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Europe devalues its bonds when it hinders hedging

The illuminated euro sign is seen in front of the headquarters of the European Central Bank (ECB) in Frankfurt April 5, 2011.


Europe's leaders are likely congratulating themselves for having outsmarted the people who are supposed to be the smartest ones in the room.

The continent's leaders have found a way to stiff derivatives traders on the Greek debt restructuring by using wordplay to stop credit default swap owners from collecting the insurance payments they are owed. However, the glow from the win won't last.

European policy makers have gone out of their way to sabotage the market for default swaps on bonds issued by Greece. Credit default swaps have long been in the sights of German Chancellor Angela Merkel and other European leaders, who blame CDS traders for instilling fear in markets and driving up the costs of borrowing for countries in Europe.

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Politically, it's a sure thing. Casting derivatives traders as the bad guy is an easy way to try to win votes and shirk blame for the crisis. The message is: "Your leaders didn't drive Europe into shambles with our management, the traders did it by driving up prices on an obscure derivative product."

In doing so, Ms. Merkel and her peers have risked making it tougher for all European countries to sell bonds and laid another heavy weight on the balance sheets of banks on their continent and around the globe.

Sovereign credit default swaps are used by bond investors to insure against defaults on the debt they hold. They are also used by speculators to bet for or against a country's creditworthiness. In an attack against the latter, the leadership in Europe, including Ms. Merkel, has hit the former.

Like bans on short sales of stocks when markets are falling, governments are blaming market mechanisms for their own woes without thinking about the wider implications.

The latest attack began last month when Europe's leaders decided to arrange the planned Greek restructuring as voluntary, thereby not triggering insurance payouts to buyers of credit default swaps on Greek debt. Under the terms of the derivatives contracts, voluntary restructurings are not considered a default. However, with losses of about 50 per cent on their bonds, common sense says the Greek plan is a default.

With each bond auction that's sparsely attended because would-be buyers can't hedge, with each sale of European debt by owners that can no longer trust a CDS contract as a hedging tool, the decision looks dumber. Goldman Sachs Group Inc. officials, led by chief financial officer David Viniar, have voiced their concern over the efficacy of sovereign CDS contracts when it comes to hedging now that the Greek issue has thrown their value into question. Analysts at Barclays Capital have echoed that concern.

For now, the dupes in this are the derivatives traders who left a loophole in their rules. The derivatives industry group as much as admits that it's been had by some canny, if misguided, manoeuvring by Europe's leaders to push through a restructuring that's voluntary, if in name only.

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"We know that officials have put significant pressure on banks to accept the deal," the International Swaps and Derivatives Association said in a communiqué on the issue. "It does sound a bit like someone has made them an offer they can't refuse. The fact remains, though, that the exchange is not binding on all debt holders."

However, it will be a short-lived victory. The derivatives industry will adapt. New wording in contracts will likely ensure that other countries won't be able to try the same trick. Fitch, the ratings industry, on Monday called for reforms to the contracts. The ISDA is already talking about revamping the language.

The shame is the blunt approach of undermining all the Greek CDS contracts, for hedgers and speculators alike, creates a polarizing controversy that overshadows the requirement for a more nuanced reform of the CDS market.

Banning speculators outright from any market saps it of liquidity and depth, but letting speculators run unhindered and trade vastly greater volumes than natural hedgers is not the answer either. Commodity market regulators in the U.S. are now trying position limits to try to curb excesses in their markets, where there is an interplay between people with an actual interest in the underlying commodity and those who are just there to take a punt.

As in commodity markets, the trick is finding the proper balance. Europe so far is nowhere close.

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