Credit Default Swap: Powerful force in Greek debt crisis

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