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A proposal for an auction-based sovereign debt

restructuring mechanism
Tim Willems 17 November 2020

The COVID-induced surge in public debt has raised concerns about its sustainability, further increasing the
Tim Willems
need to improve the debt-restructuring process. This column proposes an auction-based strategy to restructure
Economist, IMF
sovereign debt that tailors the shape of the restructured debt stock optimally to creditor preferences, subject to
debt being sustainable post-restructuring. Any debt relief provided to the country gets optimally distributed over Don't Miss
its creditors, thus minimising the pain inflicted upon them. A version of the winner’s curse can reduce the
Fostering FinTech for
‘holdout problem’ of creditors trying to free-ride on each other’s contributions towards debt relief. All this should financial transformation
smoothen the restructuring process and enable the debtor to mobilise greater creditor support (given the Beck, Park
amount of relief provided). 
Fintech and digital
currencies RPN. The soul of
the financial system
41 A A Niepelt

The ECB strategy: The 2021

review and its future
Related
This year’s Nobel Memorial Prize in Economic Reichlin, Adam, McKibbin,
Sciences to Paul Milgrom and Robert Wilson forms a Borrowing costs after debt relief McMahon, Reis, Ricco, Weder
Valentin Lang, David Mihalyi, Andrea Presbitero
useful reminder that auction theory has great practical di Mauro
relevance. The Nobel Committee highlighted Debt restructuring in the time of COVID-19
Silvia Marchesi, Tania Masi
applications to radio frequencies, electricity, and
Events
natural resources. There is however another potential A debt standstill for COVID-19 in low- and
middle-income countries VfS-Annual Conference 2021
application, to sovereign debt restructurings. 
Patrick Bolton, Lee Buchheit , Pierre-Olivier - Call for Papers
Gourinchas, Mitu Gulati, Chang-Tai Hsieh, Ugo 26 - 29 September 2021 /
Improving the debt restructuring process has great Panizza, Beatrice Weder di Mauro Regensburg University / Verein
relevance at present, where the pandemic-induced für Socialpolitik
A new way to auction off toxic assets
surge in public debt is raising concerns about Paul Klemperer 7th Annual Monetary and
sustainability. This has produced calls for ‘standstills’ Financial Policy Conference
28 September - 8 October 2021
(Bolton et al. 2020, Gelpern et al. 2020), with the / Online / Money Macro And
official sector initiating the Debt Service Suspension Initiative (DSSI) (suspending debt service on Finance Society
official-bilateral debts for eligible countries requesting it). While the DSSI has helped (Lang et al. Joint Workshop on
2020), it might not suffice for the most indebted/affected countries who may need to approach Incentives, Management and
Organization (IMO) &
creditors to obtain further relief.  Entrepreneurship Economics
(ENT)
Unfortunately, the current negotiation-based debt restructuring process is not efficient. First, the 7 - 9 October 2021 /
Copenhagen, Denmark/ Online
process is complex and time-consuming, typically taking years to resolve (IMF 2020a) at great cost /
to all parties. Second, human actors are unlikely to spot (and realise) all gains from trade.
CopenhagenMacro Days
Consequently, negotiation-based outcomes won’t typically be located at the efficient frontier, Conference
meaning that both debtor and creditors could be made better off. Within creditors, some are also 7 - 8 October 2021 / Hybrid
online/in-person, Copenhagen /
likely to be better served by any negotiated deal than others—harming inter-creditor equity. 
Joint CEPR and Seventh
Deploying an auction mechanism can improve upon negotiated outcomes. Auctions are an effective Banco de España Economic
History Seminar
way of managing many players, perfectly able to spot (and realise) efficiency gains. This should 8 - 8 October 2021 / Online /
appeal to both debtors and creditors, as this can benefit all parties involved (with much less drama
and delay). While negotiations become more complex as the number of players grows, auctions
CEPR Policy Research
converge to the optimal outcome.
Discussion Papers
Insights
The proposal starts by noting that an efficient debt restructuring should optimally ‘fit’ debtor/creditor
Homeownership of
preferences. Any debt relief that is deemed necessary to restore sustainability should take a form immigrants in France:
that is least painful to the country’s creditors. Such design allows the country to obtain the greatest selection effects related to
amount of relief, while inflicting the lowest possible damage upon creditors (thus preserving creditor international migration flows
Gobillon, Solignac
support). 
Climate Change and Long-
Run Discount Rates:
Creditor preferences are likely to display significant heterogeneity, particularly regarding the trade- Evidence from Real Estate
off between granting relief through face value haircuts, or via maturity extensions.1 Different Giglio, Maggiori, Stroebel,
creditors can have different preferences for various reasons: they can have a different outlook on Weber

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24/9/21 0:40 A proposal for an auction-based sovereign debt restructuring mechanism | VOX, CEPR Policy Portal
the country, while balance sheet considerations may be important too. Each creditor’s regulatory/tax The Permanent Effects of
Fiscal Consolidations
environment can also affect the appeal of the various options. An optimal restructuring should allow Summers, Fatás
each creditor to self-select into those options that fit their situation best, as that will maximise the
Demographics and the
relief a debtor can find subject to maintaining creditor support – hence restructurings typically offer a Secular Stagnation
menu to creditors (Van Wijnbergen 1991).  Hypothesis in Europe
Favero, Galasso
Reflecting all these factors – which differ across creditors, of which there are typically thousands – QE and the Bank Lending
in a negotiation is impossible and better handled through a price mechanism. A simple example Channel in the United
Kingdom
might prove insightful. Imagine a firm with 100 workers, needing to dismiss five. Those five will Butt, Churm, McMahon,
receive severance pay, but how to determine whom should leave? While a negotiation-based Morotz, Schanz
approach is likely to be chaotic and lengthy (leaving many bitter about the result ex post), a price-
based strategy would ask workers only one question: At what level of compensation would you Subscribe
leave your job voluntarily? Workers who hate their job and were thinking of quitting anyway, will file
a much lower price than content employees. By bidding in that way:  @VoxEU

The unhappy workers can release themselves from their much-hated job while being RSS Feeds
compensated for it 
Weekly Digest
The firm gets to restructure its employee base at the lowest-possible cost.

An auction-based strategy, which follows price-based corporate resolution proposals (Bebchuk

1988, Aghion et al. 1992, Hausch and Ramachandran 2000), can generate restructuring outcomes
with similar efficiency-properties. But in order to determine the optimal shape of the restructuring,
one first needs to learn about creditor-preferences (each creditor’s relative willingness for granting
relief via a maturity extension versus a face value haircut). Such information can be solicited
through Klemperer’s Product-Mix Auction (PMA) (Klemperer 2010). The PMA offers a single-round
method to sell goods which are considered imperfect substitutes. It allows bidders to submit
multiple, mutually exclusive bids – enabling them to approximate their demand curve.2

The PMA can be applied to sovereign debt restructurings via the following sequential process: 

Each creditor enters the auction with budgets proportional to the market value of their existing
claims. 
Like in the current framework (Buchheit et al. 2019, IMF 2020b), the process starts by
determining a sustainable debt service-profile. Suppose that this leads to zero debt service
obligations for 2021, $1 billion in debt service over 2022, $3 billion over 2023, and so forth
(say, up to 2039). For simplicity, one can think of zero-coupon bonds. Given a discount rate,
this step determines the amount of NPV-relief embedded in the restructured profile. The
question that the next step will answer is: how to optimally distribute this aggregate NPV
reduction over creditors?
Creditors bid for the various restructured bonds announced in Step 2. They do so by informing
the auctioneer about their yield curve via bids like: “I bid my budget on {the bonds due in 2022
OR 104% of that amount for the bonds due in 2023 OR 110% of that amount for the bonds
due in 2024 OR etc.}.3 Creditors with a pessimistic outlook (or other reasons to prefer quick
repayment) will specify a steeper yield curve, which increases their odds of obtaining a
shorter-dated claim (but at a larger haircut). Creditors with a more optimistic outlook (or other
reasons to prefer maturity extensions) will specify a flatter yield curve; they are fine with a
longer-dated claim, which enables them to avoid a large haircut. Haircuts are determined
endogenously to ensure market clearing; haircuts will be such that creditor preferences end up
being consistent with the pre-specified repayment profile (making sure that all restructured
holdings ‘fit’ with the schedule announced under Step 2). Under competitive bidding, the
auction allocates each creditor a combination of restructured bonds which they would have
chosen voluntarily given the haircuts that ultimately materialise.

The proposed mechanism has several intuitive and desirable properties: 

Logical consistency. Creditors who are pessimistic on the country’s future will want to be
repaid soon, the odds of which can be increased by bidding a steeper yield curve – bringing
larger haircuts to shorter-dated claims. This is consistent with the bearish outlook on the
debtor, as the logical implication of that view is that debt relief is needed. More optimistic
creditors (thinking the country doesn’t need much debt relief) will bid a flatter yield curve –
accepting that they will likely end up with longer-dated claims. But given the lower haircut, and
given their optimistic outlook, they are still happy with this outcome.
Efficient sorting. The auction allows creditors to self-select into that restructured instrument
to which they attach most relative value (be that for reasons relating to outlook, balance sheet,
or regulatory/tax implications). This feature enables the debtor to maximise the relief it can
obtain, as the auction shapes the losses (embedded in the repayment profile specified under
Step 2) in a way that is least painful to creditors. 

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Voluntariness. By relying on a price-mechanism to tailor the restructured debt stock to
creditor-preferences, no creditor will be forced into a deal. Creditors wishing to take a haircut
(maturity extension), can get their haircut (maturity extension). Creditors who end up with a
restructured claim they favoured less a priori, will be compensated by a more favourable price
(ensuring they will willingly hold their restructured position).
Inter-creditor equity. In the resulting allocation, no creditor will prefer the allocation of any
other creditor over its own.4 This makes the mechanism reflect inter-creditor equity, which
should help generate creditor support. 

An auction-based resolution may also weaken the ‘holdout problem’ (creditors trying to free-ride on
each other’s contributions towards restoring sustainability). Creditors know that a restructuring will
only go ahead if a sufficient majority of bondholders agrees to the proposed terms.5 But if other
creditors are willing to provide debt relief, they must have information that doing so is indeed
necessary and beneficial. This converse to the ‘winner’s curse’ makes creditors realise that any
relief they offer, will only come into effect if enough other creditors agree that providing relief is the
correct course of action. This makes creditors more willing to contribute to the public good of debt
reduction and decreases the likelihood of creditor coordination issues getting in the way of a deal
(Detragiache and Garella 1996).

The PMA can also be enriched to put state-contingent debt on offer in the restructuring (alongside
conventional bonds). This may help generate creditor support in the face of creditors who believe
that the pre-specified repayment profile is providing too much relief. Such creditors should be
attracted to GDP-linked bonds, since those can be expected to flourish following superfluous debt
relief.6 Other types of bonds (green, Islamic, domestic, etc.) could be put on offer as well, giving the
debtor more options to tailor the post-restructuring debt stock to creditor-preferences – further
raising prospects of reaching agreement.7 

An auction-based process is likely to improve upon the status quo, particularly since the latter is not
well suited to handle today’s dispersed creditor base. By responding to individual creditor-
preferences, an auction will be able to serve creditor-interests better, minimising costs to the debtor.
Although an auction-based resolution will not solve all difficulties (parties still need to agree on a
repayment profile under ‘Step 2’), creditors might become more willing to accept any repayment-
proposal if they know that it will be followed by a price-based allocation mechanism (which will yield
an outcome they would have chosen voluntarily, had they seen the terms in advance). Ultimately, all
parties will benefit from restructured claims taking a form and allocation that is least painful to
creditors, as that distributes the losses which need to be incurred to restore sustainability in the
most efficient way. Herewith, the current proposal should help mobilise creditor support. The entire
process can furthermore be extremely quick and cheap to implement, again benefitting both debtors
and creditors. 

Note: This proposal greatly benefited from many discussions with Paul Klemperer, who provided
numerous detailed and essential inputs. Further thanks to Craig Beaumont, Wolfgang Bergthaler,
Lee Buchheit, Jeremy Bulow, Marcos Chamon, Enrica Detragiache, Mitu Gulati, Adnan Mazarei,
Eriko Togo, Felix Vardy, Sweder van Wijnbergen, and Jeromin Zettelmeyer for useful comments.
The views expressed here are those of the author and should not be attributed to the International
Monetary Fund, its Executive Board, or its management. Any errors are my own.

References
Aghion, P, O Hart and J Moore (1992), “The Economics of Bankruptcy Reform”, in: Olivier J.
Blanchard, Kenneth A. Froot, and Jeffrey D. Sachs (eds), The Transition in Eastern Europe,
Chicago: University of Chicago Press. 

Bebchuk, L (1988), “A New Approach to Corporate Reorganization”, Harvard Law Review 101: 775-
804. 

Bolton, P, L Buchheit , P-O Gourinchas, M Gulati, C-T Hsieh, U Panizza and B Weder di Mauro
(2020), “Necessity is the Mother of Invention: How to Implement a Comprehensive Debt Standstill
for COVID-19 in Low- and Middle-income Countries”, VoxEU.org, 21 April. 

Buchheit, L, G Chabert, C DeLong and J Zettelmeyer (2019), “The Restructuring Process”, in: S. Ali
Abbas, Alex Pienkowski, and Kenneth S. Rogoff (eds), Sovereign Debt: A Guide for Economists
and Practitioners, Oxford: Oxford University Press. 

Das, U S, M G Papaioannou and C Trebesch (2012), "Sovereign Debt Restructurings 1950–2010:

Literature Survey, Data, and Stylized Facts”, IMF Working Paper No. 12/203. 

Detragiache, E and P G Garella (1996), “Debt Restructuring with Multiple Creditors and the Role of
Exchange Offers”, Journal of Financial Intermediation 5, 305–336. 
https://voxeu.org/article/proposal-auction-based-sovereign-debt-restructuring-mechanism 3/5
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Gelpern, A, S Hagan and A Mazarei (2020), “Debt Standstills Can Help Vulnerable Governments
Manage the COVID-19 Crisis”, in: Maurice Obstfeld and Adam Posen (eds), How the G20 Can
Hasten Recovery from COVID-19, PIIE Briefing 20-1. 

Hausch, D and S Ramachandran (2000), “Corporate Debt Restructuring: Auctions Speak Louder
Than Words”, in: Stijn Claessens, Simeon Djankov, and Ashoka Mody (eds), Resolution of Financial
Distress: An International Perspective on the Design of Bankruptcy Laws, World Bank Institute, 91-
106.

IMF (2020a), “The International Architecture for Resolving Sovereign Debt Involving Private-Sector
Creditors”. 

IMF (2020b), “Argentina: Technical Assistance Report-Staff Technical Note on Public Debt
Sustainability”. 

Klemperer, P (2009), “Central Bank Liquidity and “Toxic Asset” Auctions”, VoxEU.org, 25
September. 

Klemperer, P (2010), “The Product-Mix Auction: A New Auction Design for Differentiated Goods”,
Journal of the European Economic Association 8: 526-36. 

Lang, V, D Mihalyi and A Presbitero (2020), “Borrowing Costs After Debt Relief”, VoxEU.org, 14
October. 

Van Wijnbergen, S (1991), “Mexico and the Brady Plan”, Economic Policy 6: 13-56.

Endnotes
1 Das et al. (2012) report that, in general, retail investors tend to prefer maturity extensions, while
institutional investors prefer to provide relief through face value haircuts (but at shorter maturities). 

2 The PMA was originally designed for the Bank of England in 2007/8 (Klemperer 2009). During the
GFC, the BoE wanted to provide liquidity against a widened range of collateral, raising the question
how the interest rate should depend on collateral quality. Banks ideally wished to obtain liquidity
against weak collateral (like mortgage-backed securities) but could be enticed to put up strong
collateral at a sufficient discount (lower interest rate). The PMA enables banks to submit bids like “I
wish to receive £1 billion {at 5% against weak collateral OR at 4% against strong collateral}”.
Similarly, the BoE specifies how its willingness to provide liquidity against weak collateral depends
on the premium (higher interest rate) it comes with. The auction then determines how much the BoE
should lend against weak/strong collateral, and at what interest rates.

3 The PMA can also handle fractional bids: “I wish to bid 60% of my budget on {the bonds due in
2022 OR 104% of that etc.}; for the remaining 40% of my budget, I wish to buy {the bonds due in
2030 OR 107% of that etc.}” 

4 Imagine a country with a 5% discount rate. However, for whatever reason, investor A is applying a
0% discount rate to this country—thus bidding a flat yield curve. As a result, the restructuring will
boil down to a pure maturity extension for A (no face value reduction). Note that, given its 0%
discount rate, A doesn’t feel an NPV reduction following a maturity extension. But the country
(discounting at 5%) does! Moreover, no other investor (all applying positive discount rates) will look
at A’s deal and think of it as attractive relative to their own; still A is happy, considering themselves
as the only creditor to have avoided an NPV reduction in the restructuring (while all others saw face
value haircuts). 

5 These days, many sovereign bond contracts contain Collective Action Clauses (CACs) through
which all bondholders agree ex ante to accept restructuring terms if they are endorsed by a
sufficient supermajority. The underlying supermajority-threshold (often two-thirds or three-quarters)
acts like a minimum tendering requirement. 

6 Given the implementation difficulties associated with GDP-linked instruments, offering local
currency bonds instead could be an alternative. If the country recovers strongly from its crisis, the
USD-value of local currency bonds is likely to rally (e.g. on the back of an appreciating local
currency)—thus proxying the payoff structure of GDP-linked instruments, while avoiding its practical
complications (such as statistical challenges associated with accurate and timely GDP
measurement).

7 The PMA can also allow the debtor to submit its own preferences expressing its willingness to
substitute among such options, finding the efficient solution given all creditors’ (and the debtor’s)
bids—analogously to the process in footnote 1.

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41 A A
Topics: 
Covid-19 International finance

Tags: 
debt restructuring, auctions, sovereign debt, COVID-19

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