A Not-So-Noble Idea

Joseph Stiglitz, the economics professor and Nobel laureate, doesn’t much like OTC derivatives. He thinks, for example, that banks should be banned from trading them.

So it’s not a big surprise that he sees OTC derivatives – specifically CDS – as a problem in the negotiations over the Greek debt crisis.

But it is a big surprise – and a big disappointment – that his argument reprises the same erroneous and outdated information that one expects of lesser pundits.

To explain: A recent column in The Guardian, “European Central Bank in a fix over Greek debt“, explores the reasons behind the ECB’s apparent insistence that any Greek debt restructuring be deemed voluntary, so as not to trigger a CDS credit event. Professor Stiglitz cites three possible reasons for the ECB’s stance. The one he apparently finds most convincing is that:

“By insisting on it being voluntary, the ECB may be trying to ensure that the restructuring is not deep; but, in that case, it is putting the banks’ interests before that of Greece, for which a deep restructuring is essential if it is to emerge from the crisis. In fact, the ECB may be putting the interests of the few banks that have written credit-default swaps before those of Greece, Europe’s taxpayers, and creditors who acted prudently and bought insurance.”

As we have said many times and in many places, the $3.2 billion in net exposure of Greek sovereign CDS is relatively small. Plus: that $3.2 billion is the aggregate amount of all the individual net exposures, so the exposure of any one firm is less. Plus, plus: the exposures firms have to each other are marked-to-market and largely collateralized. Plus, plus, plus: the recovery value of a defaulted reference entity’s obligations further decreases the amount of cash that a protection seller would pay out to a protection buyer (so the aggregate cash payout following a credit event is less than $3.2 billion).

What does all of this mean? Simply that Greek sovereign CDS exposure is too small to be much of a factor in the Greek drama that is currently being played out.

We would have thought that Professor Stiglitz and his research staff surely know all of this? And that regulators have access to trade volumes and exposures through the CDS trade repository? And also that the EBA’s capital exercise, which detailed the CDS exposure of 65 European banks (including those from the UK, France and Germany) as of the end of the 2011 third quarter, showed that the total net CDS exposure of those firms was $545 million, all of which is already marked to market at approximately 30%?

The final oddity of Professor Stiglitz’s column relates to his views on the ISDA Determinations Committees, the group responsible for assessing whether a credit event has occurred. Here, too, we would have thought that the professor’s research team would have informed him of a few key facts. Namely, that the role of the DC is outlined in the legal contract to which CDS counterparties agree; that members of the DC are listed publicly on ISDA’s website; and that firms on the DC may be net buyers or sellers of CDS protection. As the EBA data show, the four firms included in the exercise who sit on the ISDA EMEA DC have a very small net Greek sovereign CDS exposure.


4 thoughts on “A Not-So-Noble Idea

  1. ISDA’s DC consists of buy and sell-side participants whose identities are easily determined, and it is arguable that in many ways this process of ‘decision-by-committee’ is actually more democratic compared to the alternatives. In fact, whichever the result, and whoever makes the decision, there will always be criticism because the nature of this problem is now so politicised. However it is also true that the committee which consists of derivative buyers and sellers themselves, is prone to conflicts of interest and a decision-making process that is at odds with the notion that issues such as whether or not there has been a ‘credit default event’ (or similarly, market disruption event) is a question of fact and should be objectively determined. This is the element which is missing from ISDA’s committee by virtue of its composition but raises an interesting question which ISDA should review.

  2. Pingback: ‘S&P Declares Greece in Default’ (Wall Street Journal) – ‘The Greek Default Begins (Sky News) – ECB Puts Greek Banks On Emergency Aid After Downgrade (Reuters)

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