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.

9 Responses to “Making a market in sovereign CDS”

  1. -That would bring spreads in fast-

    A disastrous eventuality for the chattering class…

  2. Yes, it would upset them. Life in Mayfair and Stamford, Conn., would not be so much fun either. I’m not seeing any downside thus far…

  3. […] Governments should write CDS on […]

  4. The flaw in this “speculative riff” is that no one would take the other side of this trade. The CDS market is over-the-counter; therefore bilateral and certainly not anonymous. No reasonable CDS market-maker wants to purchase its Spain sovereign default protection from the Kingdom of Spain, since your counterparty risk is 100% correlated with the default risk on your reference entity (in other words your contract will be worthless in the case of default that you as protection buyer are paying to protect yourself from). This is the case in the corporate CDS market as well (eg. dealers don’t allow Citi to sell protection on itself)

  5. Chris – Wrong. There are plenty of buyers. And dealers do allow Citi to sell protection on itself; or certainly they allow Dow Chemical to sell protection on itself. (Citi is riskier as the recovery is less certain for a financial: for a corporate with solid assets, it can be a decent trade.)

  6. Are sovereigns subject to ISDA rules? Can’t they just do what they want? If it came to a crunch, might they default on CDS before defaulting on gilts, so that CDS holders get nothing?

  7. Sorry, that last comment was mine. Didn’t mean to be anonymous.

  8. The short answer is that they can be. If you wanted to be sure, you’d get the sovereign to sign a CSA too and collateralise their trades with their own bonds (free for them to print). That would ensure you got the sovereign bond recovery in the event of default.

  9. Really which dealers will bid on CDS written by a corporate on itself?

    Even in 07 it was virtually impossible to get a dealer to bid on CDS written on a third party dealer. If you had wanted to the upfront cash haircut would have been chunky.

    Surely even slack dealers would demand CASH as collateral, in which case the question reduces to, why don’t governments by back their own bonds…