However, there’s been a sharp rise in net notional CDS outstanding on the supposedly safer sovereign credits in Europe, as the second chart shows. Demand for protection against a French default has doubled in a year, for example, while for the supposedly default risk-free UK (given the country’s control of a currency that it can, in theory, devalue at will) there’s been a six-fold rise since 2008 in the volumes of CDS held.
Part of the rise in demand for sovereign credit risk insurance over the last few years has come from banks’ internal credit departments, which have undergone a complete reassessment of the way they monitor and hedge counterparty exposures since the financial crisis, says Michael Hampden-Turner, credit strategist at Citi. Whereas previously most sovereign bonds and exposures to governments via derivatives contracts were considered risk-free by dealers, since 2008 these have all been hedged as a matter of course, he explains, and banks have dedicated counterparty valuation adjustment (CVA) desks to fulfil this role. A decent part of the increased demand for sovereign CDS is coming from such sources, says Hampden-Turner.
However, with the rise in demand for CDS protection on Europe’s largest countries, it’s also easy to see that investors are hedging against the risk of contagion from the weaker periphery. This is particularly the case since Europe’s blind insistence on a “no default at any cost” policy has had the effect of tying the stronger EU member states to the riskier ones, via such bailout programmes as the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM).
Although we’ve ignored the price of insurance—the cost of default protection for Germany (45bp), France (79bp) or the UK (58bp) is still ten or 20 times lower than for the most stressed Eurozone states—the steady increase in interest in hedging against the default risk of governments previously considered rock-solid is a trend worth following closely.
Forget Greece, where default is surely a done deal and it’s only a question of when and whether it’s a single or two-step write-down of debts. It’s French, German and UK CDS contracts you need to watch if you want to gauge the real risks to the financial system.