Are CDS Auctions Biased and Inefficient?

Abstract

We study the design of CDS auctions, which determine the payments by CDS sellers to CDS buyers following the defaults of bonds. Through a simple model, we find that the current design of CDS auctions leads to biased prices and inefficient allocations. This is because various restrictions imposed in CDS auctions prevent certain investors from participating in the price-discovery and allocation process. The imposition of a price cap or floor also gives dealers large influence on the final auction price. We propose an alternative double auction design that delivers more efficient price discovery and allocations.

Keywords: credit default swaps, credit event auctions, price bias, manipulation, allocative efficiency, double auction

JEL Classification: G12, G14, D44