By way of background, it helps to know a bit about how CDS settlements happen. In the old days—prior to 2009—a protection seller would deliver the defaulted bond to the protection buyer in exchange for the par value of the bond. The protection seller would have a loss equal to the difference between where the bond was trading and its face value.
As the market for CDSs expanded, however, this became impractical. Speculative buying meant that there could be more swaps on a bond than bonds in existence, creating the conditions for a short squeeze. So the ISDA folks drew up a new way to price CDS payments.
Instead of requiring delivery, CDS contracts for the most part now allow for cash settlement. The amount of the settlement is determined in a bizarrely complex auction of a small amount of the defaulted bonds. The cash settlement due is the difference between the auction price and the face value. (Click here for Pollock’s detailed explanation of this process.)
There’s always been the danger that the auction process could misprice the bonds—and some evidence that this has actually occurred on occasion. Pollock notes that this is a very real possibility when it comes to Greek bonds, because it is very likely that the bonds being auctioned won’t be the ones people bought protection on.
It now seems almost certain that nearly all of the outstanding Greek bonds governed by Greek law (as opposed to those governed by British law) will be exchanged for new Greek bonds, with would-be private-sector holdouts being forced to exchange their bonds, after Greek lawmakers write a collective-action clause into the bonds.
These new bonds, however, may trade in the CDS auction at higher prices than the old bonds would have, which would mean lower cash settlements for protection buyers.
Now, while the new Greek bonds might not trade at anything near par — by virtue of being long-dated and by Greece still being a bit of a mess debt-sustainability-wise — there’s a chance they’ll trade points higher than the old Greek bonds. This will happen if market participants deem the bond swap and bailout as making it increasingly more likely that Greece will not default.
Therefore, if only the new Greek bonds … are available to deliver into the credit event auction, it may settle unfairly high, i.e. the payouts to CDS protection buyers will be much smaller than the losses they thought that they were insured against.
You have to think that somewhere, some clever clerk is busy devising a contract to protect against this risk: A CDS squared.
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