Where the CDS was entered into as a pure “bet” on the likelihood of a Greek default, the speculators taking the other side of the bet (on there being no “default”) will prevail, despite the economic reality of Greece’s “restructuring”.
All participants who purchased protection will also have incurred the cost of hedging for the ineffective CDS contracts.
So, for banks and investors who entered into CDS contracts to insure against losses from a Greek default, the potential failure calls into question the entire economic effectiveness of credit derivatives. The technical nature of the arrangements also highlights the potential legal issues present in CDS contracts. Different legal forms of economically similar actions can lead to entirely different outcomes under the CDS contract, complicating significantly the effects of the contract and its efficacy as a hedge.
As regulators and accountants assumed that the CDS eliminated or minimised any risk of losses, the level of capital and reserves set against the risks of Greek investment may turn out to be incorrect, while the accuracy of financial statements is also in doubt.
The question now is whether similar arrangements will be used if any other sovereign entity finds itself, like Greece, in serious financial distress. In effect, the value of CDS contracts is questionable. This means that risk models and hedges will need to be amended.
Following the announcement of Greece’s voluntary restructuring, many traders, both hedgers and speculators, liquidated CDS positions. In part, this reflected traders swapping CDS for short bond positions, which would have gained on the voluntary writedowns. The five year Greek CDS spread fell by more than 20 percent to close at 34.36 percent.
Ultimately, these problems raise a vital fundamental question: are CDS and, more broadly, derivatives, useful and legitimate instruments of risk transfer?
Satyajit Das is the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011). Ten copies of his book are available for free to IndexUniverse.eu readers. Please write to
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A version of this article previously appeared in the Financial Times.