an initial mid-market price. They can then submit offers to buy or sell bonds on behalf of themselves or their clients t
Special Report
Sovereign CDS faces overhaul Derivatives Greece event exposes serious flaws in the instrument, as traders looking at other hedges to cover risk BY CHRISTOPHER WHITTALL
Sovereign credit default swaps are no longer fit for purpose and are in need of an overhaul if they are to remain valid risk management products, a range of CDS experts have warned. The International Swaps and Derivatives Association has already begun work on updating the sovereign CDS contract in response to concern that future events could leave protection-holders severely out of pocket. CDS holders ultimately did well out of the Greek auction – payouts matched losses sustained on equivalent bond positions. But experts agree that the result was a complete fluke and masked serious flaws in the process for determining sovereign CDS payouts. While sovereign CDS volumes had been soaring, in no small part thanks to Basel III encouraging banks to use the instrument to hedge derivatives counterparty risk, questions about its value are now forcing some market participants to look to reduce their reliance on the product. “Sovereigns don’t always default – they restructure their debt and the CDS contract needs to be adapted to reflect this financial reality and ensure
the payout is close to the payout on the bonds. We were fortunate with the recovery in the Greek auction,” said Nic Beckmann, head of European credit flow trading at BNP Paribas. “It’ll be challenging – this is already a complex contract that many people don’t understand – if you alter it again it’s not going to help liquidity,” he added. David Geen, ISDA’s general counsel, is upfront about the issue, saying: “ISDA recognises the contract needs to evolve in order to stay relevant and appropriately reflect market practice.” ISDA will have to evolve quickly (see “Redesigning CDS”). Many participants are already turning their attention to Portugal, which they believe will have to restructure its debt later this year. Few will be willing to take a punt on another miraculous CDS payout. “We are actively looking at updating the definitions and there are certain aspects of the contract that we may want to fix quite quickly,” added Geen, citing issues around look-back clauses in particular. Ironically, calls to overhaul the contract come after sovereign CDS passed its first
real test with flying colours. Greece represents the largest sovereign restructuring to-date and the first CDS trigger for a Western European sovereign. The ISDA Determinations Committee was under the most intense scrutiny it has ever faced going into its meeting on March 9. Finally, after more than a year of speculation, the DC ruled unanimously that Greek CDS had been triggered following the successful restructuring of the country’s debt.
“The CDS market really got out of jail on this one. The issue around the auction exposed a glaring weakness in the process. I think it’s a very serious strike against the instrument” Although many in the market were confident of such a result, this finally laid to rest speculation that the authorities would look to avoid triggering Greek CDS and the contract would be rendered worthless (see “What are CDS really worth?”, IFR 1881 p36).
REDESIGNING CDS Any adjustments to sovereign CDS will be debated by ISDA’s Credit Steering Committee, comprised of banks, investors and lawyers. ISDA’s David Geen underlined that the Committee had been looking into a revamp of its “credit definitions” for some time in any case. “We’ll likely concentrate on the immediate issues that arose around the auction before we expand to review the definitions as a whole. A whole root-and-branch update of the definitions could be
Some observers characterise it as a turning point in policymakers’ attitude to an instrument that they had previously maligned. The Greek finance ministry even put out a press release stating that all bondholders were bound by the exchange – words lifted directly from the ISDA documentation defining what would trigger CDS. “I am thoroughly encouraged that the authorities have gone from a position of criticising sovereign CDS to apparently cooperating with the DC and removing ambiguity from the process,” said William Porter, head of credit strategy at Credit Suisse. All this nevertheless has failed to allay concerns over another crucial part of the process: the CDS auction that determines payouts on the instrument (see “The auction problem”). It was fortuitous in the extreme, participants agree, that protection buyers were remunerated to the right tune in Greece. “The CDS market really got out of jail on this one. The issue around the auction exposed a glaring weakness in the process. I think it’s a very serious strike against the instrument,” said Paul McNamara, portfolio manager at emerging markets investment manager GAM.
Permanent damage? an exhaustive process and it’s important we address the immediate issues as a first priority,” he said. To solve the auction issue, the whole package of assets participants receive in exchange for their old bonds should be made deliverable into the auction, lawyers say. Other observers suggest changes to documentation should address the potential for sovereigns to structure debt exchanges to avoid CDS
triggers, even though Greece did not go down this avenue in the end. “[Greece has] shown some gaps still need to be filled where the sovereign tries to circumvent the definitions,” said Edmund Parker, co-head of the derivatives practice at Mayer Brown. “In the end we got a credit event with Greece, but it could have gone the other way, and that would have been a major problem.”
International Financing Review March 31 2012
The potential Greek debacle has certainly altered how people use the instrument. McNamara estimated his use of sovereign CDS had dropped by 60% during the past couple of years. “We are less involved in Europe as a result,” he added. This is far from an isolated case. The head of rates trading at a major European bank estimated that volumes have slumped by 40% from a year ago. “Clients are saying it’s no longer a good hedge. We need to re-design the product completely in my view,” he said.
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Overall, the continued uncertainty surrounding the product means supporters of sovereign CDS face an uphill battle to lure back investors. “Worrying for the last year whether you’d get your money or not is very different from being certain all along you’d get it – it becomes more of a gamble. You don’t buy insurance only for the final payout; you buy it for the peace of mind,” said Aaron Brown, risk manager at AQR Capital Management. But not all investors will be put off. Ajay Jani, portfolio manager at emerging markets investment manager Gramercy, said he used sovereign CDS as a mark-to-market hedge rather than a bet against a sovereign default. “To the extent CDS moves roughly in line with the bond then it’s doing its job,” he said. Jani still acknowledged that the ISDA documentation needed tightening up, though. Even the dealer community – which has historically been the product’s biggest cheerleader – is wary of over-reliance on the instrument. “Any sort of basis position between CDS and cash has to be rethought to factor in the recovery, which could be abnormally high in a restructuring event,” said Beckmann at BNP.
Regulatory confusion The problem facing many banks is that their dependence on sovereign CDS has grown
THE AUCTION PROBLEM The recovery price in the Greek CDS auction was 21.5 – very close to where Greek bonds had been trading before the restructuring. That was a major boon for the market; it was also complete luck. In a CDS auction, dealers bid on a series of pre-agreed bonds to set an initial mid-market price. They can then submit offers to buy or sell bonds on behalf of themselves or their clients to square off any exposure. Depending on the net balance of buyers and sellers of bonds, the IMM is adjusted up or down to determine the final settlement price. What was miraculous in the Greek case was the pricing of the
hugely over the past few years. This is mainly because Basel III encourages banks to use the product to hedge derivatives counterparty risk by giving regulatory capital relief. This activity has helped skew the supply and demand dynamics of the sovereign CDS market. Bank CVA desks are buying protection in droves, while many natural sellers of protection such as hedge funds have fled the market, in part out of concern about a forthcoming ban on “naked” sovereign CDS trading across the EU. The supply and demand imbalance could be turned on its head now, as regulators are considering exempting governments and
GREEK SOVEREIGN CDS PERFORMANCE AND NET NOTIONAL VOLUME US$BN EQUIVALENT
SPREAD (BP)
10
12,000
9 10,000
8 7
8,000
6 5
6,000
4 4,000
3 2
2,000 1 0 14 Nov 08 14 Nov 09 n Net notional (US$bn equiv) Spread Source: Thomson Reuters
For daily news stories visit www.ifre.com
0 14 Nov 10
14 Nov 11
bonds. ISDA normally tries to hold an auction before bonds are restructured as the “new” bonds may trade at much higher levels than the “old” ones, resulting in a CDS payout that is much lower than hoped for. This was not possible with Greece because the use of collective action clauses – which triggered the CDS – immediately haircut the old bonds by 53.5%. Coincidently, however, the “new” Greek bonds ended up trading in the low 20s – exactly where the old Greek bonds were. “It’s unheard of to shave €100bn off an issuer’s debt and to have the new bonds trading where
the old ones were. It’s honestly pretty amazing,” said Nic Beckmann at BNPP. The issue needs to be addressed to avoid seriously shortchanging sovereign CDS holders in the future. “You could see a situation where a newly exchanged bond is trading at par, so CDS wouldn’t pay out at all, even though the old bonds had to be haircut 95% to get there,” said William Porter at Credit Suisse. “Firms conducting post mortems may realise how things could have gone very badly wrong, and will be keen to participate in possible redesigns.”
supranationals from regulatory capital charges in Basel III. This would mean banks’ CVA desks have less incentive to hedge using sovereign CDS – although they may choose to do so anyway to manage their P&L volatility. “There is currently a huge bubble in sovereign CDS on the back of CVA hedging. If sovereigns get exempted, those desks may sell back their protection. Who’ll be the buyer?” said the rates trading head. “This, along with the auction issues, means sovereign CDS is becoming an extremely toxic product. We’re exploring ways of hedging via selling more bonds rather than buying CDS, because at least you have a natural buyer and seller in this market,” he added. Some observers have criticised Basel III for its encouragement of sovereign CDS hedging. The Basel Committee declined to comment, though Stefan Walter, former secretary general of the Basel Committee and now a regulatory expert at Ernst & Young, points out there have been concerted efforts to beef up the CDS market over the past few years, and so far it has worked well. “Greek CDS paid out – that’s a success story. It’s also
important to note CVA is intended to capture and hedge mark-to-market losses in a predefault context, and it clearly provides a reasonable amount of offset even if it is not perfect,” said Walter.
International Financing Review March 31 2012
“As a risk manager I have always been wary of CDS. They are designed for traders, for people betting to make money – it’s not really designed for risk protection” Widespread exiting of positions perhaps seems unlikely given the prominent role sovereign CDS now plays in the market. Regardless of how effectively the contracts are overhauled, though, only the foolhardy won’t be reassessing their reliance on the instrument. “As a risk manager I have always been wary of CDS. They are designed for traders, for people betting to make money – it’s not really designed for risk protection. From 10,000 feet CDS looks like the perfect way to hedge counterparty risk, but in reality it’s very unsatisfactory. Greece has only confirmed this,” said Brown at AQR.
