Greek auction result could undermine CDS use

An early trigger is unlikely, but fears of distorted auction outcome remain – and could undermine the use of credit default swaps as a hedge, say market participants

Technical factors could distort the result of any auction on Greek sovereign credit default swaps (CDSs), market participants warn – an outcome that could further erode confidence in the CDS market.

"Anyone who has a CDS position is interested in the outcome of this, and that includes banks hedging derivatives or loan portfolios, as well as investors with bond exposures. Anyone who has got Greek CDS, or sovereign CDS positions more generally, will be watching to see what the outcome will be," says Saul Doctor, head of credit derivatives strategies at JP Morgan in London.

While dealers initially fretted about whether CDS contracts on Greek debt would be triggered, it now seems likely a credit event will occur. Instead, participants are worried that the settlement on the CDS contacts will not reflect the losses on Greek sovereign debt.

"There is a tail risk of the final settlement of Greek CDSs not going very well, and the payout being bigger or smaller than some people might expect. The concern is that now everything is running to such a tight timescale, there's not enough time to have a proper CDS auction before all the bonds have been exchanged," explains Michael Hampden-Turner, London-based head of European collateralised debt obligation strategy at Citi.

On February 23, the Greek parliament voted to insert so-called collective action clauses (CACs) into the country's debt, which would allow Greece to impose a restructuring plan on bondholders, as long as it is approved by a two-thirds majority. A day later, Greece's finance ministry formally initiated a tender offer for €206 billion ($276 billion) of bonds.

There is a tail risk of the final settlement of Greek CDS not going very well, and the payout being bigger or smaller than some people might expect

The terms of the offer would see bondholders receive new 30-year Greek bonds with a face value of 31.5% of the face amount of the exchanged debt, plus a two-year debt security issued by the Luxembourg-based European Financial Stability Facility with a face value of 15% of the exchanged debt. In addition, bondholders will receive a detachable security with a payout linked to Greece's GDP and a notional amount equal to the face value of the new bonds.

While the retroactive insertion of CACs does not in itself constitute a credit event, any triggering of the CACs to force losses on bondholders would, say market participants. "When you insert and use a CAC, the deal is no longer voluntary. There was always a fear that if the deal was entirely voluntary, it wouldn't trigger a CDS. But the chances of the debt swap being entirely voluntary seems to be low," says Citi's Hampden-Turner.

There is a possibility an auction could occur before the CACs are enforced. A question was submitted to the International Swaps and Derivatives Association's European credit derivatives determinations committee by an unidentified market participant on February 24, asking whether a deal with the European Central Bank to shield it from losses on its Greek debt holdings constitutes a change in seniority for creditors, and therefore a restructuring credit event.

The question will be considered by the determinations committee on March 1, but market participants express scepticism it will result in the triggering of a credit event. "It sounds like it does not qualify in the legal definition of subordination," says one London-based member of the determinations committee.

Greece is under pressure to move quickly on the debt deal, with a €14.5 billion debt repayment due on March 20. According to an offering memorandum on the terms of the debt swap, investors will have until March 8 to respond to the offer, unless it is extended, re-opened or amended. Analysts expect the exchange to occur several days afterwards. Dealers say it is unlikely a credit event auction could be arranged to take place after the enforcement of the CACs but before the exchange.

During a credit event auction, market participants submit tradable bids and offers on the defaulted or restructured bonds to determine the recovery rate for the CDSs. However, some fear there will be an insufficient quantity of the original Greek debt following the exchange to trade at the auction, potentially skewing the outcome. While the new Greek bonds might be deliverable, analysts say they could trade at a different level to the original debt. "The new bonds would have a 30-year maturity and a 2% coupon that rises over a period of time. Also, Greece's overall debt load will be reduced," says Hampden-Turner.

Market participants could choose to deliver Greece's international law bonds, as they are not included in the initial debt swap and are expected to be dealt with separately in April. There are fewer of these bonds, and they typically trade at higher prices than their domestic counterparts, analysts say, reflecting the perception that investors would have more protection under English law. Consequently, some buyers of CDS protection could lose out if they are delivered into the auction. Buyers of CDS protection receive the par value of defaulted debt, minus the recovery rate.

This has prompted some market participants to warn that the credibility of CDS contracts as a hedge may be at risk. "If, for some reason, there's a clear event of default happening and the Isda committee decides it's not a default, or if the settlement of the recovery rate turns out to be incorrect, that undermines the usability of a CDS as a hedge. It raises the question of what the role of CDS protection is," says Claudia Calich, senior portfolio manager and head of emerging markets at Invesco in New York.

Nonetheless, some dismiss the worries as overplayed. One US dealer argues market players should be well aware of the risk. "It's getting blown way out of proportion. People say the international bonds will be cheapest-to-deliver and won't ensure a fair price. Well, that's true, but that was the reality when you bought protection. You've always had a documentation risk. You should have included that in your assumption of the value of the hedge all along," he says.

Dealers say the attention Greek CDSs have recently received is disproportionate compared with the size of the market. Bank credit portfolio managers are one of the biggest users of sovereign CDSs, and traders say they have recently been unwinding their long protection positions to crystallise gains. As of February 17, there was €69.91 billion of sovereign CDS notional outstanding on Greece and just €3.22 billion outstanding on a net basis, according to the New York-based Depository Trust & Clearing Corporation.