Italy shock shows sovereign CDS still active – flaws and all

LONDON (Reuters) – Italy’s recent bond shock showed that the financial derivatives market designed to insure against sovereign defaults hasn’t been killed off by doubts about whether those contracts would pay out when the time came.

The market for sovereign credit default swaps (CDS) is half the size it was six years ago at the height of the euro zone debt crisis, following a government clampdown and a patchy record as a hedge for a credit event.

But when the political crisis in Italy began to hammer the country’s huge government bond market, one of the biggest trades was to buy an updated version of the credit insurance contracts, signaling an enduring, albeit changing, appetite for the instruments.

The CDS market as a whole still has a notional value of over $10 trillion, data from industry body International Swaps and Derivatives Association (ISDA) shows.

“During the financial crisis, in some cases it didn’t provide the same protection that was expected,” said Erin Browne, head of asset allocation at UBS Asset Management.

“It may work for a directional view, but we don’t use it as a hedge against default,” she said.

A euro zone sovereign default has been a concern for investors in developed market government bonds as no country within the bloc can print money on its own if faced with debt repayment difficulties.

Even though the European Central Bank has performed that function when it deemed a country’s problems threatened the wider system, the effective Greek default of 2012 underlined the residual risk.

The notional outstanding CDS for euro zone single-name sovereigns has almost halved, but still stands at 510.6 billion, the data shows.


If investors holding a CDS believe a credit event has occurred, they make a submission to ISDA, who then pass it on to a determinations committee for a decision.

This can lead to variable results. In the case of the Greek sovereign debt crisis in 2010, investors eventually received a payout, but there was a long period where they worried Greece would default without triggering the CDS.

In the case of Portugal’s Novo Banco, they did not.

Those who assess portfolio risk for funds said they still believe in the ability of CDS to hedge debt holdings – up to a point.

“It really depends what they are trying to hedge, what the contract defines as a default event, which specific bond is in default and a multitude of other factors,” said David Cockburn, chief risk officer and chief operating officer at London-based Alfreton Capital, a hedge fund.

Sameer Saifan, CEO at Cassandra Wealth and previously chief risk officer at fund of hedge funds Tages Capital, said CDS work, but the default has to happen as set out in the contract. “The devil is in the detail,” he said.

ISDA tried to repair criticism of CDS by releasing definitions that attempted to clarify what constituted a credit event, placating some.

“(The 2014 ISDA definitions) took care of lots of questions about sovereign CDS… in terms of restructuring and what happens in case of a redenomination,” said Andrea Cicione, head of strategy at financial research firm TS Lombard.

In the Italian sell-off, traders bought CDS contracts written under the 2014 definitions over the old 2003 contracts, said Atritra Banerjee, a credit derivatives strategist at Citi, among the biggest dealers of CDS.

This drove the prices of the two contracts apart.


Activity in CDS was drained by the European Union’s 2012 ban on short-selling of sovereign debt, which prevented investors from taking so-called “naked” positions – speculating on CDS prices without owning the underlying bonds.

Governments argued such speculation led to unacceptable moral hazard, equivalent to taking fire insurance out on a house you didn’t own. In effect, they argued it encouraged players to build positions that raised debt payment stress on governments while simultaneously profiting from holding the CDS if that stress resulted in non-payment.

“The short-selling ban changed the type of market participants and it also changed the liquidity and size of the market,” said Matthew Haworth, a rates trader at JP Morgan, one of the biggest dealers of CDS in the world.

Many real money investors are also buying CDS not to hedge against a default – but simply to hedge against a sell-off on the assumption that CDS prices will rise when the underlying debt sells off.

“They are actually hoping that the debt doesn’t default,” said Cicione of TS Lombard.

Financial markets have a history of buying and selling products on certain correlation assumptions, without necessarily examining the veracity of the underlying asset; most notably sub-prime mortgages in the lead up to the 2008 financial crisis.

“When it’s questionable whether or not these CDS contracts will be honored, it means that they work as a hedge only as long as others believe they work as a hedge,” said Rabobank rates strategist Richard McGuire.

“There is no intrinsic value beyond the broader sentiment in market – which really is the same rationale behind cryptocurrency.”

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