Current plans are for Greek restructuring to be ‘voluntary’, which means that it would fail to trigger CDS (see here). CDS is supposed to be the cost of insuring against default. If Greek restructuring fails to trigger CDS, then CDS would lose its credibility as an effective hedging instrument against sovereign default. Such actions would have absolutely huge implications as all the banks who have used CDS to buy protection against their sovereign debt, and have consequently reported very little net Eurozone peripheral sovereign debt exposure, in fact have much more exposure than everyone thinks.
So who’s in trouble? Unfortunately, nobody really knows since a major problem with CDS is disclosure. It’s very difficult to figure out who has bought protection on a sovereign and who has written protection. As we wrote here, BIS (The Bank for International Settlements) data from earlier this year suggested that the US banks were large writers of protection and the European banks big buyers of protection. However the US banks in their results presentations claimed to have only small net exposures.
It’s a reasonably safe assumption, however, that on the whole European banks in core European countries would have been net buyers of protection (or at the very least large users of protection) as they will be the ones with a need to hedge exposure. Indeed, in July Deutsche Bank reported that it cut its net Italian sovereign exposure from €8bn at the end of 2010 to €997m by the start of July and had hedged Italian exposure in its trading book by using CDS. UBS this week announced €14bn gross exposure but a €9bn net exposure to sovereign bonds issued by Portugal, Ireland, Italy, Greece, Spain and Belgium.
So the guys most at risk of sovereign CDS losing its credibility as a hedge are in all likelihood the large European banks. It’s the last thing these banks need right now. What will be really interesting is whether or not the banks’ use of sovereign CDS as an effective hedge in accounting definitions remains allowable now that politicians have made a default without a credit event possible. And of course the EFSF/Eurozone rescue is also in trouble if CDS isn’t an effective hedge, since the EFSF is going to attempt to sell protection on new issues of sovereign bonds in order to get their new issue spreads down!