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ISDA Refutes Claim That CDS Speculators Are Responsible For Sovereign Spread Widening

Tyler Durden's picture




 

Some weeks ago we presented evidence that the sovereign CDS market pales in comparison with cash notionals outstanding, and furthermore, we demonstrated that sovereign spreads have been led by cash selling, which has been followed only subsequently by CDS moves, not the other way around. The fact, however, did not stop the bashers. Today, ISDA, the International Swaps and Derivatives Association, has issued the following statement, which along the lines of our observations, refutes claims that CDS speculators are to blame for widening (but not, shockingly, tightening) in sovereign spread moves.

And here is the most critical point that every single person seems to have missed so far:


Recently, a simplistic analogy has surfaced and been repeated that
compares CDS to fire insurance. People who use this analogy point to
insurance law prohibiting individuals from buying insurance on a
neighbor`s house so that they will not burn it down to collect the
insurance proceeds. Under this analogy, writing naked CDS is equivalent
to buying such insurance and committing arson and should therefore be
banned.


The analogy leaves some important points unsaid: How, for example, can
buyers of naked CDS actually burn down the house? It is important to
remember that for every buyer of CDS there is a corresponding seller
who benefits when the reference entity’s credit quality improves.
It is
unclear how such activity alone can lead to a default by a sovereign
government on bonds it has issued. Such claims ignore the commonsense
facts available and fail to show either cause or effect.
These claims
also ignore short selling activity in Greek government bonds, which
certainly has a greater effect on Greek bond prices as it involves
selling the actual instruments in the market.

Full release below:

The International Swaps and Derivatives Association, Inc. (ISDA) today issued the following statement regarding credit default swaps (CDS) on sovereign reference entities.

There has been a significant amount of
attention in the last several days regarding sovereign CDS and the
extent to which naked sovereign CDS are dictating the prices of the
underlying bond markets. This discussion has led some to propose that
naked sovereign CDS be banned or suspended. ISDA wishes to address
certain issues in this debate: market and instrument transparency,
outstanding sovereign CDS volumes and the possible impact of sovereign
CDS on the underlying Greek government bond market.

Improved Market Transparency


Critics of the CDS market assert that the market is complex and opaque.
At the same time, the critics argue that, despite its complexity and
opaqueness, the CDS market is liquid enough to influence markets of
enormous size. ISDA believes this line of reasoning is flawed and
inconsistent.


ISDA believes that the most commonly traded CDS, including sovereign
CDS, are simple and relatively liquid. At the same time, the market for
sovereign CDS is much smaller than the underlying market for government
bonds.


It is also ISDA’s view that the CDS market is far from opaque. Market
participants and the general public have ready access to data to
evaluate market activity. The amount of outstanding CDS and weekly
transaction activity for the 1,000 largest names (including sovereign
CDS) are publicly available through the website of DTCC`s Trade
Information Warehouse (www.dtcc.com/products/derivserv/data/index.php). In addition, policymakers have access to transaction level data to evaluate market activity.

Outstanding Sovereign CDS Volumes


The table at the bottom of this release shows the most recent net
outstanding CDS positions for the largest sovereign names, with a net
position of $9 billion for the Hellenic Republic.


Examination of DTCC’s reports since the beginning of 2010 shows the net
outstanding CDS position on the Hellenic Republic has changed little
over the course of this year. The net position for Greece was $8.7
billion in the week of January 1, 2010 and has ranged between $8.5
billion and $9.2 billion since then. Furthermore, the DTCC data
indicates the net position for Greece was $7.4 billion a year ago. None
of the data suggests there has been a surge of open interest in either
2009 or 2010.

Impact of Naked Sovereign CDS on Greek Government Bond Market


The activity and outstanding volumes in the Greek CDS market need to be
contrasted with the outstanding volumes in the Greek government bond
market, which exceeds $400 billion. None of the data can possibly lead
to a conclusion that a market of $9 billion can dictate prices in the
$400 billion government market.


Indeed, if prices in the CDS market widened significantly relative to
the Greek government market, arbitrageurs and holders of Greek
government bonds would simply sell the bonds and write protection in
the form of the sovereign CDS. The fact that government bond and CDS
spreads have remained essentially in line while outstanding positions
have remained constant underlies our assertion that the CDS market has
had little or no impact on the government market.


It is important to understand that Greek CDS are useful for controlling
risk for investors and lenders. Greek CDS provide effective hedges not
only for holders of Greek government bonds but also for international
banks that extend credit to Greek corporations and banks, for investors
in Greek stocks and for entities that have significant real estate or
corporate holdings in Greece. For many of these participants, the
sovereign CDS market is the most effective means of hedging credit risk
in Greece. Recent anecdotal evidence indicates that banks with
significant credit exposure to entities in Greece have been active
purchasers of Greek sovereign CDS protection. Much of this activity
could be misinterpreted as “naked CDS.” ISDA further believes that this
activity cannot have any significant impact on Greek government prices
because of its insignificant size in relation to the underlying
government bond market.


Recently, a simplistic analogy has surfaced and been repeated that
compares CDS to fire insurance. People who use this analogy point to
insurance law prohibiting individuals from buying insurance on a
neighbor`s house so that they will not burn it down to collect the
insurance proceeds. Under this analogy, writing naked CDS is equivalent
to buying such insurance and committing arson and should therefore be
banned.


The analogy leaves some important points unsaid: How, for example, can
buyers of naked CDS actually burn down the house? It is important to
remember that for every buyer of CDS there is a corresponding seller
who benefits when the reference entity’s credit quality improves. It is
unclear how such activity alone can lead to a default by a sovereign
government on bonds it has issued. Such claims ignore the commonsense
facts available and fail to show either cause or effect. These claims
also ignore short selling activity in Greek government bonds, which
certainly has a greater effect on Greek bond prices as it involves
selling the actual instruments in the market.

ISDA Remains Committed to Engaging with Policymakers


ISDA supports the efforts of global policymakers in examining the CDS
and other derivatives markets to ensure they are safe and efficient.
ISDA believes policymakers should have the supervisory tools and
authority to take action should any abuses be found in the operations
of any financial market.

About ISDA


ISDA, which represents participants in the privately negotiated
derivatives industry, is among the world’s largest global financial
trade associations as measured by number of member firms. ISDA was
chartered in 1985, and today has over 810 member institutions from 57
countries on six continents. These members include most of the world’s
major institutions that deal in privately negotiated derivatives, as
well as many of the businesses, governmental entities and other end
users that rely on over-the-counter derivatives to manage efficiently
the financial market risks inherent in their core economic activities.
Information about ISDA and its activities is available on the
Association's web site: www.isda.org.

ISDA® is a registered trademark of the International Swaps & Derivatives Association, Inc.

Sovereign Reference Entity

     

Net Notional

Republic of Italy:       $26 billion
Kingdom of Spain:       $16 billion

Federal Republic of Germany:

     

$13 billion

Federative Republic of Brazil:

     

$12 billion

Portuguese Republic:       $ 9 billion
Republic of Austria       $ 9 billion
French Republic       $ 9 billion
Hellenic Republic       $ 9 billion

(Note: data is of February 27th.
Net notional represents the maximum possible net funds transfer
(excluding any recoveries) between net sellers of protection and net
buyers of protection that could be required upon the occurrence of a
reference entity credit event. The industry uses net notional rather
than gross notional as most contracts remain outstanding even as risk
is offset. For example, if a client writes or buys protection through a
CDS, the client will typically use a dealer and the dealer making the
price to the client will very often trade a CDS with another dealer to
offset its position. This dealer, in turn, may lay off its position
with another dealer. Thus the gross position increase but the actual
risk is the amount of the original transaction.

 

 

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Mon, 03/15/2010 - 14:18 | 266030 Oracle of Kypseli
Oracle of Kypseli's picture

Naked and unregulated CDS's are fraudulent, sovereign or any other.

 

Mon, 03/15/2010 - 14:27 | 266044 Alexandra Hamilton
Alexandra Hamilton's picture

ISDA believes. Hhm.

Mon, 03/15/2010 - 19:48 | 266516 _Biggs_
_Biggs_'s picture

Exactly.

Mon, 03/15/2010 - 15:04 | 266080 knukles
knukles's picture

For every long there is a short.  For every buyer a seller.  In futures, CDS, options.  The "spec" is at best a dubious proposition when deployed by the authorities.

Quick men! A diversion!

Mon, 03/15/2010 - 18:44 | 266438 yomamma
yomamma's picture

Lemme get this straight: because transactions are two-sided then their legitimacy is intact? In other words if it's being offered, then how can you blame the purchaser; if it's in demand, then how is one to blame the supplier? Wow, that's the kind of line I usually hear from naive MBA students who are still learning business theory but have never stepped out of the door of academia. I guess that in your world, the sale of an 8-year old's virginity to a flesh-hungry western sex tourist in India by said 8-year old's pimp is totally legit as well- it's two-sided.

 

Betting on soverign credit default outcomes seems about as moral as betting on whether a little girl travelling through in a forest in her red cape towards her Grandma's house makes it there or "defaults" (i.e., painfully ripped to shreds by forest-dwelling wolves).

 

Talk about distractions- namely yours. Try considering the outcome of the intermediary being transacted when those bets are being made, and all the stakeholders (you know, the people and institutions which you're not paying attention to) who pay the prices for the results of those up/down transactional velocity ticks.

Mon, 03/15/2010 - 15:06 | 266082 Overpowered By Funk
Overpowered By Funk's picture

It's 3:00pm, do you know where your algo driven voume spike/rally is?

Mon, 03/15/2010 - 15:19 | 266099 mule65
mule65's picture

It's right on schedule -- 1150 close?

Mon, 03/15/2010 - 20:49 | 266611 JW n FL
JW n FL's picture

People would believe that because the U.S. is not printing just to artificially float the secondary that the $ is on the rise… or insert other here ( _____________________ ).

 

But the flocks leaving the Euro could arguably be looking for the safety of the dollar… and controlling the price of Gold… is in every paper currencies best interests, is it not?

 

http://www.thetrumpet.com/index.php?q=6546.5026.0.0

http://www.huffingtonpost.com/2009/06/05/stop-it-all-of-you-obama_n_211729.html

 

The Germans posturing for their Gold back out of our repositories in New York video is or has been removed? I watched the Video last year… in which the cameras had to be turned off inside oval office for the emergency of the Germans wanting their gold back… this was a full access day when the problem accidently was presented… http://www.msnbc.msn.com/id/30892505/#31073805

http://www.freerepublic.com/focus/f-news/2265231/posts this summation of the event is wonderful.

 

The CDS verse the SDR? Private monies verse pseudo public funds protectionism?

 http://www.imf.org/external/np/fin/data/rms_sdrv.aspx?Month=02&Day=25&Year=2010&submit=Submit

 

http://www.imf.org/external/country/GRC/index.htm

 

2nd time I have posted this.. but if the shoes fits.... might as well walk in them..

Mon, 03/15/2010 - 22:48 | 266744 nostromo17
nostromo17's picture

Blame the derivatives and blame the financial instruments you don't understand...this spares prosecuting the bankers and makes the politicians look like they are doing something besides shielding their special interest cronies misdirecting blame at abstractions or additional regulation that isn't enforced either. Direct the mass hostility at abstract financial instruments and spare the politicians who overspend and steal who should be run out of office or lynched. 'No CDS' won't hide the fact that Greece and the U.S. for example are 'bankrupt' ,i.e., bad credits without any help from CDS. Blame yourselfs for letting thieves rule you and letting banker thieves steal from you. Blame every one of you who wanted to believe your home was worth three times more than it was and borrowed against it. Blame people and governments they allow and you are a lot closer to truth than blaming abstractions like financial instruments. --Or is the problem then you might notice you are remiss for doing nothing to change the realities instead of blowing hot air? How about enforcing financial laws that already exist (Lehman 105 example place to start) instead of making up new crap Dodd? How about prosecuting the simple fraud of packaging mortgages that were worthless credit wise into AAA paper see Goldman et al.... How about less bs and more consequences for actions already taken provably illegal? How about replacing everyone at the SEC and FED complicit in the crimes? How about prosecuting or suing them too? Oh yah that would actually be doing something...I forgot.

Wed, 04/14/2010 - 09:46 | 299887 mark456
mark456's picture

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