Will Greece slay the CDS market?

The fate of a multi-trillion derivatives market is under a cloud after the International Swaps and Derivatives Association ruled yesterday that the latest attempt to bail out Greece wasn't "a restructuring credit event."

A key element of the looming $300 billion bailout is a $130 billion or so 'haircut' for private holders of Greek government bonds.

It had appeared likely that the institutions holding the bonds – with the exception of the European Central Bank, which is being treated separately and will avoid losses on the bonds it holds – would be asked to ‘voluntarily' accept losses of about 70 per cent on the face value of their investments.

The Greeks are, however, prepared to introduce legislation to force the haircuts onto the investors.

How those losses are triggered is critical to the future of the credit default swap market, derivative securities that enable investors – mainly banks – to take out insurance against the possibility of losses on their bond holdings. The market can also be used to speculate on the creditworthiness of companies and governments.

Ever since the prospect that a bailout of Greece would involve losses for the bond holders became apparent there has been a question mark over the future of sovereign CDS.

The ISDA is a self-regulator of the over-the-counter derivatives markets. It had been asked two critical questions by unnamed investors which have major implications for the future of sovereign CDS.

On Thursday it responded to them. The key question was whether there had been any agreement between Greece and holders of private debt that constituted a restructuring credit event – which would constitute an event of default and trigger the CDS. The other was whether the holders of the Greek bonds had been subordinated to the ECB in a fashion that created a restructuring credit event.

The ISDA's conclusion on both counts was that no restructuring credit event had occurred – but it did note that the situation in Greece was evolving and its present stance wasn't an expression of its view as to whether an event could occur at a later date.

It would appear there is a consensus in the market that if there is a voluntary agreement from the private bond holders to accept the losses a trigger event can probably be avoided, although if a bond holder with more than $US1 million of bonds held out and Greece didn't meet its interest commitments on those bonds there would be a credit event.

If Greece enacts legislation to forcibly impose the haircuts, however, there clearly would be a credit event and the $US70 billion or so of CDS held on Greek bonds would be triggered. Because banks and other institutions both buy and sell CDS the net exposure is said to be only about $US3 billion.

Whether Greece defaults formally or informally is obviously important to the CDS market, but however that plays out the prospect that CDS might prove worthless as insurance against losses on the sovereign debt the Greek bailout negotiations have demonstrated raises a major question mark over the usefulness of the securities.

What's the point of taking out expensive financial protection – millions of dollars – if, when a loss occurs, the securities prove worthless?

If Greek can effectively default without technically triggering a credit event it would undermine the credibility of the entire CDS market. If it enacts legislation to force bond holders to accept losses, on the other hand, the CDS market would retain its integrity – but that could have its own unpleasant consequences.

Because the CDS market is an over-the-counter market it has no transparency and therefore it isn't possible to identify the counterparties or their exposures. It is conceivable that there are banks or other institutions with unhedged exposures to Greek bonds after having sold credit protection without buying an offsetting exposure.

It is that invisible risk, and its potential to freeze markets because counterparties lose trust in each other, that is behind the global regulatory push to shift over-the-counter markets onto exchanges with central clearing.