Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 22 February 2012

A new species is born

Like Dr. Frankenstein, European officials are trying to breathe life into the curious amalgam that is the Eurozone. While everyone is fixated by the body of Greece and the apparatuses protruding from it, another species has quietly been born in Dr. Euro’s financial engineering laboratory. This is the SPC or Euro Sovereign Protection Certificates. European officialdom's nemesis of the evil CDS (Credit Default Swap).

SPCs (pronounced species), like CDS, offer protection to investors against sovereign restructuring/default but unlike CDS they shun the dark side (as defined in the European Treaty against Evil Speculation, Section 6, subsection F, point vi). These certificates will be issued by a special purpose entity owned by EFSF called the European Sovereign Bond Protection Facility (ESBPF). They can be issued along with sovereign bonds at the request of a sovereign that has entered into a Master Financial Assistance Framework Agreement (FFA) with the EFSF. The aim is to reduce borrowing costs for the sovereign by providing a partial guarantee to investors against default (illustrated below).

The price and trading behaviour of SPC will diverge from CDS due to the following significant differences between them:
  1. SPC is Euro-denominated and settlement currency is Euro (EUR) as opposed to Sovereign CDS which is usually traded in US dollars (USD) and settlement currency is any G7 currency, Euros or Swiss Francs.
  2. ESBPF is the sole underwriter of SPCs whereas there are multiple underwriters for CDS (usually banks).
  3. SPC claims can be settled by ESBPF through payment of either cash or EFSF bonds. In contrast, CDS is always settled through payment of cash.
  4. Payment is capped at 20% - 30% of bond par value unlike CDS which pays the difference between par and recovery.
  5. SPC requires insurable interest unlike CDS, i.e. the holder of the SPC has to hold sovereign bonds to claim in the event of default.
  6. In case of credit event (repudiation/moratorium, failure to pay or restructuring), SPC may be triggered if 25% of the holders ask for it. However CDS can only be triggered if the ISDA Credit Derivatives Determinations Committee rule that a credit event has occurred.
Euro-denomination and ESBPF being the sole counterparty introduce correlation risk into SPCs. As default probabilities for Eurozone sovereign/s increase, EUR would tend to weaken. Additionally counterparty (i.e. ESBPF) default probability would increase as well since it is backed by EFSF which itself is backed by Eurozone sovereigns. Therefore the protection afforded by SPCs would fall in value. Another way to think of this is the parallel to AIG’s Financial Products Division. The protection (ironically through CDS) it sold would have been worthless to the holders had it not been guaranteed and paid by the US Treasury.

Moreover, the ability of ESBPF to pay SPC holders in EFSF bonds makes a complete mockery of any claim that SPC provides protection against default. For a large peripheral sovereign such as Italy or Spain whose credit deterioration would significantly impact EFSF and hence ESBPF, SPCs are going to fall in value along with sovereign bonds. Hence SPCs are unlikely to protect bondholders even from mark-to-market losses on their bond holding.  

It is difficult to quantify the correlation risk implicit in SPCs. However, the discount due to currency-sovereign credit correlation risk can be discerned from observing EUR-USD CDS quanto prices. For example, Italy CDS denominated in USD is trading at 395bps (3.95%), which is 85bps (0.85%) wider than EUR denominated CDS. The market is implying that EUR CDS is only worth 78.5% of USD CDS. Adding counterparty-sovereign correlation will decrease the value further. This is unobservable since quite understandably there is no market in counterparty-sovereign correlated CDS.

Additionally SPC fails to act as a hedge as expected losses in event of default rise above its cap. It behaves as a fixed-recovery CDS. Using the standard model assumption of 40% expected recovery in event of default, SPC would be worth only 33% - 50% of Euro-denominated CDS for a 20%- 30% cap. And for one percent decline in expected recovery, the ratio of SPC’s value to CDS will fall 1.6% approximately. Therefore, ignoring counterparty-sovereign correlation and knowing that most sovereign defaults in history have led to haircuts in excess of 30%, the theoretical maximum value of SPCs is going to be 26% - 39% of USD denominated CDS. In reality due to counterparty-sovereign correlation and ability to pay in EFSF bonds, the value is going to be appreciably lower.

This value is not impacted by the requirement of insurable interest. Since the number of SPCs created are going to depend upon notional amount of bonds issued, the chances of a squeeze in the event of default are minimal.

The comparison of SPC value to CDS is complicated by the unusual triggering mechanism. First it provides enormous power to the Determination Agent (HSBC Bank Plc) to prepare grounds for triggering by concluding that “terms applicable to a "Standard Western European Sovereign" Transaction Type and/or market practices applicable to credit derivative transactions referencing the Reference Sovereign have been amended, changed, modified or replaced”. Second after such a determination, it enables 25% of the holders to trigger SPCs. The logic of vesting all power in one institution (which incidentally is not a member of the ISDA CDDC due to the low volume of CDS traded by it) is questionable and introduces unquantifiable non-market risk. This risk is magnified if HSBC is going to trade SPCs on its own account.

The ease of triggering SPCs might be a sweetener to entice investors to migrate from CDS to SPCs. But it might be more insidious; a Trojan horse through which European officials destroy the CDS market. The ease of triggering is worrying especially in light of the statement mentioning change in terms or market practices. If buying CDS is made legally difficult through removing loopholes in the current legislation then SPCs become the only alternative. By law CDDC may not be able to rule on a credit event, thus leaving CDS buyers holding worthless contracts. Although the CDS contract does provide protection from sovereigns changing domestic law to prevent a trigger but the UK being a signatory to the Lisbon Treaty means that Europeans can force a change in English law to void CDS contracts.

It would be interesting to watch how this CDS nemesis develops. The stigma of issuing SPCs along with investor scepticism may mean that it is yet another stillborn new species from Dr. Euro’s financial engineering laboratory. However, the odds are that the environment deteriorates so rapidly that this species becomes extinct before it can propagate.

1. Do read FT Alphaville's excellent (as usual) take on this: http://ftalphaville.ft.com/blog/2012/02/22/890241/an-efsf-credit-derivative-is-born/
2. For those who believe that nothing beats going to the original documents:
    2.1 http://www.esbpf.eu/attachments/esbpf-presentation.pdf
    2.2 http://www.esbpf.eu/attachments/esbpf-base-prospectus.pdf

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