A credit default swap is a contract in which the protection buyer pays a periodic premium and the protection seller agrees to compensate the buyer if a defined credit event occurs on the reference entity. But what exactly constitutes a credit event, and what happens operationally when one occurs? The process is more structured — and more consequential — than most people realise.
ISDA Credit Event Types
The 2014 ISDA Credit Derivatives Definitions specify the types of events that can trigger a CDS settlement. Not all events are applicable to every CDS — the parties select which credit events apply when they execute the trade:
Bankruptcy: The reference entity becomes insolvent, is dissolved, or makes a general assignment for the benefit of creditors. This is the most unambiguous credit event — it is typically publicly documented and undisputed.
Failure to Pay: The reference entity fails to make a scheduled payment on one or more of its obligations, exceeding a minimum threshold (usually $1 million), after any grace period has expired. This catches both bonds and loans.
Restructuring: The most controversial credit event. A restructuring occurs when the reference entity agrees with creditors to modify the terms of its debt in a way that is disadvantageous to creditors — reducing the coupon, extending the maturity, or changing the currency. Restructuring as a credit event is included in European CDS (Modified Modified Restructuring, or MMR) but was dropped from most North American CDS after disputes in the early 2000s.
Obligation Acceleration / Default: An obligation becomes immediately due and payable as a result of a default (relevant for certain debt instruments with acceleration clauses).
Governmental Intervention: Added after the European sovereign debt crisis, this covers events where a government takes action that effectively restructures financial institution obligations (as occurred with certain European bank bail-ins).
The ISDA Determinations Committee
When a potential credit event occurs, a market participant can submit a credit event notice to the regional ISDA Determinations Committee (DC). The DC is a standing committee of 15 dealer banks and 5 buy-side firms, convened by ISDA to rule definitively on whether a credit event has occurred and which bonds are deliverable.
The DC's role is critical: it removes the ambiguity that would otherwise arise from bilateral disputes between CDS counterparties about whether a credit event has occurred. A DC ruling that a credit event has occurred (by a supermajority of 12 out of 15 votes) triggers the auction process for all outstanding CDS on that reference entity simultaneously.
The DC also rules on which obligations are deliverable into the CDS settlement — not all of a company's debt qualifies. Eligible obligations must meet specified criteria (typically senior unsecured debt, sometimes subordinated debt depending on the CDS documentation).
Physical vs Cash Settlement
Historically, CDS settled physically: the protection buyer delivered the defaulted bond to the protection seller and received par value in cash. This worked when there were few CDS outstanding relative to the amount of deliverable bonds — the buyer could easily acquire a deliverable bond and tender it.
By the mid-2000s, the notional outstanding of CDS on many names vastly exceeded the face value of deliverable bonds. Physical settlement became impractical — not all protection buyers could source deliverable bonds. The market shifted to auction settlement, now the standard for almost all single-name CDS and all CDS index settlements.
The ISDA Auction Process
The auction settlement process works in two stages:
Stage 1 — Initial Market Midpoint: On the auction date, each participating dealer submits two-way markets (bid and offer) for the defaulted bonds. These are used to calculate an initial market midpoint for the bonds. Dealers also submit their open interest — the net amount they need to buy or sell the defaulted bonds to settle their physical CDS positions.
Stage 2 — Dutch Auction: The net open interest from all dealers (some wanting to buy bonds, some wanting to sell) is aggregated. A Dutch auction is then run to find the clearing price that matches all open interest. The final auction price — the recovery rate — is published by ISDA and is used to settle all outstanding CDS on that reference entity.
The CDS cash settlement payment is then: Notional × (1 − Recovery Rate). If the final auction price is 40 cents on the dollar (40% recovery), a $10 million CDS pays $6 million to the protection buyer.
Cheapest-to-Deliver
In physical settlement (and in the context of the auction), the protection buyer has the right to deliver the cheapest available deliverable obligation — a concept called cheapest-to-deliver (CTD). Different bonds of the same issuer may trade at different prices post-default depending on their seniority, maturity, and specific terms. The buyer will naturally choose the cheapest bond to deliver, receiving par from the seller. This CTD optionality has value and is one reason CDS spreads are not a pure reflection of expected loss — they also include a CTD premium.
Notable Credit Events: Lehman and Greece
The Lehman Brothers bankruptcy in September 2008 triggered a CDS auction with a final recovery rate of 8.625 cents on the dollar — meaning protection buyers received over 91 cents per dollar of notional. The auction settled approximately $400 billion of notional CDS cleanly and efficiently, which was widely cited as evidence that the CDS market's infrastructure could withstand a major default without systemic failure.
The Greek sovereign restructuring in 2012 presented a harder test. The DC initially declined to rule it a credit event, arguing the restructuring was voluntary. Eventually, after the "collective action clause" (CAC) was invoked and holdouts were forced to restructure, the DC ruled it a credit event. The episode highlighted the complexity of restructuring as a credit event type and the political sensitivities involved when a sovereign CDS triggers.