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CDS market: The rise of sovereign default swaps

Investors are showing their nerves in the CDS market.

There’s a small irony that might be lost on western governments. As they prepare legislation to clamp down on the credit default swap market, which, they claim, creates systemic risk, the very same instrument is becoming the tool of choice in hedging the ultimate of all systemic risks, sovereign default.

Since October, the net amount of credit default swaps outstanding on 54 governments from Japan to Greece has jumped 14%, compared with just 2.6% for all other contracts, consisting of investment-grade and high-yield companies, according to the Depository Trust & Clearing Corporation. The increase is largely driven by European sovereigns, with contracts on Portugal up 23% and on Spain up 16%. As the IMF points out in its Global Financial Stability Report, the financial system is still fragile, with sovereign debt posing a risk to markets.

Traders say that sovereign volumes have gone through the roof since the beginning of the year. Whereas as recently as December they made up 5% of trading volumes, they now constitute about 20% of daily volumes, according to Deutsche Bank. Part of that is explained by the introduction of a sovereign CDS index in January by index provider Markit iTraxx, which enables investors to hedge their indexed bond portfolios against a similar synthetic index.

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