Making a market in sovereign CDS June 19, 2010 at 11:54 am
A couple of thoughts about sovereign CDS. I’ll kick off with an article from Derivatives Week. They say (from behind a firewall):
Increased hedging by banks has been an influential factor behind moves in sovereign credit default swap spreads, according to the Bank of England. In its quarterly bulletin, the central bank said that according to its contacts in the industry, specific counterparty valuation adjustment desks of banks with large uncollateralized foreign exchange and interest rate swap positions with supranational or sovereign counterparties have been hedging positions in the sovereign CDS markets.
(The Bulletin is here.)
This is a classic example of unintended consequences. One element of Basel 3 is a capital charge for the variation of counterparty valuation adjustment – basically the adjustment derivatives traders take to reflect the credit quality of their counterparties. The CVA is largest on uncollateralised swaps: collateral reduces it massively. And which is the most significant class of counterparties who refuse to post collateral? Sovereigns and supranationals. Therefore making banks hedge their CVA better has the effect of forcing them to buy more sovereign CDS, which in turn may increase government borrowing costs. Spread widening isn’t necessarily caused by the evil CDS market speculating on sovereign default; instead it may well be regulatory action that is the cause.
What to do about it? That brings me to my second, more speculative riff. Whatever the cause of sovereign CDS spread widening, if governments don’t like it, the answer is clear. Write CDS on yourself. The principle is actually well established in the corporate area. An ISDA claim is pari passu with senior debt, therefore in the event of default a self-written CDS gets recovery. (OK, it is a little more complicated than that given the auction process, but it’s broadly right.) Therefore if you think, say, recovery = 33%, a self written CDS is equivalent to a CDS written by a risk free counterparty on a third of the notional. Governments need simply go into the sovereign CDS market and write protection on themselves in crushing size. That would bring spreads in fast, and raise them some premium income in the process. Simples.