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Credit default swaps ‘not to blame’ for Greek crisis

Text by Benjamin DODMAN

Latest update : 2010-03-06

The European Commission is taking a closer look at credit default swaps amid claims that this trading and investment tool played a part in the Greek crisis. But Prof. Geoffrey Wood of the Cass Business School says Brussels is on the wrong track.

The European Commission summoned banks and national regulators to a meeting in Brussels Friday to discuss ways to regulate the growing credit default swaps market amid claims the complex trading and investment tool precipitated the debt crisis that has engulfed Greece and seen the euro take a pummeling on the foreign exchange markets.

To put the importance of this credit derivative into context, since the first CDS contract appeared in 1997 the value of the market has skyrocketed, reaching approximately $45.5 trillion by mid-2007 according to the International Swaps and Derivatives Association. In other words, the size of the CDS market in 2007 was already twice that of the entire US stock market.

In the wake of the shockwaves created by the Greek economy spiraling into freefall, many have pointed the finger of blame at CDSs, but economist Geoffrey Wood, a professor at the Cass School of Business in London, says Brussels is barking up the wrong tree.

FRANCE 24: In layman’s terms, what are Credit Default Swaps?

Prof. G. Wood: A credit default swap is a form of financial insurance. The buyer of the swap makes regular payments to the seller, in return for protection in the event of a financial instrument (typically a loan or a bond) defaulting. If you buy a CDS you get some return from a bond or a loan, but not all, because you are taking less risk. It is also a way of insuring yourself against a firm, or a country, going bankrupt. It is actually a very useful device.

F24: Could they have played a part in the Greek debt crisis?

G. W.: What happened in Greece is that some investors who had bought Greek bonds found out – or knew already – that the Greek government was faking the numbers. They therefore decided to relinquish part of their returns from the bonds by buying CDSs. In practice, they paid someone who agreed to cover them in the event of a Greek default.
But they didn’t cause the debt crisis. What they might have done is send out negative signals about Greece and make people more reluctant to buy Greek debt. The one lesson we can certainly draw from this crisis is that it looks like Greece is not a responsible country.

F24: What can the European Union do to regulate the market for CDSs?

G.W.: The EU is simply scared of something it feels powerless to control. It is also completely off track. It is hard to imagine how they could regulate credit default swaps in the EU, because the swaps would simply be carried out elsewhere. For instance, if France began to misbehave the way the Greeks have done, one could always buy swaps on French debt in the Seychelles.

Brussels could decide to restrict the purchase of a CDS to people who actually own the instrument (eg. the bond) against which they are buying insurance; whereas as things stand at the moment, you can buy a swap to insure yourself against pretty much anything. But that would simply push investors abroad, making the European market a lot thinner and ultimately more volatile.

Date created : 2010-03-06

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