Streetwise Professor

I was quoted in this WSJ/Dow Jones article about why sovereign CDS are not being cleared.  I think that legal risk has something to do with it.  But upon further consideration, I think the problem with sovereign CDS is far deeper than that.

The problem is not exclusively with clearing vs. bank intermediated-bilateral.  The problem is with wrong way risk which makes it very dangerous to have a bank as the counterparty selling protection in a sovereign CDS.  Clearing sovereign CDS through a bank-dominated CCP means that banks are the ultimate counterparty, and if the protection seller defaults there is a possibility that banks will be on the hook to pay out on the defaulted contracts precisely when they are in financial distress.

The recent crisis in Europe demonstrates that with current monetary arrangements, the default of any sovereign name of any size can trigger a financial crisis that threatens banks.  Note that bank CDS spreads tend to blow out whenever one of the PIIGS looks shaky. I don’t have the data at hand, but I would wager there is a very high correlation between Greek, or Portugese, or Spanish, or Italian CDS spreads and bank CDS spreads.  Which means that there is a substantially elevated risk that a bank or bank-backstopped counterparty (i.e., a CCP) won’t be there if a sovereign defaults.

There are structural reasons for correlation.  Banks tend to hold large amounts of sov debt in their portfolios.  A surge in sovereign default risk tends to lead to funding problems for banks–especially those with large sovereign exposures.  Thus, sovereign debt crises are associated with substantially elevated risk of bank failure.

This is actually a firmer basis for governments and regulators to be skeptical about–and perhaps even hostile to– sovereign CDS than their usual kill-the-messenger bleats about evil speculators.  Sovereign CDS are potentially beset with wrong way risk, and they pose a real systemic threat to banks if the banks sell protection: in contrast, banks buying protection makes good sense as a hedge if the counterparty is likely to be able to perform in a sovereign debt crisis.  The risk is right-way when banks are protection buyers.

The issue with clearing sovereign CDS is that clearing makes banks contingent protection sellers, and the contingency kicks in right when banks are least able to afford it.  But even a bank running a balanced book would still pose problems because if a counterparty from whom it bought protection defaults, it would be obligated to dip into its capital to pay off the parties to whom it had sold protection, and again precisely when it is least able to afford it.

This suggests that there are acute systematic risks inherent in sovereign CDS under both bilateral and cleared approaches.  Since we have seen that the potential default of any European sovereign name, even those of middling size, can precipitate financial panic, sovereign CDS are arguably the most problematic derivatives out there from a counterparty risk/systemic risk perspective.  They are likely beneficial as long as banks are not major protection sellers under any contingency.  That’s impossible to achieve with clearing, and likely very difficult to achieve in a bilateral market.

What this suggests to me is that (a) it is unwise in the extreme to clear sovereign CDS, and (b) banks should be subject to a hefty capital charge on their gross sales of sovereign protection.  Gross, not net, because the gross drives their contingent exposure.  Low capital charges on a positive net position in protection purchases would be defensible as that risk is right way and net protection purchases gives banks an incentive to lay off sovereign debt risk on those who can bear it at a lower cost than they can.

Looking at the issue of sovereign debt risk more broadly, this analysis again raises serious alarms about the wisdom of mandating or incentivizing banks to hold large sovereign debt positions, where the incentivizing comes in the form of liquidity requirements that must be met by sovereign debt holdings and favorable capital charges, and the mandating comes in the form of margin and clearing requirements.  But the financial repression pressures driven by the pressing need of governments to get somebody to hold their bonds is driving us in that direction.

Which suggests to me that the systemic risk of the future–and the systemic risk from hell–is the prospect for chronic fiscal crises around the world.

And on that cheery note . . . back to work.