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Precedential Election: Can Trust Be Maintained in Sovereign CDS Markets?

e21 | January 26, 2012

There is little doubt policymakers both within the EU and without will make sure a Hellenic default is avoided. Perhaps the better question is what precedent will the deal set and how will its impact reverberate throughout global financial markets? Whether considering the first deal proposed in October 2011 or the deal now being formulated at the beginning of 2012, the critical point is whether or not credit default swaps should be triggered.

The ECB prefers that a deal be struck without triggering CDS. However, growing sentiment finds that a deal which undermines CDS payment obligations will create yet more moral hazard, bringing the entire CDS market into a state of confusion. Here are several prudent questions which have been posed regarding a Greek debt deal which would ignore basic economic and legal fundamentals:

Does it really matter if the CDS is triggered?

While a full blown default would certainly pose a significant risk to European and global markets, a mere trigger of CDS on Greek debt would have a “muted response” in markets, as this Barclays report shows. Barclays estimates there is only €3.3 billion in coverage which would be triggered. While the number itself is fairly harmless in comparison with the prospect of a true default, its impact is diminished further by the fact markets and counterparties have had months to plan for a triggering event. If a market response would be muted, as Barclay’s suggests, then it would seem a fair price to pay for the benefit of maintaining trust in CDS markets.

If Greek CDS Don’t Trigger, Why Would EFSF?

This commentary from Alen Mattich in the WSJ, makes an ironic analogy between the European Financial Stability Fund and sovereign debt CDS. In principle, both offer an insurance policy against sovereign debt. A Greek deal where sovereigns encourage a failure to honor the commitments that market participants have freely contracted with each other raises concerns on commitments sovereigns themselves have extended to market participants, such as with the EFSF. Since both sovereign debt CDS and the EFSF insure against the same thing, shouldn’t they also be triggered by congruent events?

What’s the value of buying insurance on sovereign debt if a buyer won’t even get paid on the most high-profile sovereign restructuring in the last 10 years?

Another piece from the WSJ plays the role of market participant in pondering what a non-triggering deal would mean for CDS demand—echoing ideas from this e21 editorial in October. In response to the prospect of a voluntary deal last fall, the International Derivatives and Swaps Association issued this statement “the bond restructuring is voluntary and not binding on all bondholders. As such, it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts.” At the time of that statement, the net notional value of the CDS market on Greek debt had already plummeted 47% from a year ago, a trend which can be seen in continuation in the chart below from the FT. Clearly, market demand for CDS against sovereign debt is diminishing as policymakers have perpetuated the idea of undermining the legality and fundamentals of the CDS market.

As other sovereigns inch closer to the cliff upon which Greece now hangs, the precedent set by a Greek debt deal will be important for the future. Will policymakers look to honor the commitments informed market participants have willingly entered into, or will they look to finagle the rules in hopes of short-term benefits at the cost of long-term economic fundamentals?

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