Sovereign Credit Default Swaps - Stylianos Malliaris Paper

8/9/2019 Sovereign Credit Default Swaps - Stylianos Malliaris Paper

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FLETCHER SCHOOL OF LAW AND DIPLOMACY

ILO L233

INTERNATIONAL FINANCIAL AND FISCAL LAW

Spring 2010

Professor John A. Burgess

SOVEREIGN CREDIT DEFAULT SWAPS:

DERIVATIVES IN NEED OF REGULATION

The Greek Case and the Systemic Risk in the Global Economy

Stylianos Malliaris, MALD 2010

BOSTON

MARCH 2010


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Stylianos MalliarisMALD 2010

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Table of contents

I. Introduction p. 3

II. Definitions:

II.A. Sovereign CDS p. 6

II.B. ISDA Definitions of Sovereign Credit Events p. 7

III. Current Regulatory Framework and its inefficiencies

III.A. The Pattern of Self-Regulation p. 10

III.B. Systemic Risks in the Global Market and Speculation p. 13

IV. Proposed Amendment: Better Go International

IV.A. Owning the underlying Assets p. 15

IV.B. Central Public Trading and Public Disclosure of CDS Trades p. 15

IV.C. Minimum Capitalization p. 16

IV.D. Defining Credit Event by Sovereigns p. 16

V. Conclusion p. 18

Bibliography p. 19


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and other companies in their derivatives arrangements regarding Greece, since using CDS to

destabilize a government is counter-productive .6

On the other hand, Bankers and the International Swaps and Derivatives Association (hereinafter,

ISDA)7 have defended trading activity of CDS on Greek sovereign debt. Major financial

institutions are emphasizing on the usefulness of CDS as hedging tool to disperse risk and point out

that the spike in Greek CDS at the height of Greeces debt crisis earlier this year was mainly due

to banks buying protection against default on the countrys bonds, rather than speculators. 8 Such

interpretation of the current trend would suggest that the purchase of CDS without owning

underlying bonds was not responsible for exacerbating the sell-off in the Greek debt markets.

The same rationale was recently supported by ISDA pointing out that the market for sovereignCDS is much smaller than the underlying market for government bonds. In particular, ISDA

invoked publicly available data from the Trade Information Warehouse of Depository Trust and

Clearing Corporation (hereinafter, DTCC)9 suggesting that the outstanding volumes in the Greek

CDS market is $9 billion. Accordingly, ISDA stated that it is impossible that such market can

dictate prices in the $400 billion Greek government bond market, especially since government

bond and CDS spreads have remained essentially in line while outstanding positions have remained

constant.10

Moreover, ISDA dismiss the inherently speculative character of naked CDS trading, since it

considers that the sovereign CDS market is the most effective means of hedging credit risk to the

Greek private sector as well. It is not only the holders of Greek government bonds that are being

6 Wolfgang Mnchau, Time to outlaw naked credit default swaps, Financial Times, February 28, 2010, availableat http://www.ft.com/cms/s/0/7b56f5b2-24a3-11df-8be0-00144feab49a.html. Accessed March 25, 2010.7 ISDA represents participants in the privately negotiated derivatives industry and is one of the worlds largestglobal financial trade associations. ISDA, chartered in 1985, comprises over 810 member institutions from 57countries. These members include some of the worlds major institutions that deal in privately negotiatedderivatives, as well as many of the businesses, governmental entities and other end users that use over-the-counterderivatives to manage the financial market risks that come with their core economic activities Information

derived from ISDAs website: www.isda.org. Accessed March 25, 2010.8 Nikki Tait, Bank Defend Use of Sovereign CDS Trade, Financial Times, March 5, 2010, available athttp://www.ft.com/cms/s/0/4dbf5706-2887-11df-a0b1-00144feabdc0.html. Accessed March 25, 2010.9 DTCC is a private organization that provides clearing, settlement and information services for equities, corporateand municipal bonds, government and mortgage-backed securities, money market instruments and OTCderivatives. In addition, DTCC is a processor of mutual funds and insurance transactions, linking funds andcarriers with their distribution networks. DTCC's depository provides custody and asset servicing for 3.5 millionsecurities issues on a worldwide basis valued at $28 trillion. DTCC has over 6,000 customers in 45 countries andhas an important role in institutional post-trade processing, acting as a central information management and

processing hub for brokers, investment managers and custodian banks. Information derived from DTTCswebsite: www.dttc.com. Accessed March 25, 2010.10 ISDA, News Release, March 15, 2010 available at http://www.isda.org/media/press/2010/press031510.html.Accessed March 27, 2010.


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secured, but also international banks that extend credit to Greek corporations and banks,

investors in Greek stocks and entities that have significant real estate or corporate holdings in

Greece.11

So, where does the truth lie? The controversy in the aforementioned conflicting views of

policymakers and participants in the CDS market is fundamental to this paper. After I shortly

introduce the main features of the sovereign CDS as a credit derivative, I will try to shed light to

the inefficiencies of the existing self-regulated normative framework for sovereign CDS and

present the main proposals for its strengthening.

11Ibid.


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II. Definitions

II.A. Sovereign CDS

Credit default swaps began as instruments for managing credit risk .12 Sovereign CDS are

particular types of CDS where the reference entity is a sovereign. Accordingly, we need first to

define CDS in general; accordingly, a CDS is a mutual agreement (a bilateral contract) that

provides protection on the par value of a specified reference asset. The protection buyer pays a

periodic fixed fee or a one-off premium to a protection seller, in return for which the seller will

make a payment on the occurrence of a specified credit event, such as a default or a restructuring of

the reference entity, to compensate the buyer for the value of the lost reference asset. 13 The

maturity of the credit default swap does not have to match the maturity of the reference asset, and

often does not. Moreover, contrary to the corporate CDS market, where trading has been

concentrated largely in the 5-year maturity contract, sovereign CDS contracts comprise severalmaturity points between 1 and 10 years.14

The default payment can be paid in whatever way suits the protection buyer or both counterparties,

i.e., it may be cash that will be calculated either at the time of the credit event in conjunction with

the change in price of the reference asset or another specified asset, or it may be fixed at a

predetermined recovery rate (cash settlement) or it may be in the form of actual delivery of the

reference asset at a specified price, usually the face value, despite the applicable reference assets

decline in value (physical settlement).15 Since the agreed-upon principal (i.e., the amount of

protection against loss) is not paid at the execution of the transaction, a CDS is not accompanied by

capital-raising and the protection seller merely assumes the credit risk and not the market risk, i.e.,

the price risk of the reference asset.16

A premium is the price of the CDS and is usually based a floating interest rate used to hedge the

interest fluctuation risk.17 Premium prices in sovereign CDS reflect the creditworthiness of the

sovereign issuing the insured bonds,18 the credit risk concerning the protection seller, the

12 Robert D. Aicher, Deborah L. Cotton & T.K. Khan, Credit Enhancement: Letters of Credit, Guaranties,

Insurance and Swaps (The Clash of Cultures), 59 Bus. Law 954 (2004)13 Moorad Choudhry, Structured Credit Products: Credit Derivatives and Synthetic Securitization, John Wiley &Sons (2004), p. 47 and Moorad Choudhry, The Credit Default Swap Basis, New York : Bloomberg Press (2006),

p. 9.14 See PAN and SINGLETON, supra note 2.15 See Kim, supra note 1, pg. 729.16 Janet M. Tavakoli, Credit Derivatives: A Guide to Instruments and Applications, New York : Wiley, John &Sons (1998), pg. 61.17 Chan-Lau, Jorge A.,Anticipating Credit Events Using Credit Default Swaps: An Application to Sovereign DebtCrises. CREDIT RISK: MODELS, DERIVATIVES, AND MANAGEMENT, Chapter 9, Niklas Wagner, ed.,CRC Press (2008), available at SSRN: http://ssrn.com/abstract=1124143. Accessed March 29, 2010.18 Rating downgrades for Greece after October 2009, when it became clear that the budget deficit for 2009 would

be significantly higher than expected, caused credit spread for bonds as well as Greek sovereign CDS premia to


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anticipated recovery rate19 of the principal if a credit event occurs, and financial markets

considerations.20 The protection sellers credit risk, often called counterparty risk, refers to the

likelihood that the CDS agreement will not be performed due to a bankruptcy or other event related

to the issuer of the CDS.21

Based on the above, a CDS in general functions as a medium for transferring the protection buyers

credit risk position to the protection seller, since the reference asset holder signs the CDS

agreement as a way to replace the reference entitys credit risk with the counterparty risk, for a

specific period of time.22 The sovereign CDS market offers protection buyers the opportunity to

reduce credit concentration and regulatory capital while maintaining customer relationships with

the sovereign, while, for sellers of protection, it offers the opportunity to take credit exposure over

a customised term and receive payment without funding the position.

23

A clear benefit stemmingout of the use of CDS is the increase in the liquidity in the banking industry, since CDS enable

banks to lend with lower risk.24

Most of the parties in the CDS market in general are sophisticated institutions and the primary

participants include globally active banks, financial holding companies, hedge funds, registered

investment companies, as well as large insurance companies. In particular, JP Morgan, Morgan

Stanley, Deutsche Bank, and Goldman Sachs represented jointly in the last few years at least half

of CDS trading volume.25

II.B. ISDA Definitions of Sovereign Credit Events

As it is the case in most credit derivatives, it is a credit event under a sovereign CDS that triggers

the protection sellers obligation to repay the reference asset to the protection buyer.26 Sovereign

CDS contracts are often documented using ISDA model-agreement, the so-called ISDA Master

increase significantly For a brief analysis, see Jacob Gyntelberg and Peter Hrdahl, Overview: sovereign risk jolts markets, BIS Quarterly Review, March 2010, pg. 3-6, available athttp://www.bis.org/publ/qtrpdf/r_qt1003a.pdf. Accessed March 29, 2010.

19 See Moorad Choudhry (2004), supra note 13, pg. 15 The percentage of the original loan that is receivedback [when a corporation enters into liquidation, winding-up or dissolution] is known as the recovery rate, whichis defined as the percentage of par value that is returned to the creditor .20 See Kim, supra note 1, pg. 731.21 Antulio N. Bomfim, Understanding Credit Derivatives and Related Instruments, San Diego: Academic Press(2005), pg 75, 77-78.22Ibid, pg. 54-55.23 Frank Packer and Chamaree Suthiphongchai, Sovereign Credit Default Swaps, BIS Quarterly Review,December 2003, pg. 80, available at http://www.bis.org/publ/qtrpdf/r_qt0312g.pdf. Accessed March 29, 2010.24 Frank Partnoy, The Promise and Perils of Credit Derivatives, 75 U. CIN. L. REV., (2007), pg. 1024.25 Noah L. Wynkoop, The Unregulables: The Perilous Confluence of Hedge Funds and Credit Derivatives, 76FORDHAM L. REV. pg. 3095, 3105 (2008).26 Moorad Choudhry (2004), supra note 13, pg. 54-55.


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Agreement, and by incorporation of standard definitions applicable to CDS published by ISDA.

The trend of standardisation of contract form and definitions that took place in 1998 and 1999 gave

a boost to the sovereign CDS market.27

Under article IV of the latest version of ISDA Definitions (2003), there are six credit events

pertaining to the reference entity that can be included in a credit derivative transaction: (i)

bankruptcy (insolvency events such as winding up, administration and receivership); (ii) failure to

pay (either principal or interest-if the parties to a CDS do not contemplate a particular threshold

amount, the Definitions deem it to be $1 million); (iii) obligation acceleration (by reason of an

event of default--if the parties to a CDS do not contemplate a particular threshold amount, the

Definitions deem it to be $10million); (iv) obligation default (in any of the reference entitys debt

obligation-such credit event is mutually exclusionary with an obligation acceleration event, sinceonly one can be nominated in the CDS agreement); (v) repudiation/moratorium (against all or some

of the reference entitys debts); and (vi) restructuring (any arrangement for all or some of the

reference entitys debts causing a material adverse change in its creditworthiness).28

However, ISDA Definitions for credit events have so far proven insufficient to capture the

dynamics of the sovereign debt market. In particular, sovereign debt restructurings are different

from corporate debt restructurings for reasons other than the absence of an international sovereign

bankruptcy regime. A state, in contrast to a firm, may issue its own currency and it can indirectly

backstop the banking system. Accordingly, sovereign debt is typically a far more important asset

in a countrys financial system than the debt of even a very large local firm, so a sovereign default

is bound to be more disruptive than the default of a firm.29

Moreover, pursuant to ISDA Definitions, among the events that constitute a restructuring is an

Obligation Exchange which is defined as a mandatory transfer of any assets to holders of

Obligations in exchange for such Obligations of the Reference Entity resulting from a

deterioration in the creditworthiness or financial condition of the Reference Entity. However,

such definition of Obligation Exchange does not account for the means by which sovereignsrestructure their debts. While firms would only enter into such an exchange after they had defaulted

or entered bankruptcy, a sovereign may undertake such an exchange merely to decrease the yield

curve on its debt. Under the ISDA Definitions though, if a sovereign conducted such actions while

27 See Frank Packer and Chamaree Suthiphongchai, supra note 23.28 Edmund Parker and Mayer Brown, The 2003 ISDA Credit Derivatives Definitions, PLC Finance, pg. 3,available at http://www.mayerbrown.com/publications/article.asp?id=4281&nid=6. Accessed March 29, 2010.29 Nouriel Roubini & Brad Setser, The Reform of the Sovereign Debt Restructuring Process: Problems, ProposedSolutions and the Argentine Episode, Journal of Restructuring Finance, Vol. 1, No. 1 (2004), pg. 183.


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its credit rating was being downgraded, the restructuring requirements would have been met, even

though the sovereign may be financially sound. Accordingly, sovereign CDS could be performed

without any material change in the creditworthiness of the sovereign resulting to buyers of

sovereign CDS obtaining a higher probability of receiving a payout than corporate CDS buyers. 30

The most pertinent example regarding ISDA Definitions insufficiency to cover sovereign debt

issues was the Argentina financial crisis of 2001 and its sovereign debt restructuring. Argentinas

interim President, Adolfo Rodriguez Saa, issued on December 24, 2001 a decree suspending all of

the countrys external debt. Following this moratorium declaration, legal disputes ensued between

the financial institutions active in Argentina-related sovereign CDS over whether the restructuring

up until that day amounted to a credit event according to the CDS agreements.31 The major issue

under dispute was whether the proclaimed voluntary restructuring process was covered under theISDA Definitions of credit events.32

In general, restructuring should be agreed upon by the reference entity, government authority, or

the holders of the obligation, or, alternatively, should be declared by a governmental authority in a

obligatory form binding the reference entity. The then applicable 1999 ISDA Definitions did not

include restructuring by the reference entity unilaterally (that is common with sovereigns) as a

credit event if such restructuring is voluntary. In specific, the Definitions provided that only events

that are involuntary or mandatory may constitute credit events. However, such technical

interpretation of the ISDA Definitions failed to acknowledge the economically coercive character

of the restructuring, thus not triggering the performance of respective CDS.33

30 Joseph P. Collins, Pamela J. Sackman,Assessing the legal and regulatory environment for Credit Derivatives,ABA Section of Business Law, Volume 2, Number 5, October 2003, pg. 23.31 See Kim, supra note 1, pg. 769.32 Argentina declared officially on November 19, 2001 that it intended to execute a voluntary debt exchange fordomestic pension funds and for sovereign debt holders, so as to extend the maturity of its sovereign debt owned

by domestic bondholders and lower the coupon rate. Argentina insisted that this type of debt restructuring wouldbe voluntary rather than forced and, hence, would not amount to a default - See Timeline: Argentinas FinancialCrisis, Fox News, Dec. 6, 2001, available athttp://www.foxnews.com/story/0,2933,40274,00.html. Accessed March 29, 2010.33 See Kim, supra note 1, pg. 774-779.


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III. Regulatory Framework

III.A. The Pattern of Self-Regulation

The OTC derivatives are generally considered an unregulated financial market. A prima facie

reasoning lies in the assumption that the participants are sophisticated professionals that do not

need governmental protection. Moreover, regulation is not only unnecessary in these markets, it is

potentially damaging, because regulation presupposes disclosure and forced disclosure of

proprietary information can undercut innovations in financial markets.34

Distinguished scholars submit that imposing governmental regulation that might be too rigid or too

mechanical may limit the ability of investors to create capital structures that provide the necessary

liquidity for the global capital market.35 Moreover, even if regulators could adequately embrace in

a normative framework the understanding of the complex interplay between CDS and the rest ofthe economy, that regulatory efforts could be futile because creative financial professionals will

simply offer substitute financial products that mimic the prohibited or [regulated] investment .36

Accordingly, self-regulation mechanisms operate to facilitate derivative transactions, an approach

that is considered by some scholars as the most efficient, since participants in the CDS market

understand the particularities of these instruments and try to minimize risk for their own benefit.37

As indicated above, most sovereign CDS are documented pursuant to the ISDA Master Agreement

(including the negotiated schedule, confirmation, credit support annex and various definitions

books which are incorporated by reference into the ISDA Master Agreement, collectively, the

ISDA Documentation).38

With regard to transparency and disclosure considerations on the CDS market, the DTCCs Trade

Information Warehouse provide publicly accessed data regarding the amount of outstanding CDS

and weekly transaction activity for the 1,000 largest names covering more than 50% of the market.

They suggest that the largest category consists of CDS on sovereigns, particularly emerging

countries, although hedges against Greece, Italy, Portugal and Spain have increased considerable in

34 Alan Greenspan, at the time Federal Reserve Chairman,Regulation,Innovation, and Wealth Creation, Remarks before the Society of Business Economists, London, U.K Sept. 25, 2002, available athttp://www.federalreserve.gov/BoardDocs/Speeches/2002/200209252/default.htm. Accessed March 29, 2010.35 Douglas G. Baird, Other Peoples Money, 60 STAN. L. REV. (2008), pg. 1015.36 Steven M. Davidoff, Paradigm Shift: Federal Securities Regulation In the New Millennium, 2 BROOK. J.CORP. FIN. & COM. L. (2008), pg. 315.37 John T. Lynch, Credit Derivatives: Industry Initiative Supplants Need For Direct Regulatory InterventionA

Model For the Future of U.S. Regulation?, 55 BUFF. L. REV. (2008), pg. 1371.38 Joseph P. Collins, Pamela J. Sackman, supra note 30, pg. 19.


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the last twelve months. Such documenting mechanism provides policymakers with transaction

level data enabling them to evaluate market activity.39

Moreover, ISDA jointly with a group of financial market trade associations including, The Bond

Market Association, the International Association of Credit Portfolio Managers and the Loan

Syndications and Trading Association (comprising the Joint Forum) released a draft statement of

principals and recommendations regarding how banks should handle and use material non-public

information (hereinafter MNPI) when managing credit risk (the Statement of Principles). Such

guidelines are directed to financial institutions using securities and securities-based swaps to hedge

their credit portfolios. The Joint Forum concluded in the Statement of Principles that CDS may

qualify as security-based swaps and, as such, should be to the anti-fraud and anti-manipulation

provisions of the Securities Laws.

40

With regard to speculation and market manipulation concerns, CDS protection sellers have raised

issues pertaining to use by banks of MNPI obtained through their lending relationships when such

banks have a double role as both lenders and protection buyers to the same reference entity. The

Statement of Principles addresses such concerns in both the securities and credit derivative markets

to secure that financial institutions unilaterally implement appropriate MNPI control procedures to

fully comply with securities laws and regulations.41

However, self-regulating norms may not be always deemed by the Courts as an authoritative source

of law or it may prove to be insufficient to deal with every particular dispute arising out of a CDS

contract that refer to ISDA documents.42 The economic stakes in the CDS market are high and the

states have attempted lately to introduce a regulatory framework.

In the US regulation of financial instruments depends on their legal classification. Accordingly,

securities are under the jurisdiction of the Securities and Exchange Commission (hereinafter,

39 Antoine Bouveret, The Credit Default Swap (CDS) Market, Trresor Economics, No. 52, February 2009, pg. 2-3,

available at SSRN: http://ssrn.com/abstract=1483245. Accessed March 29, 2010.40 Joseph P. Collins, Pamela J. Sackman, supra note 30, pg. 5-6.41 Such controls may include: (i) establishing a wall to prevent access to MNPI including a functional and

physical separation of departments, (ii) need-to-know policies to limit dissemination of MNPI within the firmand (iii) restricted lists, watch lists and trading reviews to help restrict, monitor and control transactions when in

possession of MNPI See Joint Market Practices Forum, Statement of Principles and Recommendations Regarding the Handling of Material Nonpublic Information by Credit Market Participants, October 2003,available at http://www.isda.org/c_and_a/pdf/jmpfStatement.pdf. Accessed March 29, 2010.42 As it was the case in an English court decision Australia and New Zealand Banking Group Ltd. v. SocieteGenerale, 1999] 2 All E.R. (comm.) 625; New Law Online 2990915802; affd by, [2000] C.L.C. 833; 1 All E.R.(comm.) 682, where the Court interpreted the terms of a CDS contract in different manner than the one envisaged

by the industry leaders that drafted the original ISDA Documentation See Joseph P. Collins, Pamela J. Sackman,supra note 30, pg. 24.


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SEC), futures are under the jurisdiction of the Commodity Futures Trading Commission

(hereinafter, CFTC), insurance is under the jurisdiction of state insurance regulators and certain

bank products are under the jurisdiction of federal banking regulators. Under the Commodity

Futures Modernization Act of 2000, most swap agreements were exempted from regulation under

the CFTC. Accordingly, sovereign CDS regulation was effectively left to banking regulators, since

most credit derivatives are entered into by banks. Federal banking regulations simply permit banks

to buy and sell credit derivatives.43 . Currently, two plans for establishing CDS clearing houses

have been launched and wait approval by SEC: the CME/Citadel plan, modeled on the existing

energy-derivatives clearing house; and the ICE/TCC plan, backed by major banks, which would be

placed under the dual oversight of the New York Fed and the New York State Banking

Department.44

In Europe, sovereign CDS market is similarly unregulated. The Ecofin Council, the European

Central Bank, and the European Commission had initiated in 2009 a project to establish a

European-based CDS clearing house to no avail, although the ISDA and the European Banking

Federation had originally announced their support for the plan and their intention to adopt the

system. 45 France and Germany are promulgating a directive on OTC derivatives by the European

Commission which is widely expected to encourage more centralised clearing of swaps, so that

security and transparency are enhanced.46

Both countries asked for strict rules, such as banning speculative trading in sovereign CDS and

establishing a compulsory register of derivatives trading, so as to control speculation and police the

deficit spending of member states. Moreover, their plan contemplates unlimited access for

regulators to a register of derivatives trading in order to identify possible speculators and confines

derivatives transactions taking place only on exchanges, electronic platforms and through

centralised clearing houses. Mario Draghi, chairman of the Financial Stability Board echoed the

international consensus in such regulation pointing out that speculative sovereign CDS trading has

systemic implications and whenever something has systemic implications, you can bet it is going

to get systemic regulation.

47

III.B. Systemic Risks in the Global Market and Speculation

43 See Joseph P. Collins, Pamela J. Sackman, supra note 30, pg. 5.44 Antoine Bouvaret, supra note 39, pg. 4.45Ibid.46 Nikki Tait, Bank Defend Use of Sovereign CDS Trade, Financial Times, March 5, 2010, available athttp://www.ft.com/cms/s/0/4dbf5706-2887-11df-a0b1-00144feabdc0.html. Accessed March 25, 2010.47Gwen Robinson, Call for EU CDS Speculation Ban, Financial Times, March 11, 2010, available athttp://www.ft.com/cms/s/0/e7ba5862-2c7c-11df-be45-00144feabdc0.html. Accessed March 29, 2010.


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The major reasons why appropriate regulation should be introduced in the sovereign CDS market

are twofold: first to ensure the sustainability of the global financial system and reduce the systemic

risk that the CDS create and second to counteract the negative effective of pure speculative trading

on sovereign CDS.

Systemic risk refers to the possibility of a sudden, often unexpected, event or series of events that

disrupts financial markets, and thereby the efficient channelling of resources, to such a great degree

that it causes a significant loss to, or collapse of, the real economy as a whole. Systemic collapse is

distinct from regular financial loss or market volatility in that it affects most, if not all, people and

market place participants.48

Banks and other governmental bond buyers (mostly hedge funds) purchase sovereign CDS toeffectively ensure that they will receive full value for the credit extended. Because of this

insurance, bond holders are no longer that concerned about the risk of sovereign default, as long as

there are available counterparties in the market willing to sell CDS referenced to the bonds.

Consequently, bond buyers have incentive to extend always more credit to default-prone

borrowers, who are usually paying higher interest rates to the benefit of the bond buyers.

However, such trend could increase monetary liquidity in a state, inflate prices (starting from the

wages in the public sector) and lead to the creation of dangerous asset bubbles, where the assets

price exceeds the fundamental value of the asset.49 Accordingly, sovereign CDS have the same

causal effect on asset bubbles as an expansionary monetary policy.

Moreover, excessive trade on a sovereigns CDS may cause the default of a net protection seller

that is too big to fail and may bring down other banks, pension or hedge funds that share extensive

interlinkages with it. Such financial institutions are too interconnected to fail because they are

counterparties to thousands upon thousands of transactions in numerous markets. As numerous

parties attempt to unwind their transactions and sell their positions, market liquidity disappears.

The result is that solvent, but suddenly illiquid market participants may default on their ownobligations.50

A last major systemic risk that the sovereign CDS entail is that they undermine the basic principles

pertaining to creditor rights. Since CDS separate the economic interests of creditors (receiving

48 Steven L. Schwarcz, Systemic Risk, 97 Geo L. J. (2008), pg. 193, 204.49 See Gadi Barlevy, Economic Theory and Asset Bubbles, 31 ECON. PERSPECTIVES (2007), pg. 1, 46.Fundamental value is defined as the expected value of all dividends that the asset will yield over its lifetime,discounted for present value.50 Dombalagian, Onnig H.,Requiem for the Bulge Bracket?: Revisiting Investment Bank Regulation (February 1,2009). Available at SSRN: http://ssrn.com/abstract=1249441. Accessed March 29, 2010.


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payment but bearing risk of debtor default) from the control rights of creditors (to enforce, waive,

or modify debt contracts, as well as the right to participate in bankruptcy proceedings), contractual

creditors may be subjected to moral hazard and debtholders my be provided with a negative

economic interest to affirmatively destroy value.51 The moral hazard instance refers to a creditor

who has hedged with CDS, in that the creditor has no interest in wasting its time and resources

monitoring the borrower, while the protection seller who has no contractual obligation with the

borrower cannot also monitor the observance of the bond. On the other hand, the negative

economic interest instance describes a creditor who owns less debt than CDS protection against the

same sovereign. Such a creditor stands to gain by sending the sovereign into default triggering a

CDS payout rather than, i.e., assenting to a voluntary restructuring.52

Apart from the systemic risks, sovereign CDS can also be used as a tool for speculation. Asovereign CDS buyer profits by betting a particular state will fail, and a CDS seller, like a

bondholder, profits by betting that a state will not default on its debt. However, speculation may

lead to CDS market manipulation by driving up demand for default protection by participants with

a massive position in the relevant sovereign market.53 Such inflated demand could bring up also the

bond yields, thus negatively affecting a states finances.

In September 2009, the Markit Group of London, introduced the iTraxx SovX Western Europe

index comprising the fifteen most heavily traded CDS in Europe including the sovereign CDS

against Greece, Portugal and Spain. In February, demand for such index contracts hit $109.3

billion, up from $52.9 billion in January.

Markit, which collects a flat fee by licensing brokers to trade the index, asserts that its index is a

tool for traders, rather than a market driver and accommodates traders needs to hedge their risks.

Although EU politicians have indirectly accused it of market manipulation, the company says the

index make it easier for participants in the CDS market to gauge prices for OTC instruments and

has helped bring transparency to the sovereign CDS market, since prior to its creation, there was no

established benchmark index enabling investors to track the performance of market segments.

54

51 Henry T.C. Hu and Bernard S. Black, Debt, Equity, and Hybrid Decoupling: Governance and Systemic RiskImplications, European Financial Management Journal, Vol. 14, 2008.52Ibid.53 For an analogous example from the corporate CDS market, see the Gotham Case in Joseph P. Collins, Pamela J.Sackman, supra note 30, pg. 9.54 NELSON D. SCHWARTZ and ERIC DASH, Banks Bet Greece Defaults on Debt They Helped Hide, NEWYORK TIMES, February 25, 2010.


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IV. Proposed Amendment: Better Go International

The Greek budget deficit crisis has focused attention on the sovereign CDS market because of

accusations that speculating hedge funds used it to cause a sell-off in Greeces debt and stock

markets and made large sums from violent moves in prices. Such accusations prompted politicians

worldwide to demand more oversight and restrictions of the market. The current trend is that

regulators will force sovereign CDS to become a public market by making banks and funds trade

them on exchanges or through clearing houses, which will oversee and publish trades.

The Financial Stability Board is co-ordinating the G20s response to the financial crisis and has

echoed its support to similar regulations in different jurisdictions. If regulations are not co-

ordinated globally, then traders will simply migrate to the markets where there are no regulations. 55

Unlike shares on stock markets, CDS are traded privately and not on exchanges. This means thatunless every big regulator introduced stricter norms, investors would simply be able to trade in the

locations where bans did not exist.56

IV.A. Owning the underlying Assets

Although the calls for total prohibition of naked short-selling of sovereign CDS have increased,

there are concerns regarding the implications of such ban on the liquidity in the global market. A

ban could prevent banks from being able to hedge their risk by buying sovereign CDS, as the hedge

funds that are the main sellers of protection would no longer be allowed to trade the market.57In

general, hedging parties create an economic purpose for the existence of the market, while

speculative traders offer the needed liquidity for the market to function. Accordingly, the calls for a

total ban seem to be stemming from political considerations, such as the non-existence of a clear

social benefit and the risk of price manipulation for the bond markets.58 However, the latter seems

to be unsubstantiated in the recent Greek case, since the rise in bond yields earlier this year

preceded that in CDS prices, not the reverse, while the most active CDS buyers lately were

European banks holding most of Greeces debt, not speculating hedge funds.59

IV.B.Central Public Trading and Public Disclosure of CDS Trades

The trend in both the US and the EU seems to favour at the time the institution of a central trading

mechanism for sovereign CDS replicating that of regulated securities (such as the stock market). It

55 Gwen Robinson, Call for EU CDS Speculation Ban, Financial Times, March 11, 2010, available athttp://www.ft.com/cms/s/0/e7ba5862-2c7c-11df-be45-00144feabdc0.html. Accessed March 29, 2010.56 See Nikki Tait, supra note 3.57Ibid.58 See Wolfgang Mnchau, supra note 6.59 Editorial Comment, Europes Sovereign Credit Default Flop, Financial Times, March 10, 2009, available athttp://www.ft.com/cms/s/0/7256bd26-2c78-11df-be45-00144feabdc0.html. Accessed March 29, 2010.


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is believed that such central trading will reduce the risk of market manipulation and will make the

intentions of pure speculators clear.

It is true that the lack of transparency in the OTC market in general makes it difficult for investors

to accurately assess credit derivatives risk regarding sovereigns. On November 15, 2008, the

leaders of the G-20 made a public declaration that we will strengthen financial market

transparency, including by enhancing required disclosure on complex financial products and

ensuring complete and accurate disclosure by firms of their financial conditions.60

However, arguments for the relative usefulness of such measures may be derived from the fact that

the DTCC Warehouse has already been providing publicly available information in this regard for

the past two years, while the centralized public trading of a collection of CDS through the iTraxxSovX seems rather to have contributed to the exacerbation of a negative financial momentum for

Greece.61

IV.C. Minimum Capitalization

Since the CDS market is not currently an organized market, the counterparty risk, i.e., the CDS

sellers default risk, is quite high. Imposing increased capital reserve requirements for protection

sellers will decrease the possibility of a systemic risk, although it will also decrease the liquidity in

both the CDS and the bond markets. The Financial Services Authority of the UK had undergone an

analysis of the OTC derivatives market and found that protection sellers tend to engage in

regulatory arbitrage so as to maximize their liquidity. To this end, it recommended revising the

Basel Accord to modernize capital requirements for credit risk transfers on a uniform basis

globally.62

IV.D. Defining Credit Event by Sovereigns

At a minimum, the Argentinean financial crisis illustrates the need for a detailed legal and practical

understanding of the technical mechanics of the standard ISDA documents. Although the exact

nature of the credit event triggering the performance of any OTC derivative will be ad hocnegotiated and agreed upon in each separate contract, there seems to be sufficient grounds for a

regulatory intervention by States with regard to sovereign CDS. The ISDA documents fail to

distinguish clearly the profound differences between a sovereign and a corporate CDS with regard

to the definition of credit events.

60 Available online at Wall Street Journal http://online.wsj.com/article/SB122677642316131071.html. AccessedMarch 29, 2010.61 NELSON D. SCHWARTZ and ERIC DASH, supra note 54.62 See Joseph P. Collins, Pamela J. Sackman, supra note 30, pg. 15.


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Even if it is obvious that the ultimate decision will still lie with the parties of the CDS contract, a

sovereigns statutory standardization of credit events pertaining to sovereign CDS would provide

more clarity in this loophole and guide the Courts of each jurisdiction to a particular approach

when dealing with such subtle issues.


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V. Conclusion

In a meeting in Berlin earlier in March, Angela Merkel, the German chancellor, and George

Papandreou, the Greek prime minister, agreed to push both EU and G-20 leading economies to

restrict speculators who seek to exploit uncertainty over sovereign debt. Although there seems to be

a linkage between speculators activities and rise of yield on Greek bonds interest rates, there has

not been any persuasive evidence that the CDS market dictated the much bigger bond market.

The debate on regulating the systemic risk so far seems to have been based on the wrong grounds:

it is the global financial market that might be endangered by the systemic risk inherent in the CDS

trading rather than the finances of a particular country. Liquidity is needed in the market and only

the fast-profit-oriented hedge funds can provide it. By outlawing their participation in the CDS

market, the impact on Greeces and other sovereigns ability to secure sufficient funding to covertheir current account deficits might be disastrous.

What is needed is more transparency and disclosure of the relevant market data, so as to enable

policy makers and participants better evaluate the environment and take informed and reasonable

decisions. The self-regulation mechanisms have expanded the last years and the nascent DTCC has

already a positive impact enabling parties to trade in the margin. Where self-regulatory norms have

proven to be insufficient so far (as it is the case with the definition of a sovereigns credit event),

the sovereigns authorities should intervene and set authoritative rules that would help the Courts

reach a just, reasoned decision.


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Documents

Sovereign Credit Default Swaps - Stylianos Malliaris Paper