used as the basis for various derivative contracts. An auction gives a reference price that can be included in all indexes and so reduces basis risk for people who have matched physical and derivative positions via a number of different indexes.
The auction proceeds in two rounds and all prices are based on a par value of 100.
In the first round brokers submit a bid and offer on their own behalf and that of their clients The bid-offer spread may not differ by more than 2. If desired, a request can be made to buy or sell a physical amount of bonds – this amount may not be in excess of the party’s market position. If the highest bid is higher than the lowest offer then both quotes are removed from the pool; this step is the repeated. When all bids are below all offers the unweighted average of the highest 50% of bids and lowest 50% of offers is calculated. This is the inside market midpoint. The net sum of the requests to buy and sell physical instruments is called the open interest. If the open interest is zero then the inside market midpoint is the final auction settlement price for physical and derivative contracts. Otherwise round 2 starts, which clears the open interest.
Dealers can then submit any number of limit orders (size and price) for physical instruments, with a limit of ±1 of the inside market midpoint. If the open interest is to sell bonds then the limit on the buy orders is a dollar above midpoint, if the open interest is to buy then the limit on sell orders is one dollar below the midpoint. The open interest is then matched against the limit orders and the clearing price is the final auction settlement price for all physical and derivative instruments.

[1] This information is summarised from Helwege et al http://ssrn.com/paper=1407272