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Credit Default Swaps and Greek Debt Crisis

February 27, 2012

~  SMARTINMONEY.COM  ~  Credit default swap (CDS) has great influence in the crisis faced by Greece and other members of the euro zone recently. European policy makers have looked cautiously CDS, while they structured the Greek rescue. They aimed for a voluntary debt exchange that would not trigger the credit event, so avoid destabilizing chain reactions through Europe’s financial system due to payments on the swaps.

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.

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