You have to love the media’s penchant and talent for creating stories out of nothing. It has become something of an art form to weave kernels of truth, tendrils of fear and threads of doubt into infinitely varied tapestries of potential crises, actual crises and crises averted. These days it seems that the sky is always falling somewhere and that the consequences of the crisis du jour will always rise to the pandemic level—be it the Chinese real estate bubble, the ending of the second tech boom or the hullaballoo from politicians waiting until the last possible moment to raise the U.S. debt ceiling. Ironically and interestingly, this seems to be happening somewhat disproportionately in the derivatives space.
Five years ago finding frequent (virtually daily) references to derivatives in the mainstream media would have been impossible, even in the more aloof financial press. Today, stories about all manner of derivatives literally pepper a wide variety of publications and news outlets well beyond the traditional coverage provided by Derivatives Week (now Derivatives Intelligence—if anyone knows the story there I’d be curious to hear it—and, yes, I’m skipping the oxymoron joke, way too easy), CreditFlux and other trade publications. Indeed, on June 23rd David Oakley published an article in the Financial Times suggesting that if there was no credit event in respect of a Greece bailout that it could very well be the end of the sovereign CDS markets (there was another piece subsequently published by Reuters before the most recent bailout was finalized indicating it would be unlikely to cause a credit event, but noting that ISDA DC decisions are never certain).
Mr. Oakley points out that regulators were and are well aware of the importance of avoiding a credit event in respect of Greece and that effecting a bailout without causing a credit event was at the forefront of their minds in trying to come up with a plan to avoid Greece defaulting on its bonds. Citing “some strategists” Mr. Oakley goes on to say that a solution not resulting in a credit event could bring the “sovereign CDS market to a standstill.” His one named source, Gary Jenkins of Evolution Securities, is quoted as saying that there is a risk that no credit event in respect of Greece could cause market participants “‘to decide it is no longer worth buying protection.’”
My response: No—no credit event in respect of Greece at this juncture will not destroy the sovereign CDS market. Anyone who doesn’t understand the nuances of what triggers a credit event under a CDS shouldn’t be using them either to hedge or to speculate, and should instead stick to the basics like puts and calls or shorting, etc. CDS are only triggered and provide protection in certain circumstances. Market participants have to know that in situations like this all of the governmental actors will do everything they can to avoid a credit event entirely, or at least, for as long as possible. Thus, it should come as a surprise to no one that the current Greece bailout was structured to avoid a credit event and that it is entirely possible all future bailouts will be similarly structured to avoid credit events.
Why then will no credit event in respect of Greece at present have only a minimal impact on the sovereign CDS market? Because if Greece ever actually does default it will be a credit event and if Greece doesn’t actually default (or suffer another credit event) then buyers of protection received exactly what they paid for. Those looking for complete transfer of risk should have effected actual sales or entered into TRSs. Those looking for a better hedge or speculative mechanism could have employed alternative artifices. Of course, viewing the non-occurrence of a credit event in respect of Greece as a non-event is much less sensational and makes for a far less interesting story than Mr. Oakley’s.
Agree? Disagree? Share your thoughts in the comments.