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Credit derivatives: Isda defends sovereign CDS

Press offensive launched; Q&A faux pas

The International Swaps and Derivatives Association has ramped up its efforts to protect that market’s compromised reputation amid growing concern that political interference from Brussels in the Greek debt restructuring has undermined the credibility of sovereign CDS as a credit risk management tool for banks and investors.

In an escalation of its name-and-shame campaign against journalists that it claims are exaggerating the danger posed by credit default swaps, last month Isda criticized five articles recently published in the financial press. Statements such as "don’t stir the pot if you don’t understand the ingredients" and "it’s time to stop the nonsense" left little ambiguity over Isda’s position.

Poor understanding

Isda claimed the journalists – who see another round of severe losses, bank failures and economic hardship coming from the role played by CDS in the European sovereign debt crisis – exhibited poor technical understanding of the product. Isda’s press offensive claimed a lack of awareness on the part of some writers of primary data sources, such as the Depository Trust & Clearing Corporation’s CDS Trade Information Warehouse, and corporate finance fundamentals. A recent release, for example, criticizes an intentional conflation of bond repurchase agreements (repos) with OTC derivatives published in The New York Times.

The organization is also attempting to highlight the positives in the derivatives market, recently emphasizing that vanilla credit derivatives caused losses of just $2.7 billion between 2007 and the first quarter of this year.

“The news that plain vanilla derivatives caused relatively insignificant losses among international banks during the financial crisis is another piece of evidence about where the risks are in our market place”

Conrad Voldstad, Isda

Conrad Voldstad, Isda’s departing chief executive

The OTC derivatives industry is determined to strip out what it sees as the most onerous elements of Dodd-Frank ahead of implementation, with Conrad Voldstad, Isda’s departing chief executive, saying: "The news that plain vanilla derivatives caused relatively insignificant losses among international banks during the financial crisis compared with structured credit is another piece of evidence about where the risks are in our market place. While we support clearing, the current proposals only cover plain vanilla products and insist on very expensive initial margins, for products where the loss potential is not all that great. The more that regulators, participants and the press know about the market, eventually people will move away from the sound bites and start to look at the numbers." Unfortunately for Isda, sovereign debt has replaced structured finance as the hot-button issue at the centre of the financial crisis, and the organization’s focus on a story from three years ago seems strangely at odds with a market wholly preoccupied by the prospect of sovereign default. Moreover, the Isda leadership’s decision to pre-empt the determinations committee’s (DC) vote on whether the Greek restructuring will trigger sovereign CDS by indicating that it will not leaves a question mark over both the product’s use as credit insurance and Isda’s own procedures. Subsequent attempts by Isda to explain the determinations committee process have only served to highlight the initial faux pas.

For his part, Voldstad says he has been surprised by the frenzy around what he says amounts to a "relatively small credit event". "Compared to the notional bond market, Greek sovereign CDS does not represent a big risk concentration," he says. Voldstad also emphasizes that as much as "99% of dealer derivatives exposures are collateralized primarily with cash".

Trading still happening

Although dealers say that investors have begun reducing exposure over the past two months, participants remain engaged on both sides of the market and net notionals show that trading is still happening.

According to one London-based European head of credit trading, the argument that sovereign CDS has been proven a worthless construct appears to be coming from the media, or from naked shorts, rather than real-money participants using CDS to hedge bond positions. These participants apparently remain engaged on both sides of the market.

"We have seen both buyers and sellers of Greek CDS as the instrument continues to perform well from a mark to market perspective," he says. "Investors have been unwinding positions and making 60 points, and pretty much covering their losses on the bonds. If you are a retail fund or insurance company outside of the European regulators of the jurisdiction, you can properly hedge your Greek exposure with CDS because you won’t be coerced to exchange your bonds. If you don’t exchange, then you are owed some money by Greece. If Greece fails to pay, then you have the right to trigger your CDS. For these holders, it will be a much more clear-cut case."

Volumes hold up
Net notional sovereign CDS volumes, 2011 
Source: DTCC

However, with less than 25% of the €350 billion-equivalent of outstanding Greek government debt held by non-European investors, the number of noteholders with an incentive to hold out for the chance of default, CDS activation and better than 50% recovery is relatively small. Dealers report strong interest for Italian, Spanish, French, Belgian and Dutch CDS among real-money investors, the sovereign CDS market apparently remains liquid and, in some cases, more liquid than the underlying cash bond market. "People believe that Greece is a special case," says the European credit trading head. "The regulators and sovereigns are bullying the European banks to accept the Greek restructuring, while Italy and Spain are in much better shape. Greek CDS is trading at 60 points up front, while Italy and Spain are at around 500bp with the bonds trading close to par."

Given Isda’s position in the eye of the storm, it was perhaps unfortunate timing that the association announced Voldstad’s departure on November 10, to be replaced by Robert Pickel, the man who preceded him in the role for eight years. Asked whether he is leaving because of the way Isda has handled the Greek CDS situation so far, Voldstad is unequivocal. "I am 61 and it’s time to retire. My departure was planned in advance and has got nothing to do with the European sovereign crisis," he tells Euromoney. "Rob Pickel did a great job before and will do so again."

It will now fall to Pickel to deal with the conclusion of the Greek debacle.

Indeed, critics of the 50% haircut solution argue that Greece must raise it to 80% and make it binding on all debt holders to fund its austerity programme, not just the private sector investors represented by the Institute of International Finance.

While local legislators will be unable to modify the terms of the 5% of Greek debt documented under UK law, the insertion of collective action clauses in the remaining 95% could lead to a jarring volte-face at Isda.


“The European Union doesn’t see default as being so critical to avoid now. All the negative headlines they wanted to avoid have been put out anyway”

"If, after three months, the Greeks decide they can’t afford to pay their bills on the 50% voluntary haircut plan, and default and come back and ram it through, then the determinations committee will have to take that into account," says Voldstad. "Things will work the way they are supposed to work and the outcome will be transparent to everyone."

By the time Pickel takes up the mantle, it’s possible that the taboo of European sovereign default will have been broken, perhaps by tacit acceptance of a reality that had been priced into credit markets for more than a year.

"The European Union doesn’t see default as being so critical to avoid now," says the European credit trading head. "A year ago, they were trying to find the right word and focused on exchange; now the regulators talk openly about default and restructuring. All the negative headlines they wanted to avoid have been put out anyway."

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