As it wrestled with Greece’s debt crisis for the past two years, the European Central Bank took great pains to avoid triggering credit-default swaps written on Greek bonds.
But on March 9, Greece forced payouts on swaps contracts when it required all private bondholders to forgive more than 100 billion euros of debt as part of the biggest sovereign-debt restructuring in history.
The International Swaps and Derivatives Association, a trade group of large financial institutions, euphemistically calls Greece’s debt deal a “credit event.” The rest of the world calls it what it is: a default. Still, no panic has ensued; no contagion has swept over U.S. banks. On Monday, the world’s bourses held steady. Yields on large, financially strapped sovereigns, including Spain and Italy, ticked up only slightly. The financial markets, it seems, are treating the CDS trigger as a nonevent.
All of this is a healthy sign that credit-default swaps remain effective instruments to transfer and hedge risk. Banks and other financial institutions rely on the instruments to protect against losses. Others use them as a way to bet on a government’s or a company’s ability to repay debt. Hedge funds especially like credit-default swaps because they offer a low- cost means of taking on credit exposure. A CDS can gain value even if no default occurs. A fund manager who thinks a bond might decline in value -- or that a CDS is underpriced -- can buy protection in anticipation that spreads will widen. If the view turns out to be correct, the fund reverses the transaction at a profit.