Latin American officials are looking at ‘naked’ credit default swaps (CDS) – instruments allowing investors to insure against a country’s default without actually owning the country’s bonds – with concern, Emerging Markets can reveal.
The instruments, which have been compared by market experts to buying insurance on a neighbour’s house and were partly blamed for the sharp spike in bond yields that triggered the eurozone’s debt crisis, were banned in the European Union last year.
Euro-MP Sven Giegold, a member of the German Green party, called for a ban on ‘naked’ CDS in emerging markets’ debt too, after a non-scientific online poll that he organized nominated them the most dangerous financial products around.
Although the market in those instruments is not very developed in Latin America, the use of the CDS market “has certainly been a contentious issue,” Alejandro Diaz de Leon, deputy undersecretary for public debt in Mexico, said.
But he added that Latin American regulators must look first at how the rest of the world deals with the issue. “We have to see how regulations around the world evolve on the use of credit default swaps,” he told Emerging Markets.
“As far as we are concerned, they are a useful instrument for investors and the market allows flexibility for them in hedging positions,” Diaz de Leon added.
Julio Velarde, president of the Central Bank of Peru, said CDS could be useful instruments, provided they were used for their real purpose: that of hedging against default on bonds that investors hold. “Concerns are mostly surrounding ‘naked’ CDS,” Velarde said.
He noted that monoline credit operators, which used to offer insurance against default, “have disappeared completely” and CDS now fill that void. “They are a way to protect yourself without selling the underlying paper and so it makes the overall market more efficient,” Velarde said.
But the way the instruments are traded could do with some improvements, in his opinion. “It would be better to have a centralized market and not rely so much on the over-the-counter market for trading this paper. It’s a way of getting protection and is better than just selling the underlying bonds, which adds volatility to the market”. Another problem that Velarde sees with the instruments is the definition that they give to a default event. “Sometimes the CDS contract makes non-payment on the bonds as non-binding for CDS. That is a bad idea as then you don’t need the CDS market at all.” But overall, he said, “I would say the market has more benefits than dangers.”
Credit default swaps were very much in the public eye when Greek debt was restructured last year but discussions surrounding what exactly constituted default so as to trigger payments for CDS holders have died down since.
“There has to be a process of revisiting the topic,” Azucena Arbeleche, director of public credit in Uruguay, said. Because Uruguay does not have a liquid credit default market, it looks at the CDSs of neighbouring countries, such as Brazil, for pricing, she added.
—Additional reporting by Thierry Ogier
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