Sovereign CDS questions remain

Traders responsible for managing dealers’ counterparty credit risk from derivatives contracts have expressed concern over the value of sovereign CDS hedges covering some of their largest exposures. 

Credit value adjustment desks are encouraged under Basel III to use sovereign CDS to hedge their counterparty credit risk, but uncertainty over whether Greek CDS would be triggered in the event of a debt restructuring has caused CVA desks to worry that their sizeable exposures to sovereigns and agencies may not be fully covered.

“CDS’s efficiency in terms of a jump-to-default protection mechanism is in question for sovereigns,” said one CVA desk head at a major house.

“We use sovereign CDS to manage our sovereign CVA P&L – which has grown to be quite a significant part of our uncollateralised derivatives exposure. Greece trying to avoid CDS triggering raises the question whether our jump-to-default risk is really covered by this instrument.”

Most sovereigns and agencies refuse to post collateral to dealers on derivatives trades, meaning these entities make up a substantial part of dealers’ uncollateralised derivatives exposures. As a result, dealers have to use sovereign CDS to hedge their counterparty credit risk to their sovereign counterparties.

Regulators have also encouraged dealers to pay greater attention to CVA hedging, leading to CVA desks accounting for a “large proportion” of sovereign CDS trading, according to a report by the Bank of England last year.

“We are torn between two sides. On the one hand, CDS perhaps isn’t as well suited for sovereign entities as it is for corporates – which can default in a relatively orderly fashion – but on the other hand, there is a strong regulatory push in Basel III to get CVA desks to use sovereign CDS more,” said the CVA desk head.

One person close to the Basel Committee said there had not been in-depth regulatory discussions around sovereign CDS use as a hedge, but added: “The Greece situation is a bit unique and whether one can generalise from this experience to all CVA and counterparty credit risk hedging is not necessarily valid. What it does show is that with any hedge there is event and basis risk, and that argues for prudence.”

Some CVA desks are already reported to have dumped CDS hedges owing to concerns over their effectiveness (see “Greek CDS uncertainty fuels dumping “, IFR 1885 p56). The CVA desk head said he hoped the focus on sovereign CDS might encourage regulators to reassess whether sovereigns and agencies should be required to post collateral, which would reduce dealers’ exposure to these counterparties and their reliance on sovereign CDS hedges.

The peripheral crisis has already spurred bilateral negotiations: Portugal agreed to post collateral to its dealers in mid-2010 and Italy is rumoured to have been in discussions, while the CVA desk head said Ireland was “looking very closely at it”.

Bond portfolios

The main debate around sovereign CDS has focused on whether it still represents a valid hedge for bond portfolios. Some traders have defended the instrument, pointing out that it does protect against mark-to-market moves.

“There is a general misconception that when you buy CDS you’re either betting or insuring solely against a default. This is simply not the case. Most buyers of CDS are simply taking a view that credit spreads are going wider. They can, therefore, either sell bonds or buy CDS,” said Peter Duenas-Brockovich, global co-head of credit flow trading at Nomura.

Nevertheless, participants concede it would be bad for the product if CDS were not triggered when they were meant to.

“If there is a coercive restructuring that doesn’t trigger CDS, people that have bought CDS for legitimate hedging purposes will have to find other proxy hedges, such as shorting government bonds,” said Saul Doctor, a credit derivatives strategist at JP Morgan in London.

A debt restructuring needs to bind all holders for it to trigger CDS. David Geen, general counsel at ISDA, explained that the word “voluntary” was dropped from the ISDA definitions after the Argentina default in 2003.

“There was a lack of clarity over what was voluntary or not – it wasn’t legally binding, but there was some arm-twisting going on. So now the definitions just say a restructuring has to bind all holders,” he said.

Even this has led to confusion, Geen conceded. For example, some have suggested that if the ECB were not to accept Greek debt that had not been restructured for its liquidity operations, it could be seen as forcing holders to exchange their bonds.

“My personal view is that wouldn’t trigger CDS, as not all Greek bond-holders may need to place them as collateral to the ECB,” said Geen. “This could be one of the slightly grey areas [ISDA’s determinations committee] needs to discuss.”

The ability of governments to coerce creditors behind the scenes adds to the confusion.

“It’s a real grey area, no question,” said one senior credit trader. “It’s not uncommon for corporate restructurings to not trigger CDS, but sovereigns can exert a disproportionate amount of influence and so there is a bit of a moral dilemma from a regulatory perspective.”

Ultimately, though, participants seem confident that Greek CDS will be triggered if there is a hard restructuring.  

“I find it very hard to believe that they can get around triggering CDS if there truly is a failure to pay or hard restructuring,” said Tim Gately, head of European credit trading at Citigroup. “Ultimately, for the good of the product and for regulators to get comfortable with regulatory capital relief, I think the precedent has to be that if there is a true trigger then it has to pay out.”