Greek CDS uncertainty fuels dumping

Uncertainty over whether credit default swaps referencing Greece may be triggered when the country restructures its debt has led to some desks reportedly dumping Greek credit protection they fear could be rendered useless.

As doubts persist that authorities may look to avoid triggering CDS in a potential restructuring of Greek debt, banks that have bought costly hedges are faced with the prospect that they may not pay out and cushion losses on bond portfolios.

“The vast majority of Greek CDS positions are hedges,” said one head of European credit trading at a US house. “Restructuring in a way that specifically won’t trigger CDS not only undermines the product – it eliminates the insurance participants have bought to protect themselves. In effect, they’re doubly hurting participants that did prudent risk management.

“One CVA [credit value adjustment] desk told me: ’We’re taking our Greek hedges off because we’re going to get screwed both ways: we’ll be forced to take haircuts and CDS won’t trigger so we lose out on the hedge. It’s the absolute worst outcome for us.’ And I’m sure they’re not the only ones thinking that.”

The uncertainty over the value Greek CDS represents as a hedge has been reflected in nervy markets. Basis players – one of the few sources of Greek bond buying in recent times – are reportedly more hesitant to put on trades, while others are taking off hedges altogether.

“Nobody is buying Greek protection because of the concern about how it will be treated,” said the head of European credit trading. “Players who would take the other side of trades are more hesitant to get involved, so you have to be more conservative with liquidity provision.

“It’s ultimately hurting corporate Greece, as people have less options to hedge Greek risk. Bank lines have already contracted to corporate Greece, and that’s just going to increase.”

Given the prohibitive cost of buying Greek credit protection, it is thought that many banks have not directly hedged their Greek exposure with sovereign CDS. This is reflected in the relatively small amount of net notional of Greek CDS, which is currently US$5.3bn according to the Depository Trust and Clearing Corporation, compared with total Greek debt of about US$394bn.

If anything, the relatively paltry size of the Greek CDS market should be a reason in favour of triggering CDS, dealers argue, as a credit event would be unlikely to have systemic implications.

“The focus on CDS triggers misses the point – it’s such a tiny portion of the whole thing it’s irrelevant,” said one senior credit trader.

According to lawyers, a voluntary exchange of Greek debt that does not bind all bondholders should not constitute a credit event (see “What are CDS really worth?” IFR 1881 p36). Some have speculated the International Swaps and Derivatives Association Determination Committee might look to safeguard the integrity of the CDS product by ruling a credit event has occurred regardless of how Greek debt is restructured. However, a former member of the Committee thought this unlikely – a view supported by lawyers.

“If it is clear as a matter of law that a credit event has not occurred, then I don’t think it’s likely that the Determinations Committee would contrive to declare a credit event anyway as it would risk bringing the whole system into disrepute,” said Simon Firth, a partner of Linklaters in London.

“If the Committee starts making decisions on the basis of what it believes is good for the market (whatever that means), in disregard of the true contractual position, there will no longer be any certainty about the result of credit event determinations. The system only works if the market is confident the Committee will make decisions on the correct legal basis according to the documentation.”

However, whether or not credit definitions need to be tightened to prevent debt being deliberately restructured to avoid trigger CDS could well be debated going forward.

“This could lead to a tightening up of the language around credit events. That said, it depends on what people think ought to be covered,” said Firth. “CDS triggering is meant to be the result of a really serious financial problem and you could argue a voluntary exchange shouldn’t be a restructuring. 

“The problem is that an exchange can purport to be voluntary, while actually there is implicit coercion behind the scenes. And it’s very difficult to know where to draw the line.”

Christopher Whittall