CDS auction settlement to include physical delivery

NEW YORK, Dec 3 (Reuters) - Credit derivative contracts are expected to start trading with specific terms on how to settle a debt default within an auction from the end of the year, and the option of physically delivering the bonds will be included in the auction process, sources said.

The $47 trillion credit default swap market is used by investors to protect against the risk of a borrower defaulting on their debt, or to speculate on their credit quality.

In previous defaults, buyers and sellers of protection on Lehman Brothers, Washington Mutual and others have had the option of settling the contracts with cash payments, based on the results of an auction, or protection buyers could give protection sellers the defaulted bonds, in return for the full amount insured.

For example, an auction used to close out credit default swaps on Lehman's debt credit default swaps found the contracts to be worth 8.625 cents on the dollar, meaning protection sellers participating in the auction would pay buyers $9.137 million per $10 million insured.

Alternatively, protection buyers could have closed out the contracts by offering protection sellers Lehman's bonds, which were trading at around 13 cents at the time of the auction, in return for the full sum insured.

Officials including the Federal Reserve, however, have expressed discomfort with the method of passing over the bonds, known as physical settlement, because it can delay the process of closing out the trades, sources said.

For example, a seller of protection on a company may have also bought protection with a different counterparty. When the company defaulted, they would receive the bond and pay the protection buyer, and then pass on the bond to the other counterparty to be paid out their insurance.

In some cases, this chain would pass through several contracts and counterparties, delaying contract settlement.

Credit default swaps will begin trading from the beginning of the year with language specifying that settlement, either in cash or through delivery of the debt, will be made via an auction process, the sources said.

Industry players are also discussing how to apply the auction requirement to existing contracts, and may implement a protocol among large credit derivative dealers, which account for the majority of trading in the market, to apply the new auction requirement to existing contracts, the sources added. (Reporting by Karen Brettell)