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Swap Talks Over Greece Could Test the Market

The financial system could face a test this week as industry officials debate a provision of the Greek bailout.

Greek Parliament
PNC | Brand X Pictures | Getty Images
Greek Parliament

Greece is preparing to overhaul its bonds next month, a restructuring that could potentially prompt payouts on credit-default swaps, the financial instruments that protect against losses on debt. The International Swaps and Derivatives Associationwill meet on Thursday to decide whether a certain aspect of the deal will make those payments necessary.

If parties have to make good on the credit-default swaps, the situation could send shivers through the market. An important and long-planned measure that aims to strengthen the derivatives market is not yet in place, raising questions about how the financial system will react if the credit-default swapshave to pay out.

In the financial crisis of 2008, banks feared that their trading partners might not be able to meet such obligations on derivatives and other financial arrangements. The situation set off a chain reaction that paralyzed global markets until governments and central banks provided enormous financial support.

To prevent a similar disaster from happening again, finance ministers in the United States and Europe committed in 2009 to move derivatives like credit-default swaps onto clearinghouses. These organizations, if they work properly, can sharply reduce the chances that a large bank will not make good on their contracts.

But credit swaps that pay out if a European country defaults are not yet centrally cleared. Instead, banks remain largely responsible for making sure the various parties can meet their obligations. While financial firms have taken steps to ensure counterparties can pay, some industry participants say the market would be far stronger if central clearing existed now for the swaps.

John Sprow, chief risk officer at Smith Breeden Associates, a fund management firm, said regulators could have used the relative calm in the markets over the last two years to reduce risks in places like the credit-default swap market. “There’s no doubt, that, by having central clearing, you’d mitigate counterparty risk,” he said.

A small number of credit-default swaps have moved onto clearinghouses, but not swaps on European sovereign debt , even though they are traded relatively frequently and lie at the heart of the Continent’s debt maelstrom.

The reason for the delay in Europe appears to reside with the Financial Services Authority, the British financial regulator. The regulator has yet to approve credit-default swaps on sovereign debt for clearing. The American-based IntercontinentalExchange has said it is in a position to start doing so through a European arm. IntercontinentalExchange started clearing default swaps on Latin American government debt last year after it received approval from the Securities and Exchange Commission. The British regulator declined to comment.

Clearinghouses have played a major role in strengthening other parts of the derivatives market, like futures. When executing trades through a clearinghouse, market participants have to back up their deals with adequate collateral in case they suddenly cannot make payments. As a result, when a potentially destabilizing event happens, banks are less likely to panic, because they believe money they are owed on trades will be paid.

With Greece moving toward default, all eyes are on how credit-default swaps will behave. One worry is that they may not pay out, even when bondholders suffer a loss. While the Greek bailout package could force investors to take a 70 percent haircut on the country’s bonds, the restructuring was set up as a potentially voluntary exchange, an outcome that would not prompt the credit-default swaps.

But a voluntary exchange looks increasingly unlikely. Greece is preparing to use legal means to force all qualifying bondholders to accept a haircut.

Now, industry officials will have to decide whether the credit-default swaps will pay out.

This week, an undisclosed entity officially asked the International Swaps and Derivatives Association to debate whether a particular feature of the Greek debt exchange could activate the swaps. The association said Tuesday that a committee would consider this question on Thursday.

One part of the Greek exchange being examined allows the European Central Bank to avoid a haircut on the Greek bonds it holds, even though other creditors take a hit. In effect, the committee has to decide whether this constitutes the type of “subordination” for non-ECB bondholders that would prompt a payout on Greek credit-default swaps. Subordination describes the process of relegating a creditor’s claim below that of others.

Rating agencies have already said that the European Central Bank’s move amounts to economic subordination for bondholders. But some lawyers don’t think it will cause the default swaps to pay out, since subordination is narrowly defined in the swaps’ contracts.

“I can’t see any legal event that would also be a credit event,” said Simon Firth, a partner at Linklaters in London. A required payout would most likely happen if a bond issuer actually changed the terms of some existing bonds to make them subordinate, he said, and he added that shielding the central bank from losses did not appear to do this.

Still, some analysts say they believe that such a move would undermine the credibility of credit-default swaps. “It may result in investors deciding it’s just too uncertain to enter into CDS,” said Peter Green, a partner with Morrison & Foerster in London.

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