SOVEREIGN CREDIT DEFAULT SWAPS: DERIVATIVES IN NEED OF REGULATION The Greek Case and the Systemic Risk in the Global Economy

Sovereign credit default swaps (hereinafter, ‘CDS’) have been traded privately on a gradually increasing amount since 1993. Since they are over-the-counter (hereinafter, ‘OTC’) derivatives, they are traded off-exchange, with no clearing house or margin-call mechanism. These credit derivatives follow in general the rules applicable on corporate CDS (which is a rather self-regulated market) and, since recently, there had not been any major discussion for its non-particularized regulation. Contrary to many sovereign bonds, sovereign CDS contracts do not comprise complicated guarantees or embedded options and, thus, trading activity in sovereign CDS has developed to the point that they are more liquid than many of the underlying bonds.

But amidst the current Greek financial turbulence came voices from EU leaders that the CDS market may have actually caused or at least contributed to the deterioration of the terms of a sovereign’s debt market, i.e. on the yield of the interest rates the market sets for the Greek bonds. This could be characterized as a “knock-on” effect of a secondary derivatives market upon the main debt market, the actual implications of which have been difficult to trace. However, this is a pattern of a vicious circle: it is the sovereign’s debt market that should be setting the prices for the respective CDS, not the opposite. Since holding of the debt instruments is not required for the sale or the purchase of CDS, there is room for speculative action.

It is exactly these concerns that motivated the political appetite in Europe for clamping down on speculative trading. France and Germany were reported to ask the President of the European Commission to introduce more transparency into the trading of credit default swaps so as to a sovereign debt market being destabilized by speculative trading activity, such as the naked short selling of CDS, i.e, the short selling of instruments by a party that does not own them. At the same time, following pressure from EU officials, the US Department of Justice announced it would begin investigations on hedge funds’ alleged speculative trading on Greece’s CDS in an orchestrated attempt to drive down the value of euro. Ben Bernanke, chairman of US Federal Reserve, stated that the Fed was investigating “a number of questions relating to Goldman Sachs and other companies in their derivatives arrangements regarding Greece”, since using CDS to destabilize a government is “counter-productive”.

On the other hand, Bankers and the International Swaps and Derivatives Association (hereinafter, ‘ISDA’) 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 Greece’s debt crisis earlier this year was mainly due to banks buying protection against default on the country’s bonds, rather than speculators”. 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 sovereign CDS 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’) 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.

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 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.

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.

II. Definitions
II.A. Sovereign CDS
“Credit default swaps began as instruments for managing credit risk”. 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. 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 several maturity points between 1 and 10 years.

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 asset’s decline in value (physical settlement). 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.

A premium is the price of the CDS and is usually based a floating interest rate used to hedge the interest fluctuation risk. Premium prices in sovereign CDS reflect the creditworthiness of the sovereign issuing the insured bonds, the credit risk concerning the protection seller, the anticipated “recovery rate” of the principal if a credit event occurs, and financial markets considerations. The protection seller’s 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.

Based on the above, a CDS in general functions as a medium for transferring the protection buyer’s credit risk position to the protection seller, since the reference asset holder signs the CDS agreement as a way to replace the reference entity’s credit risk with the counterparty risk, for a specific period of time. 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. A clear benefit stemming out of the use of CDS is the increase in the liquidity in the banking industry, since CDS enable banks to lend with lower risk.

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.

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 seller’s obligation to repay the reference asset to the protection buyer. Sovereign CDS contracts are often documented using ISDA model-agreement, the so-called ‘ISDA Master 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.

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 entity’s debt obligation-such credit event is mutually exclusionary with an obligation acceleration event, since only one can be nominated in the CDS agreement); (v) repudiation/moratorium (against all or some of the reference entity’s debts); and (vi) restructuring (any arrangement for all or some of the reference entity’s debts causing a material adverse change in its creditworthiness).

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 country’s 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”.

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 sovereigns restructure 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 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.

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. Argentina’s interim President, Adolfo Rodriguez Saa, issued on December 24, 2001 a decree suspending all of the country’s 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. The major issue under dispute was whether the proclaimed voluntary restructuring process was covered under the ISDA Definitions of credit events.

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.

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”.

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. Moreover, even if regulators could adequately embrace in a normative framework the understanding of the complex interplay between CDS and the rest of the economy, that regulatory efforts could be futile because “creative financial professionals will simply offer substitute financial products that mimic the prohibited or [regulated] investment”.

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. 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”).

With regard to transparency and disclosure considerations on the CDS market, the DTCC’s 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 the last twelve months. Such documenting mechanism provides policymakers with transaction level data enabling them to evaluate market activity.

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.

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.

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. 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, ‘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. . 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.

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. 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.

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”.

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

Banks and other governmental bond buyers (mostly hedge funds) purchase sovereign CDS to effectively 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 asset’s price exceeds the fundamental value of the asset. Accordingly, sovereign CDS have the same causal effect on asset bubbles as an expansionary monetary policy.

Moreover, excessive trade on a sovereign’s 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 own obligations.
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 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. 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.

Apart from the systemic risks, sovereign CDS can also be used as a tool for speculation. A sovereign 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. Such inflated demand could bring up also the bond yields, thus negatively affecting a state’s 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.


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 Greece’s 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 G20’s 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. Unlike shares on stock markets, CDS are traded privately and not on exchanges. This means that unless every big regulator introduced stricter norms, investors would simply be able to trade in the locations where bans did not exist.

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. In 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. 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 Greece’s debt, not speculating hedge funds.

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 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”.

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 iTraxx SovX seems rather to have contributed to the exacerbation of a negative financial momentum for Greece.

IV.C. Minimum Capitalization
Since the CDS market is not currently an organized market, the counterparty risk, i.e., the CDS seller’s 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.

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 hoc negotiated 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.
Even if it is obvious that the ultimate decision will still lie with the parties of the CDS contract, a sovereign’s 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.

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 Greece’s and other sovereigns’ ability to secure sufficient funding to cover their 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 sovereign’s credit event), the sovereign’s authorities should intervene and set authoritative rules that would help the Courts reach a just, reasoned decision.