FT Alphaville is starting to feel a bit bemused at the level of outrage expressed around town the globe on the behalf of those poor buyers of credit default swap protection on Greece. But, here’s a question: are they deserving of your pity? And who are they?
The situation at present is that there have been a couple of attempts to get the Isda Determinations Committee to declare a credit event. After a credit event is triggered, and it looks likely that it will be next week if collective action clauses are used in order to get maximum participation in the Greek bond swap, there will be an auction, again organised among dealers coordinated by Isda.
That auction will determine final payouts under the contracts. There are reasons to believe that some market participants will be miffed by the result. But then again, for every miffed participant, there will be a happy participant because CDS are a zero-sum game.
Regulation creates markets
The outrage about Isda not declaring an event already sounds a little like this, “everyone knows Greece is in default! The rating agencies know it, everybody knows it! How can Isda not call this a default! This market is broken! Who in their right mind would buy these worthless things?!!”
Ahhh, so you wanna know who would? – Banks.
But why, if they are so worthless? – Because they are baked into regulations, and into Basel III too, and damn that is some tasty capital relief. Asides from that, there’s the margin on trading them. And the amount of leverage and flexibility they allow versus trading say bonds or loans.
Back to the capital relief point though, Deux Ex Macchiato put it best when he wrote this last November:
Unfortunately, Basel is finding it difficult to do the right thing here. If it takes away the benefit of CDS hedges, especially sovereign CDS hedges, it will be the beleaguered large European banks who will suffer. And the Basel Committee will look like idiots; Basel III recently entrenched the role of CDS by making single name default swaps the main way of reducing capital charges on CVA risk. An about face on that issue would be embarrassing, so I think it is more likely than not that the Committee won’t be prudent. Which, frankly, is not a big surprise.
Asides from capital relief, CDS are still reasonable mark-to-market hedges.
In short, the banks, that represent the vast majority of trading in CDS, don’t need them to work that well, they just need them to work well enough. We suspect that “enough” isn’t too distant from “as long as the regulations give us credit”.
As for Greece CDS specifically, only $3.2bn of net notional is outstanding, according to DTCC. Spread out across banks, that’s not a big deal (for when a credit event eventually does happen and the contracts pay out). This is even more so given that this has been a slow-motion train wreck, i.e. we expect all parties who are in-the-money right now to be collateralised to the hilt against their out-of-the-money counterparties.
Is(da) derivatives industry misunderstood – reprise
FT Alphaville has gotten philosophical on this point before, and what it comes down to for us is this: debt is complicated. Credit derivatives aren’t like interest rate swaps. There are only so many things that an interest rate can do, like go up or go down. Of course, one can write complicated derivatives on them, but the underlying thing isn’t that complex.
Equity can do some interesting things, for sure, but frankly we think debt takes the cake. It can take a tonne of different forms. There are different types of bonds, with various features, and don’t even get us started on loan structures.
Credit default swaps are meant to allow parties to the contract to take a view on credit risk in isolation. That is, they are a derivative that — rather than referencing a specific interest rate, for example — derives value from debt. As that debt takes many forms, a lot of complicated rules have to be written up to link the CDS contract and the debt that it’s meant to reference. And the most important part of the rules are those that govern payouts in a “credit event”.
The mark-to-market value of CDS is linked to the likelihood of payout (statement of the obvious), so there has to be a robust mechanism in place to determine credit events. Now, here’s our interpretation of the history of rule-marking of this aspect of the industry:
CDS Industry: Maybe if we agree to standard contracts, and we write a rulebook around them, more people will trade credit derivatives, then we can use them more, make more money, and it’ll be cheaper to pay for capital relief too.
Isda: Hi guys, can we help? How about we write the rulebook? We’re really good at this sort of thing.
CDS Industry: Great, thanks!
[Time passes]
CDS Industry Participant: Whoa! This company’s debt did something really weird and it isn’t in the definitions… man, this sucks, this trade didn’t go at all how I thought it would.
Isda: Hey, are the rest of you angry, or is it just that guy?
CDS Industry: We’re angry too.
Isda: Ah-ha. Well then, we’ll write a special protocol for how to handle that and we might rewrite the rulebook too, so that this doesn’t happen again.
CDS Industry: We ♥ you, Isda.
In short, Isda has a long history of having to rewrite its own rulebook for eventualities that were not foreseen by participants. This Greece CDS thing is, in a way, part of a long history of whoops-we-didn’t-think-of-that’s.
The Conflicted Isda Determinations Committee
Part of standardising was agreeing that the DC has the final say. The DC is meant to stick to the Isda rulebook to interpret what is, and what isn’t, a credit event.
Most of the time, it could just as well be called “Isda’s Rubber Stamp Committee” — deciding that a company has experienced a credit event when it’s filed for Chapter 11 is pretty darn straight forward.
Unfortunately for Isda and the industry, the DC isn’t judged on its ability to provide rubber stamps. It’s judged on how it handles the less straight-forward cases, like Seat Pagine Gialle, and lately Greece.
The fact that there isn’t a lot of explanation given for why the DC rules the way it does has been a source of frustration for buyside participants.
Here are some excerpts from the WSJ piece that Isda’s media blog slated.
“The biggest problem is the lack of transparency,” said James Rickards, senior managing director at New York investment bank Tangent Capital [1] and a pioneer in the sovereign CDS market. …
Jim Huynh, who trades CDS for Western Asset Management [2], which oversees $442 billion, said “it would be in every investor’s interest” to know the rationale for any decision. However, ISDA committees rarely elaborate on decisions.
“The incentives are high to attempt to manage triggering events,” said Bill Awad, managing director of Babson Capital [3], a $139 billion money manager.
Said Krishna Memani, head investment grade fixed income at OppenheimerFunds [4]: “Ideally you would want an independent entity to make these determinations.”
That’s four less-than-pleased-sounding end-users who are in this market not because of capital relief. Isda’s response: ”Providing an explanation would slow the process.”
Dear Isda
Just a thought… Maybe some of the time that’s spent on the media blog PR strategy could go towards explaining DC decisions? Seeing as there is so little time for that at present.
Related links:
Debt and CDS: It’s complicated - FT Alphaville
It’s not easy, being Isda - FT Alphaville
Isda has a bone to pick with you (and so can we!) – FT Alphaville
Is(da) derivatives industry misunderstood? – FT Alphaville
The conflicted Isda committee – FT Alphaville
More on the conflicted Isda committee – FT Alphaville
So Maybe Greek CDS Won’t Be Fine, Who Knows, I Give Up - Dealbreaker