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