A Credit default swap
(CDS) has become one of the most powerful forces in the crisis faced by Greece
and other members of the euro zone recently. European policy makers have looked
cautiously at credit-default swaps, while they structured the Greek rescue over
the last six months, according Smartinmoney.com. They aimed for a voluntary
debt exchange that would not trigger the credit event, fearing that payments on
the swaps might set off destabilizing chain reactions through Europe’s
financial system.
Credit default swaps
were invented by Wall Street in the late 1990s as a form of insurance contract
against the default of one or more borrowers. Between 2000 and 2008, the
market for such swaps ballooned from $900 billion to more than $30 trillion. In
sharp contrast to traditional insurance, swaps are totally unregulated. CDSs
are not traded on an exchange and there is no required reporting of
transactions to a government agency. During the 2007-2010 financial crisis the
lack of transparency became a concern to regulators. They played a pivotal role
in the global financial meltdown.
Credit default swaps are a type of credit insurance contract in
which one party protect another party from the risk of default on a particular
debt instrument. The purchaser of the swap pays an annual premium (like an
insurance premium) for protection from the credit risk. Just as house insurance
will cost more for those living next to a fireworks factory, a CDS becomes more
expensive when the finances of the bond issuer deteriorate, such as in the
Greek debt crisis.
If the underlying debt
instrument defaults, the CDS insurer compensates the insured for his
loss. As with any insurance contract, there is scope for dispute about
when a claim can be made on a default. Under a sovereign CDS, a claim depends
on a “credit event”, which is defined broadly as a failure to pay interest, a
moratorium on principal repayments or a restructuring of the debt.
Would a re-profiling of
Greek debts qualify? It depends how it was done. If investors agree to
such a deal of their own free will, as happened for Uruguay in 2003, it would
not constitute a credit event. Nor would one occur if European banks succumbed
to some arm-twisting by their own governments to agree to a swap. But a credit
event probably would occur if all bondholders were forced into the
switch. Should there be a dispute in the CDS market over a Greek re-profiling,
it would be resolved by the International Swap Dealers Association (ISDA), a
voluntary body which governs the market. Under ISDA rules, each region has a
“determinations committee”, comprising ten bankers and five investors, which
rules on such issues. Read “Credit Default Swap: Powerful force infinancial crisis” on Smartinmoney.com
