Friday, 28 October 2011

Sovereign CDS

The Eurozone deal is done.  Judging by the reaction of the equity markets, even the 50% 'haircut' on Greek government debt, when taken together with the rest of the package, is a good deal for the banks. One interesting aspect is that the 'haircut' being taken by private banks has been structured as a 'voluntary' exchange of bonds, with the intention that it should not be a default event triggering CDS payoffs.  ISDA, the body responsible for ruling on CDS, seems willing to go along with this, even while acknowledging that "there has been a lot of arm-twisting".

The effect is that anyone who has insured against loss on Greek government debt by buying sovereign CDS will find that their insurance is worthless and they just have to take the loss.  Conversely, anyone who has blithely written Greek sovereign CDS will make a tidy profit.  It seems strange that we should be encouraging banks to accept downside risk and discouraging them from insuring against losses.  Not that I am going to spend any time feeling sorry for investment bankers - if you trade sovereign debt derivatives you have to be aware that governments can manipulate the market.

I suppose that this will destroy the sovereign CDS market in Europe, especially if the threatened ban on naked buying of sovereign CDS is implement, since that would leave no buyers.  Instead, the EFSF (European Financial Stability Facility) will be offering insurance.  I doubt that the bond markets will be in a hurry to trust the EFSF actually to be there with the cash should the need arise.

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