As it wrestled with Greece’s debt crisis for the past two years, the European Central Bank took great pains to avoid triggering credit-default swaps written on Greek bonds.
But on March 9, Greece forced payouts on swaps contracts when it required all private bondholders to forgive more than 100 billion euros of debt as part of the biggest sovereign-debt restructuring in history.
The International Swaps and Derivatives Association, a trade group of large financial institutions, euphemistically calls Greece’s debt deal a “credit event.” The rest of the world calls it what it is: a default. Still, no panic has ensued; no contagion has swept over U.S. banks. On Monday, the world’s bourses held steady. Yields on large, financially strapped sovereigns, including Spain and Italy, ticked up only slightly. The financial markets, it seems, are treating the CDS trigger as a nonevent.
All of this is a healthy sign that credit-default swaps remain effective instruments to transfer and hedge risk. Banks and other financial institutions rely on the instruments to protect against losses. Others use them as a way to bet on a government’s or a company’s ability to repay debt. Hedge funds especially like credit-default swaps because they offer a low-cost means of taking on credit exposure. A CDS can gain value even if no default occurs. A fund manager who thinks a bond might decline in value -- or that a CDS is underpriced -- can buy protection in anticipation that spreads will widen. If the view turns out to be correct, the fund reverses the transaction at a profit.
$32 Trillion Market
Whether you think any of that is a productive use of capital, credit-default swaps have become so ingrained in the financial markets, with $32 trillion in contracts outstanding, that any hiccup in their use could be disastrous. Concerns arose earlier this month that CDS were no longer reliable after an ISDA panel ruled that a Greek credit event hadn’t occurred, even though bondholders were accepting more than 50 percent reductions in value. But when Greece invoked a legal clause making the reductions mandatory for all private bondholders, the ISDA panel immediately moved to trigger the swaps.
One reason for the markets’ insouciance is that the amount of money expected to change hands is, in the context of derivatives, minimal. The gross amount of outstanding swaps on Greek debt is about $70 billion, of which only about $3.2 billion remains after buyers and sellers net out their positions.
But the bigger reason Greek officials felt they could pull the trigger is that the financial markets have come a long way since the 2008 collapse of Lehman Brothers Holdings Inc. Any interruption in the daisy chain of CDS payments ($5.2 billion as a result of Lehman’s bankruptcy) could have set off a panic. At the time, most credit-default swaps were settled between buyers and sellers, leaving counterparties down the chain in the dark over whether they would get paid. In the end, the contracts were all unwound, but the New York Fed, other regulators and Congress demanded changes.
Since then, large banks and investment funds, through the ISDA, have created legally binding procedures, more clearly defined what constitutes a credit event and written rules for settling contracts after payouts are triggered. Fifty-eight credit events have gone off largely without a hitch.
Today’s CDS market is less opaque (though it still needs improvement on this front). Banks have sped up back-office mechanics by automating trade confirmations. About 90 percent of CDS transactions are now collateralized, meaning that protection sellers don’t need to scrounge for huge sums of cash in case of a default. And many banks that deal in swaps now publicly report their positions.
Margin and Clearinghouses
Still, market players and regulators don’t always know who owes what to whom and whether CDS sellers can make good on their protection promises. Rules to be written as part of the Dodd-Frank financial reform law, which some large banks continue to lobby against, will help. Clearinghouses, for example, which act as the buyer to every seller and seller to every buyer, can reduce the risk of failed transactions and give regulators a window on market positions and prices.
For that reason, regulators should interpret the law broadly and require as many CDS trades as possible to be centrally cleared. Overseers should also require margin -- regular payments to a counterparty as the value of a CDS changes -- in as many situations as possible. Regulators should require so-called legal entity identifiers that would enable them to know who is conducting trades. And because none of these rules will work if only U.S. dealers follow them, regulators should work closely with international counterparts to establish global rules of the road.
Things could still go wrong with Greece’s default. An auction will take place March 19 to set a recovery value on the Greek bonds underlying the credit-default swaps, which will determine the amount of any payout. By then, old Greek bonds will have been replaced with new ones, forcing the ISDA to figure out what bonds will suffice in the settlement process. A potential glitch, yes. But in the big picture, it makes the CDS market seem a lot safer than it was just a few years ago.
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