Greek leaders' overtures for far tougher curbs on credit default swaps fell largely on deaf ears in Washington, but they'll go back to Athens with some sage advice from local policy wonks: look in the mirror and don't blame market messengers for your debt woes.
"It's fairly common for finance ministers and political leaders under threat to blame the speculators. But sometimes the speculators are right," said Edwin Truman, a former U.S. Treasury and Federal Reserve international finance official.
For a second day this week, Greek Prime Minister George Papandreou and his finance minister, George Papaconstantinou, urged backing for tougher rules for credit default swaps and a ban on some activities such as "naked" short-selling of sovereign debt or trading "naked" credit default swaps (CDS) without owning the underlying bonds.
Hedge funds have been accused of aggravating Greece's debt crisis by using such trading activities to bet on a government default.
Credit default swaps have been condemned by many U.S. lawmakers because of the $62.5 billion taxpayers handed global banks to unwind CDS contracts written by bailed-out insurer American International Group. But any outright ban is highly unlikely.
Strong, if Unflattering Signal
The trading of CDS on Greece's sovereign debt -- essentially an insurance policy against a default -- provided a valuable market signal about worrisome policies, said Douglas
Elliott, a senior fellow at the Brookings Institution in Washington and a former JPMorgan investment banker.
"The Greek bond market could directly deliver the same bad news by itself and Greek bond yields would widen," he said. "The CDS gives you one more pretty liquid way of delivering the
signal from the markets. Just because you don't like the signal, you shouldn't blame the messenger," said Elliott.
The Obama administration effectively said it would prefer to stay on its own course for reforming derivatives markets by making them more transparent and increasing capital
CDS and other standardized derivatives contracts would be moved away from opaque over-the-counter trades onto exchanges or sold through central clearing houses under reform plans
backed by the White House that are currently stalled in Congress.
An administration official also said regulators will get enhanced tools to crack down on market manipulation and abuse through position limits and tougher prudential requirements.
"But the central task before the Greek government is to continue to move forward on their plans to restore fiscal stability and growth to its economy," the official said. "We commend them for the bold steps they've already taken and have confidence that their European partners will support them on this difficult road."
CDS on sovereign debt are seen as likely standardized contracts that would be put onto an exchange or central clearing under the Obama plan, making manipulation difficult.
A recent report by Citigroup analysts in London said the sovereign CDS market is still tiny compared to the sovereign debt market, limiting its impact. There are $9 billion in Greek sovereign CDS outstanding relative to $406 billion of government bonds. For Europe as a whole, there are only $108 billion in sovereign CDS versus $11 trillion in debt.
The Citigroup analysts, who say that much of the trade in sovereign CDS is legitimate hedging, argue that the inability to arbitrage between CDS and bonds makes it difficult to push sovereign yields higher as is often alleged.
Conversely, they say it is easier for CDS to drive bond yields tighter: a shrinking spread on a CDS will often cause higher market demand for the underlying bonds.
While European Union members and other G20 economies may be more amenable to Greece's call to rein in speculators, a global ban on sovereign CDS would not be possible without the support of the United States, home to one of the largest CDS trading centers.
And a ban on naked credit default swaps without owning the underlying bonds, would be difficult to define, administer and police, experts say.
An investor might not hold the same debt security in the same amount as the CDS reference security, but may hold other debt securities from the same issuer, which may be senior or
subordinate to the reference security, said Denis McCusker, a partner at the Bryan Cave law firm.
"If the euro zone were to ban naked CDS transactions but the U.S. not, or vice versa, it would be expected that traders and speculators would find a way to move across the borders for these transactions," he said.
If the U.S. Securities and Exchange Commission and the Commodities Futures Trading Commission get the authority to regulate the private swaps market under the Obama plan they could prevent investors from amassing large positions in a particular derivative such as a CDS.
The regulators could also make it unpalatable for issuers to write swaps by imposing onerous capital requirements.
But the Citigroup analysts, who titled their report, "Don't blame the mirror for your ugly face," suggested that CDS bans would not stop markets from beating up on Greece over its debt
"We strongly believe that the medium term likelihood is that many of these legitimate hedgers would simply sell or short government bonds instead," they wrote.