EFSF to write CDS (with a two-way CSA and ISDA master)? | FT Alphaville

EFSF to write CDS (with a two-way CSA and ISDA master)?

Or, how many acronyms does it take to make an FT Alphaville headline?

On Thursday, the FT reported on BNP Paribas’ proposal to have the EFSF write CDS on sovereign bonds.

This may of course smack straight into Article 125 of the Treaty on the Functioning of the European Union and die on impact. Let that not stop us, however, from discussing the meaning of a bailout fund’s life when it comes to CDS and a few other things besides.

Here’s an excerpt from a summary of the proposal in a document which has been doing the rounds (emphasis ours):

The sovereign default protection will provide the investor protection in the case of default or other credit event trigger (to be defined) associated with the issuer of the EGB.

If only it were so easy to have a sovereign credit event! Whether or not there has been a credit event on CDS contracts is decided by a committee that looks at the ISDA Definitions to see if the alleged event fits within them. The decision of the committee, that there has or has not been an event, is binding on effectively all of the holders of such contracts.

Now, we imagine that once politicians had figured out how CDS work and someone had whispered in their ear that some parties may have bought protection just to speculate that Greece would default, they must have been overjoyed to figure out that there were rather specific rules around what constituents a credit event. As any banker worth his or her salt will tell you, rules are just so much easy to engineer your way around. This is versus more principle-based approaches…

The reaction of those holding CDS referencing Greece hasn’t been pretty when it has come to political meddling, and the net position of contracts outstanding has plummeted from $7.1bn a year ago to $3.7bn as of the end of last week, according to DTCC data.

Just how keen some are to avoid a sovereign credit event on Greece CDS is truly outstanding, especially given that there has been at least some recognition that killing the ability for bondholders to hedge may be detrimental to bond yields. Here we have it from Rt Hon the Lord Roper, Chairman of the Select Committee on the European Union, writing to Financial Secretary of HM Treasury back in March about the proposed ban on naked short sales using sovereign CDS:

We were warned that if investors were prevented from hedging their positions, there would be greater uncertainty involved in holding the debt and fewer investors in the market. This would lead to lower liquidity and increased borrowing costs.

That, of course, is just one of the views that the letter outlines. The whole feel of it is “there’s not a lot of conclusive evidence, but here’s what we’ve heard. In the absence of such conclusive evidence, we’d prefer not to mess with it, thanks.” The European parliament didn’t go for that so much.

Back to BNP Paribas though.. (emphasis still ours)..

EFSF will post/receive collateral (e.g. cash or newly-issued EFSF bonds) to reflect changes in value of the sovereign default protection contract it has provided.

Ohhh, snap!! FT Alphaville has been dying to have someone something, anything (even when it involves unicorns), about collateral!! And what with said collateral being linked to value.. smell that? Do you? It’s a two-way CSA with a supranational. Smells a lot like roses if you’re a bank.

And lastly:

As the investor in the new instrument would be running EFSF credit risk, it would not need to be traditional buyer of EGBs of the sovereign in question.

Which leads us to wonder when the first CDS contract will be written that references the EFSF. Bond insurer, CDS protection seller, bond issuer — all different flavours of credit/counterparty risk going on. And if there’s one thing that modern finance excels at it’s developing new hedging tools and convincing you that you can’t live without them even though you did for the longest time and it wasn’t that bad at all.

Just in case your imagination needs stretching, here is (we’re not making this up), the CDS curve of the European Investment Bank:

And for the European Bank for Reconstruction and Development:

The CDS referencing both supranationals are very, very illiquid. They do, however, exist since those curves were constructed using price contributions from dealers (who wouldn’t bother sending them in if they didn’t have anything to mark).

Here’s a trick question if to ask your local MEP: would CDS referencing the EFSF be covered under the naked shorting ban? It’s kinda a “sovereign”, isn’t it? What if it’s not? The hedgies may not be able to have their cheap naked shorts betting against the Eurozone via CDS referencing Germany and France anymore, but how about the EFSF then?

While on this trip to la-la land, consider that the spreads on the bonds that the EFSF has issued have been widening lately..

Related links:
Sovereigns wrestle with debt impact of CSAs – Risk
BNP urges EFSF to issue credit default swaps – FT
Crack down on short selling and sovereign debt speculation – European Parliament