Hugh Hendry is a London-based hedge fund manager, a self-styled «guard dog of the capitalist system», who went head to head with the leader of the Party of European Socialists on the BBC’s Newsnight programme last month in a showdown on financial speculation. He admits he is making money from short selling, offering up bonds he doesn’t own on a hunch that prices will fall and he can buy them back for a song later. Where it gets even more complicated - morally and technically - is when speculation turns on government bonds. PES president Poul Nyrup Rasmussen says he has evidence that fund managers like Hendry forced Greece’s borrowing costs to record highs and in so doing put at risk the entire single currency. But Hendry contends that he is intervening where regulators failed, shining a bright light on reckless government spending, and risking good money to prove a theory about «the black hole that is Greece». He’s not immune from loss, he says: if his theory is wrong, he and his investors lose a hefty sum. But whatever your ideological standpoint, he and Rasmussen are coming to represent two extremes in an increasingly polarised argument about the role markets play - or should play - in fiscal policy.

A GREEK TRAGEDY

«Hedge fund speculation is making the whole situation many times worse for Greece,» Rasmussen told Europolitics, «and it’s absolutely impossible to imagine that [Greek premier] George Papandreou should be forced by hedge fund speculation to come back to his people and government time and time over to make cuts in welfare.» The Greek leader has alleged that speculators used «malicious rumours, endlessly repeated and tactically amplified» to manipulate markets into fearing a Greek default, forcing interest rates on his country’s bonds to «record highs». Critics have concentrated their ire, rightly or wrongly, on credit default swaps (CDSs), derivatives contracts where investors effectively bet on a government going bust.

But the central fact to bear in mind about the Greek problem, says Brandon Davies, CEO of London-based financial consultancy dRisk.biz Limited, is that it is just that: a Greek problem. «The big problem is Greek debt - not CDS or bond markets - and unless you address the problem you are likely to see people taking out insurance on it,» he says. «CDSs are a good way of taking out insurance. The CDS market is used by people who really need the insurance, people who have commercial contracts with Greece that could be affected by a Greek government default or a euro exit. That’s the untold story.»

Rasmussen says speculation has pushed up Greek bond spreads, the difference between the rates of return on Greek and German bonds. The wider the spread - that is, the further away from the German benchmark the Greek bonds stray - the riskier the country’s debt is considered to be. The upshot is that investors charge punitive interest rates to high-risk countries, which is why Papandreou will have to shell out €725 million more than Germany on the €5 billion bond it sold off at the beginning of March.

Germany’s financial supervisor BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht) said as much in a statement recently, admitting that it could find no evidence of speculation seriously affecting CDS spreads. «A major cause of the increase in the CDS spread was growing demand for credit hedging against the country risk Greece,» it said. «The market data currently available to BaFin do not support the conclusion that speculation is taking place on a massive scale.»

Greece is in debt to the tune of €300 billion, one and a quarter times its gross domestic product (economic output). The government deficit - the shortfall of revenue over expenditure - was 12.7% of GDP in 2009, the highest in the EU. Athens had previously predicted it would be half that, but the Socialist government last October revealed its predecessors had been cooking the books, tricking EU statisticians into believing public spending was much lower than it actually was. «Markets may have overreacted,» says Zsolt Darvas, a research fellow at the Bruegel think-tank in Brussels, «but Greece is in a very tough situation and has a much higher deficit than expected.»

In fact, a cursory glance at Eurostat’s deficit tables shows Greece has only once gone below the EU’s 3% deficit limit since joining the euro (and even then only by 0.01%). It’s a similar story for government debt, which has stuck close to 100% of GDP for years - well above the EU’s 60% threshold. Papandreou has made severe cuts to reassure investors that his government can remain solvent - he aims to slash the deficit by four percentage points this year - but Darvas insists that this has nothing to do with speculative pressure. «I simply don’t agree that the CDS market contributed to the Greek troubles. The market reaction was fully rational and there is still a risk. If Greek citizens block the reforms they will be difficult to implement,» he adds, referring to the general strikes that have gripped Athens in recent weeks.

SHORT SELLING

EU leaders, particularly Germany, are firmly in favour of Greece doing its homework. The last-ditch deal cobbled together at a European Council meeting on 25 March says as much, offering Greece a loan only if it agrees to make further budget cuts, and even then at above average interest rates. However, that does not mean that EU leaders are willing to leave Greece at the mercy of the markets. German Chancellor Angela Merkel had already written to Commission President José Manuel Barroso weeks before the summit - a letter also signed by her French, Luxembourg and Greek counterparts - urging a crackdown on speculators. «We must prevent speculative actions from causing so much uncertainty on the market that prices no longer provide accurate information and state financing reaches a fundamentally unjustifiable high level,» the letter said.

It drew a swift reaction from the EU executive. Both Barroso and Internal Market Chief Michel Barnier pledged to look into the effect the trade in CDSs and short selling has on eurozone bond spreads, a mammoth task given that CDS are traded privately (over the counter). Add to that the fact that the largest holder of data on CDSs (the DTCC) is based in the US, which is making it difficult to access information, said one EU official.

An outright ban on naked selling is looking increasingly unlikely, first because of the difficulty of distinguishing when a trader is making a purely speculative move from when he is insuring himself against a risk (hedging), and second, because there is always a way around legislation. «Whenever there is a ban on certain products, markets find a way to circumvent the ban,» Darvas says. For Brandon Davies, a ban would harm legitimate traders. «In banning naked purchasing you’re doing a lot of damage to people who might have insurable risk,» he says. «It is unlikely that major holders of bonds would want to write that insurance.»

In 2008, Austria, Italy, France, Germany, Greece and Luxembourg temporarily banned naked selling in certain markets, while Spain, Portugal, the UK and Sweden forced traders to report to supervisors when they were going short (above certain levels). What the EU will most likely do in October, says one official, is to set out a way in which EU governments can coordinate their efforts if and when they do suspend the practice, although the Commission has not yet taken a stance for or against a ban.

DERIVATIVES

What is for certain is that in June, Michel Barnier will publish a package of legislation to regulate the trade in derivatives, including CDSs. Essentially contracts used to bet on a future event occurring, derivatives are based on underlying assets such as stocks, interest rates or commodities. The market is dominated by shadowy over-the-counter transactions, and they do a roaring trade - at the end of June last year, there was US$605 trillion outstanding in the entire OTC market, according to the Bank for International Settlements. The CDS market was worth around US$36 trillion, less than 6% of the total. «Derivatives in general are dangerous,» Darvas says. «Building up speculative positions and unwinding speculative positions can create turbulence on the markets.» G20 leaders agreed at their London meeting last year and Barnier’s predecessor, Charlie McCreevy, set out a four-pronged strategy to bring OTC products into the open:

-create universally standardised derivatives contracts -move the trade in standardised derivatives on to centralised exchanges -clear all transactions through central counterparties, creating a sort of middleman to manage defaults -force traders to report all their movements to data repositories.

WAITING GAME

«Markets are very volatile and unstable now,» says Brandon Davies. «In terms of price they’re trying to contest the truth between opposing views. There are people betting that everything will be all right... and there are people betting that Greece will actually go bust.» Darvas agrees. «Markets believe there is a heightened risk for default,» he says. «During the good times, before the crisis, the markets gave no reaction to Greece or any other country.» If they are right, it is simply a waiting game until derivatives markets return to normal - or until they are fundamentally overhauled. Paul Moxey of the Association of Chartered Certified Accountants has a final word of warning to Greek statisticians: «Governments thinking of using techniques to improve the look of their finances might be more likely to think twice in future if they realise that, by doing so, they are laying themselves open to speculators.»

Short selling

Shorting, or short selling, is considered a legitimate market practice by regulators, often used by investors to hedge risk. A trader temporarily borrows a bond (for a fee), sells it on a bet that the price will fall, and buys it back at the (now lower) market price. «Short sellers are taking a risk,» says Paul Moxey of the Association of Chartered Certified Accountants. «They are gambling that the current price of the shares or bonds is overvalued. They’re betting they can buy those back at a lower price.» The problem for regulators is when traders don’t borrow the bonds they’re shorting. This is called naked selling and was banned by several EU member states when the financial crisis unravelled in 2008.