Senior derivatives users, including a member of the board at the International Swaps and Derivatives Association, have warned that the intrinsic value of credit default swaps could be severely compromised if Greece restructured its debt without triggering a credit event.
As consensus has grown that authorities will look to avoid triggering CDS when restructuring Greek bonds, market participants have been scrambling to understand the potential ramifications of such a development, with many fearing the worst.
“If there is a restructuring that doesn’t trigger CDS, that calls in to question the value of the instrument,” said the ISDA board member. “If you buy CDS and it doesn’t economically protect you as expected, you will question the usefulness of that tool as a risk mitigant, and you’ll be unlikely to ever buy protection again.”
Some dispute this analysis – pointing out that Greek CDS has performed well in hedging the mark-to-market risk of Greek bonds over the past year. While conceding this to be true, other senior derivatives traders are worried CDS will be devalued in the eyes of end-users if Greece were to sidestep a CDS restructuring event via legal manoeuvring.
It could also have more immediate repercussions for European debt. One London-based sovereign CDS trader said much recent peripheral sovereign bond-buying has stemmed from negative basis players (where an investor buys a bond and CDS protection in order to arbitrage differences between the two levels). These investors might not take kindly to Greek CDS not triggering.
“For the last six months, the only Greek bond buying that’s happened away from the ECB has been basis buying,” said the trader. “If you take those guys out of the equation, there would be a lot of sellers coming out of Portuguese and Irish bonds, because they would realise their CDS hedges aren’t good. If Greek debt restructures, then CDS should trigger just in terms of the economics of what it’s meant to do.”
Lawyers say the most likely way to avoid a CDS credit event when restructuring Greek debt would be to propose a consensual debt exchange. “To have a restructuring credit event, there has to be something that binds all bond-holders. There is no restructuring from a CDS point of view if not all holders are bound,” said Simon Firth, partner at Linklaters in London. “A consensual amendment to the terms of the bonds that didn’t bind all the holders, because not everyone participated, wouldn’t constitute a restructuring.”
Coordinated action would be essential to pull this off, bankers say. The senior European credit trader calculated the ECB, France and Germany own around 50% of Greek bonds between them, many of which trade at around a 40% discount. Exchanging these bonds for new paper issued at current trading levels would reduce Greece’s debt burden, and shouldn’t trigger a credit event as it would not bind all bondholders.
The ECB could also incentivise the exchange by only offering secured financing on Greek bonds that have had haircuts. “It would be a massive incentive for banks that hold the bonds to do the exchange,” said the senior European credit trader.
While some point out CDS triggers are very much a secondary consideration when restructuring debt, market consensus holds the authorities will look to avoid such a scenario with respect to Greek bonds. Although a Greek trigger is unlikely to have systemic implications – net notional of CDS referencing Greece is currently US$5.6bn according to the Depository Trust and Clearing Corporation compared to around €223bn of euro-denominated bonds outstanding (and US$394bn of Greek debt in total) – some fear it could spread contagion to other peripheral sovereigns.
“It also comes down to pride,” said a senior European credit trader. “They want to ensure the Eurozone is strong and committed to pay its debts, that the euro is here to stay, and they don’t want headlines saying Greece defaults or triggers CDS.”
Christopher Whittall
A longer version of this article will appear in this week’s IFR.