Eurozone politicians desperate attempts to stave off a Greek default dealt a heavy reputational blow to sovereign credit default swaps in October, when banks were strong-armed into accepting a bond exchange with a 50% haircut that would not trigger protection. The private sector involvement (PSI) move described as a clever heist or ruse by angry CDS traders brought cries of betrayal that both the hedging and price discovery value of contracts had at once been destroyed.
However, the actual economic hit on Greek CDS holders has since been disputed and the logic of the political manoeuvre called into question. Dealers, buy-side participants and industry bodies such as the International Swaps and Derivatives Association (Isda) have also collaborated in mounting a rearguard defence of the product and its viability, raising arguments that could restore faith and have far reaching impact amid the deepening challenges the market faces in 2012.
Controversy is centred on the Greek debt exchange having been called voluntary, when in fact any banks that dont co-operate face the threat of losing their access to funding. As such, it could be said that the futures of Greece and banks have been set at odds with the future of sovereign CDS.
A counter argument to this view is that only banks are bound by the exchange and that CDS continues to work for other users.
"Investors have the option to hold out and continue to receive the bond coupon, so CDS is not meant to trigger," says Adeel Khan, head of European investment grade trading at Barclays Capital in London. "They have their cash side and also their CDS side and no one is forcing them to do anything. So CDS does protect non-bank holders of risk and counterparties who are hedging highly correlated risk."
At the same time, even without a restructuring trigger, holders of CDS protection on Greece can still monetise a mark-to-market gain by selling out of positions. This is possible because of the active bid for Greek protection that remains from those who believe a hard default is still close at hand.
For example, someone who previously bought Greek protection when it was at 20 points up front could now sell protection at around 60 to close their exposure with a 40 point gain, largely offsetting the 50% bond haircut.
The maths work less well for participants who entered the trade more recently. However, there is little market sympathy for such complaints.
"If you bought protection at 40 points up front because you absolutely had to reduce your Greek exposure on paper then youre probably a banker and youve probably been a moron," says one buy-side portfolio manager. "The PSI was already on the cards, but there are always idiots out there who do things that dont make financial sense to achieve some other political objective."
By early December it was unclear that the Greek exchange would even go ahead, should a large enough number of non-bank bondholders reject the terms. It was also possible that Greece could subsequently miss a coupon payment on any new bonds.
"Our base scenario is a voluntary agreement which does not trigger CDS but there is a lot of risk around this and the haircut and participation rate will be key," says Alberto Gallo, head of European credit strategy at RBS in London.
"There will obviously be persuasion for banks, but if the haircut requirement is very deep we will have some holders not necessarily banks but retail holders or hedge funds that do not participate. This will make the situation less clear and could push Greece to a hard default."
Whats all the fuss about?
The CDS non-triggers effect on banks also looks limited. In November, the aggregate outstanding net notional of protection sold was just 3.5bn, with gross notional at 74.5bn compared to over 400bn of outstanding Greek bonds.
These figures suggest that banks are far more imperilled by the scale of their unhedged Greek cash exposures. Isdas general counsel in London, David Geen, points out that this 3.5bn exposure, even if concentrated in one bank, would be unlikely to topple any institution particularly when recovery is taken into account. It is more probable that a number of banks would share the hit, with minimal systemic impact.
All of which raises the question why politicians have been so hell bent on not triggering.
The symbolic nature of a credit event is one reason dealers posit with the implication that Portugal and Ireland might be allowed to follow. It would, they say, also create headlines that would serve as a damning indictment of political mismanagement at a time when the break-up of the Eurozone is threatened.
Policymakers have long made CDS (and in particular sovereign CDS) a scapegoat of the crisis because of their use by speculators. Those betting against sovereigns in this way would lose, they said. Traders claim CDS was an easy target for officials to attack and deflect public opinion away from their own failings. However, as one dealer observes: "If Greek bonds are trading at 50 then it is they who have lost."
An alternative view less discussed by dealers is that banks themselves may have put pressure on policymakers to hold off from triggering CDS. It could be that some big houses simply werent prepared for a messy credit event and needed time to manage cash exposures.
"If the outstanding was much bigger then youd think that banks must be holding a lot of protection and would want this to trigger to be made whole," says one buy-side trader. "But maybe banks are actually net sellers. You can take a view about who is sitting on the DC but unless theres obviously been a default people generally dont like to upset the status quo so theres an inherent bias to not call a credit event. And if Deutsche and JP Morgan are net sellers, well then its difficult."
What does seem clear from the relative size of CDS outstanding to bonds is that claims of rampant speculation having brought sovereigns low are wide of the mark.
Small trades can indeed cause big moves in CDS due to market illiquidity, say market makers, but this has been increasingly true of the cash market as well, where volatility has hit flows hard. It is a far cry from the highly liquid pre-2007 corporate credit dynamics, where CDS trading led first and bonds followed via arbitrage.
Such has been the plight of European peripherals that most moves wider have been driven by bondholders scrambling to jettison their inventory, followed by a wave of interbank hedging through CDS.
"The easiest way to reduce risk on something specific is to sell it rather than hedge," says one dealer. "When confidence erodes in an asset class people want to get shot of their exposure. We saw that when MF Global went down we heard all kinds of rumours about Jefferies and they had to come out and say they didnt hold any peripheral exposure. The sentiment in the market is to reduce Eurozone risk by whatever means."
Missing the point
As such, perennial calls for banning of CDS appear either misguided or in wilful disregard of the facts. Historical records will also show that most big peripheral sell-offs were precipitated either by shock revelations about a countrys ability to repay debt, lack of central co-ordination or Eurozone officials wont of speaking off script.
Says one bank proprietary credit trader: "Anyone who says that CDS has been a causal factor in whats happened with Greece is just smoking dope or theyre a German politician."
Despite these claims, there is no doubting that CDSs ease of use does facilitate speculation, since those that have limited knowledge of the bond space macro funds for example can readily place quick trades.
Unlike other politically demonised products such as CDOs of ABS, there is nothing opaque about sovereign CDS. It is a plain vanilla instrument and has acted as a fast barometer of the industrys health. Fears that this function would be compromised by the Greek bond exchange have not been realised, as Greek CDS continues to reflect its high probability of default.
Some traders claim it is this very transparency of CDS that has riled politicians against the product, because it makes the economic consequences of their failings highly visible and easy to monitor by the market, by journalists and ultimately by the general public. Without this, one would require much more specialist bond knowledge in fact the same politicians who have backed a sovereign CDS ban need it themselves to understand the relative standing of sovereign credits.
It is perhaps telling that politicians shy away from an arguably more legitimate complaint about CDS namely that the efficiency they brought to the market pre-2008 helped governments to borrow too much and too cheaply. That complaint would, of course, say more about governments than the instrument.
These ironies may be lost on those who want to shoot the messenger, but traders point out that politicians could end up shooting themselves in the foot.
The Greek debacle and its wide reaching effect points to an even bigger, uglier outlook in 2012, in which the foremost priority of Eurozone countries will be to keep down funding costs and generate growth. Traders believe that without the confidence that liquid CDS helps provide, this would only be made more difficult.
In particular, there is concern that recent negotiations over Greece may dampen enthusiasm for political initiatives such as the European Financial Stability Facility.
"What happens with Greek CDS will set the tone for what can happen in the future, particularly with regard to the potential for the various support mechanisms to issue partial guarantees of future sovereign bond issues," says Brett Tejpaul, head of European credit sales and head of UK and Ireland at Barclays Capital in London. "There has been some suggestion that the guarantee could be separately traded. Now, that sounds a lot like CDS doesnt it?"
"Its very difficult to see how that market can develop if we are not able to preserve some of the process and dynamics around sovereign CDS," he adds. "If this crumbles then how are we going to help create a liquid, well understood, transparent and tradable super-sovereign guarantee?"
Traders are quietly confident that Greece will prove to be a special case and that politicians would not dare undertake similar manoeuvres for a larger sovereign.
"This would never be allowed to happen for the likes of Italy, Spain and UK," says one fund manager.
Despite this, there have been calls in the industry to adapt the CDS contract to ensure that politicians cannot pull off a similar stunt in future.
Most traders say this would be very difficult to do, however. Such a rewording would presumably have to include language about bond exchanges taking place below par, they say, but that would merely open up the possibility of another moral hazard in that protection buyers could themselves engineer a credit event by privately negotiating a sub-par exchange with the borrower.
Isda for its part is wary of making a knee-jerk reaction and says that it is not under any pressure to try to legislate for deals that happen outside of the contract.
"Its a little bit muddled to say were thinking of changing the rules on the 50% haircut being voluntary," says Isdas Geen. "Its either voluntary or its not. Nothing Isda says or does changes that."
However, he allows that restructuring could be one area of Isdas definitions that it may address as part of broader discussions next year.
"We are looking at updating some sections of the definitions but this was something we were contemplating before this even came up," he says. "The restructuring definition was last updated in 2003. Obviously weve had the big bang and small bang protocols and the formation of the DC and many other initiatives, but things are happening in the market that werent even contemplated at that time, so they need to be updated to reflect market developments."
What is certain is that troubled sovereigns will find it much harder to issue new debt if there is not a satisfactory means of hedging risk. It is suggested that absent the reliability of sovereign CDS, investors might look to a portfolio of bank CDS related or correlated to the country, but this kind of hedge does come with basis and would be to employ a strategy rather than a designated product.
For sovereign lenders, the alternative could get even bleaker, in that they might be required to pledge assets to raise new debt. Even the Islamic market, where asset backed lending is paramount, has relaxed its principles somewhat when it comes to sovereigns electing, in most cases, to follow an asset-based approach instead. The reason is that pledging national assets to lenders opens up the possibility of even more emotional connotations than the present situation.
"Imagine France had to give up the Eiffel Tower to some hedge funds because it was unable to repay debt," says one French banker. "Id say to those American hedge funds come and get it but youd have to get past me first. Youre American so I hate you. Secondly youre a hedge fund so I hate you even more."
BarCaps Tejpaul believes it would spell disaster if the market reached a point at which a country like Spain might require corporate-style IOUs to borrow.
"We must get back to a model where each sovereign whether peripheral or core has the ability to issue unsecured government bonds into the private sector without the added assurance of secured borrowing," he says.
"The idea of governments having to put up a defined pool of assets is not a great dynamic for future issuance. If we got to a point where, say, a sovereign needs to issue but it is required to post collateral to borrow that would be unsustainable on a long term basis, in our view. A key catalyst for normalisation to happen will be the markets belief that the sovereigns debt dynamics are clearly sustainable. That will likely take time."
"The fate of sovereign CDS is tied up in the market, its regulators, politicians and central banks becoming convinced that the interbank CDS hedging market is viable and sustainable," he adds."If they decide it is good for banks to be able to recycle risk and it goes the way of being transparent, clearable and all those other things then my guess is that those dynamics will invite the participation of non-banks. Youll get increased activity from real money, hedge funds and other players because theres a liquid, transparent, standardised product that works. If they dont, well then it potentially becomes less relevant."