The spotlight in recent weeks has been shining intensely on a financial product known as a sovereign Credit Default Swap (CDS) and the role it may have played in Greece’s current financial woes. Europolitics charts the origins of the sovereign CDS, asks whether it really is the culprit in the Greek crisis, and assesses how likely it is that the EU or US will restrict trade in them.

A CDS is often likened to a bet in which the better reaps a reward if the company or country they bet on can longer pay its debts, i.e. it defaults. The buyer of a CDS can bet once, twice, a hundred times on the default happening. If there is a default, they win, but if there is none, they lose all their money. Supporters of the CDS argue that it is a legitimate and useful way for parties to insure themselves against a genuine financial risk. Critics counter that it encourages parties to speculate on someone defaulting purely to make a profit rather than to hedge a financial risk, the purpose for which it is intended. The analogy is sometimes used of a person being allowed to take out a fire insurance policy on their neighbour’s house. Such a policy holder has no incentive to prevent the house from catching fire because they only make money if it burns down.

The current controversy with Greece concerns sovereign CDS. They differ from corporate CDS only in that the party is insuring against a country defaulting, not a company. Sovereign CDS are classified as ‘single-name instruments’ because the reference entity is a single name, in this instance a government. They grew more popular after 2001, the year Argentina defaulted, causing massive turmoil in the financial markets in the process. Thus, sovereign CDS are a subset of CDS, which are a subset of derivatives. A derivative is a complex financial product whose value is based on underlying assets, such as commodities, stocks, or credit default risk. CDS are typically bought and sold by reporting dealers, banks, insurance companies and other governments. They have grown increasingly popular, their total outstanding value reaching US$36 trillion in June 2009, compared with US$6.4 trillion in December 2004. The volume of trade in sovereign CDS is smaller than for corporate CDS because the risk of a country defaulting on payments is lower than for a company (see table).

The CDS market first developed in the 1980s and 1990s in the form of over-the-counter (OTC) derivatives, meaning they were traded privately rather than on a public stock exchange. A combination of successful lobbying by the financial markets, coupled with a prevailing anti-regulatory zeal among lawmakers in Washington caused CDS to be exempted from regulation. Two figures, heavily criticised subsequently because of the role CDS would play in the near collapse of the global banking system in autumn 2008, were key in this process. They were Wendy Gramm, who from 1988-1993 was chair of the Commodity Futures Trading Commission (CFTC), the US government agency that regulates futures and derivatives, and her husband Phil Gramm, a former US congressman and senator.

Wendy Gramm once worked as an economist for US President Ronald Reagan, who famously said in his 1981 inaugural address that “government is not the solution to our problem - government is the problem.” As CFTC chair, she signed an order exempting derivatives from regulation. That meant there were no disclosure obligations for them and no limits on what kinds of derivatives, or how many of them, could be traded. Another crucial moment came in December 2000 when the US Congress adopted the Commodity Futures Modernisation Act that barred the CFTC and Securities and Exchange Commission from regulating CDS.

This provision was inserted into an 11,000-page bill on the US budget without being debated. One of its leading advocates was Gramm’s husband, the Republican Phil Gramm. The media and public paid little attention to a decision that ultimately ended up being hugely significant for the global economy. The US at the time was gripped by a dispute of epic proportions over who won the November 2000 US presidential election between Al Gore and George W. Bush. The dispute was in full flow, with multiple ongoing legal battles that would culminate in the US Supreme Court effectively declaring Bush the winner.

Consequently, when the financial crisis and credit crunch hit in September 2008, following the collapse of investment bank Lehman Brothers, the wider public woke up to the fact that US regulators had no oversight of OTC derivatives. Neither was there oversight of these products in Asia or Europe. The world’s top political leaders, meeting in the G20 forum, responded by agreeing this needed to change and that OTC derivatives should be cleared by third parties by the end of 2012. US and EU reuglators are now in the midst of deciding how to implement this goal (see separate articles).

Sovereign CDS

Sovereign swaps are credit derivatives where one party to a contract gets paid if the country that issued the underlying bonds defaults.

Greek sovereign CDS = US$9 billion (early 2010)

Greek government bonds = US$400 billion (2010)

CDS = US$36 trillion (June 2009)

Derivatives = US$604.6 trillion (June 2009)

Total value of

Greek sovereign CDS = US$9 billion (early 2010)

Greek government bonds = US$400 billion (2010)

CDS = US$36 trillion (June 2009)

Derivatives = US$604.6 trillion (June 2009)