The restructuring of Greek government debt will not trigger payouts of billions of euros to holders of insurance on the bonds, known as credit default swaps. At least, not yet.
The ruling Thursday, by a panel of the International Swaps and Derivatives Association, was expected. But it still sent a shudder through the sovereign debt market, driving up already high yields on the bonds of Italy and other troubled countries. If market participants lose confidence that they can collect on their default protection, they will demand higher yields to cover the added risks, analysts said.
"There is now a high degree of risk that sovereign CDS will not pay off and that using this vehicle to hedge is worthless," said John Braive, vice-chairman of CIBC Global Asset Management Inc.
Major bond-rating agencies have already determined that Greece will be in "selective default" on its obligations as soon as a deal is completed for major private creditors to take a hefty haircut in excess of 70 per cent on their Greek bond holdings. Officials expect it to be wrapped up by mid-March, freeing up the €130-billion ($170.58-billion Canadian) rescue funds and enabling Athens to meet a bond repayment of €14.5-billion due on March 20.
The restructuring is designed to trim more than €100-billion from the beleaguered country's mountain of debt. But the ISDA has ruled that because the cuts are voluntary, the plan does not constitute a "credit event" that would require payouts on the swaps contracts.
The derivatives industry lobby group also ruled that another part of the rescue package involving a bond swap with the European Central Bank does not leave other creditors in a subordinate position, which would normally amount to a default. Under the deal, the central bank, the largest holder of Greek debt, will do a straight swap of new bonds for old, but will not be subject to the cuts reluctantly accepted by the private-sector banks and other institutional creditors.
But the ISDA said in a statement that the situation in Greece "is still evolving" and it did not discount the possibility of a "credit event" occurring in future "as further facts come to light."
The trigger would almost certainly be a planned Greek government move to retroactively impose newly legislated collective action clauses (CACs), which would compel all bondholders to accept the same losses as those participating in the voluntary transaction.
"The assumption in the market is that it will be deemed a credit event if and when the CACs are activated," said Beat Siegenthaler, senior foreign-exchange strategist with UBS in Zurich. "At that point, it will be crucial to trigger a payout, as otherwise CDS would lose most of their value as an insurance instrument, which in turn would adversely affect other euro-zone sovereigns."
Athens is expected to use the CACs to mop up the 5 per cent or so of bonds on which holders have so far refused to accept losses. Some of these bonds are held by hedge funds eager to trigger a payout of the default swaps, which cover more than $3-billion (U.S.) of Greek debt, slightly more than half the level of a year ago.
The ISDA's more than 800 members include all the major global derivatives players, including JPMorgan Chase, which has a seat on the committee that ruled on the Greek default issue. Another member is bond fund powerhouse Pacific Investment Management Co., which holds no Greek debt.
The committee probably faces at least one more vote on the Greek question. "It's not a slam dunk," Bill Gross, Pimco's co-chief investment officer, told Bloomberg television. "We expect the next few days, perhaps next few weeks, to ultimately send the ISDA committee back for one final vote."