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Sunday, 11/14/2010 9:30:26 AM

Sunday, November 14, 2010 9:30:26 AM

Post# of 687
Credit Default Swaps: What's All the Fuss About?

The cost of insuring Irish government bonds against default rose sharply this week—as it did for the bonds of other governments—in what was widely reported as a harbinger of doom for the continent's weaker economies.

These costs reflect what's happening in the over-the-counter market for credit default swaps. But the emphasis on the costs of default protection in this market raises questions about how much importance should be attached to its day-to-day price gyrations.

One way of assessing their significance is to look at statistics from the Depository Trust & Clearing Corp., the New York clearinghouse through which a vast majority of global CDS trades are directed.

The figures are released after a significant lag and don't say anything about prices, but they tell you about market volumes. And although sovereign CDS are more actively traded than all but a few corporate names, mainly banks, most aren't traded very actively at all.

In the three months ended June 20, the most active sovereign CDS market in Europe was in Spanish debt, where an average 34 trades a day took place. Greece, facing a repayments crisis that was relieved only by a bailout from its euro-zone partners, was the third most active name with 26 daily trades. Ireland, the focus of this week's activity, occupied eighth place with an average eight trades a day.

So how much is at stake in these trades? The notional volumes of debt insured are on the face of it higher: some $500 million on average per day in the case of Spain; $575 million of Italian debt, $325 million of Greek debt and $150 million of Irish debt. But even these nominal sums are of the order of a thousandth or less of the total debt outstanding of these governments. At the end of 2009, according to the latest figures from Eurostat, the total government debt of Spain was €561 billion, of Italy €1.76 trillion; of Greece €273 billion and of Ireland €105 billion.

And banks, hedge funds and other users of the market stake only fractions of the notional sums insured. For example, according to Markit, a company that tracks the CDS market and produces indexes of market movements, the cost of insuring $10 million of five-year Spanish government bonds for one year was being quoted Thursday afternoon at about $220,000.

According to Gavin Nolan, a Markit credit research analyst, premiums in the market are conventionally paid quarterly.

In other words, a buyer would put $54,000 down immediately to insure $10 million worth of bonds for three months. Assuming Spanish CDS trading volumes are about the same as in the second quarter, that suggests sentiment in the half-a-trillion euro market for Spanish government paper is being influenced by people staking around $2.5 million a day.

Mr. Nolan says that some names are barely traded—with barely a handful of dealers offering quotes—but that in recent days the market in Irish CDS has been fairly active. One conventional measure of trading depth is the spread between price a dealer will offer to sellers and that offered to sellers. In the case of Ireland Thursday, the bid price was $590,000 and the offer $610,000, a relatively narrow spread, he said.

He said trading volumes in the underlying Irish government debt market are currently very low—with few if any buyers. (One reason for this, apart from a lack of buyer appetite, is related to the fact that most bonds are traded actively only soon after they are issued and then are usually locked up in portfolios. Neither Ireland nor Greece are currently issuing new bonds.) In these circumstances, he said, the CDS market could be offering price signals that are at least as important as those being sent by the underlying bond market, if not more so.

Pessimism over the prospects for weaker euro-zone economies to surmount the crisis without a debt default has undoubtedly grown over the past week, fueled probably by last week's decision of European Union governments to examine ways of making bond restructurings an essential element of future government rescue packages. However, a closer look at the sovereign CDS market suggests its day-to-day price movements, and sometimes even daily price shifts in the underlying bond markets, should not be invested with too much significance.

Write to Stephen Fidler at stephen.fidler@wsj.com



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