Greek CDS drama holds lessons for investors It's over. The long-running drama over Greek credit default swaps finally came to uneventful end on Monday with a $2.5bn pay-out for those who had bought protection against default by Athens. Yet, while market disorder was avoided, there remain concerns that CDS are flawed. Market participants insist lessons need to be learned from the Greek debt restructuring deal and bond exchange, or these insurance-like instruments, untested in a sovereign restructuring before Greece and which are used as a protection against losses on bonds, could lose their appeal. An auction held by 14 banks set a market-wide payout of $2.5bn, or 78.5 per cent of the $3.2bn of net outstanding CDS as of March 9, when a so-called "credit event" was declared by the International Swaps & Derivatives Association, the industry body that rules on pay-outs. The payout was considered fair value by many strategists and investors. But these same strategists and investors said that this was more down to luck than design as the Greek debt exchange, under which private sector holdings of Greek debt were written down by about €100bn, failed to consider the potential negative fallout for CDS. Michael Hampden-Turner, credit strategist at Citi, says: "I would like to see the market look very closely at how CDS works in the event of future sovereign restructurings. We had a lucky break with Greece in that the process went smoothly, but it might not do so the next time round. Portugal could be next major test The next big test for credit default swaps may be Portugal, according to traders and investors, writes David Oakley. Markets are already expecting a Portuguese debt default as bond prices are hovering around 50 per cent of par for benchmark 10-year debt, a distressed level. Portugal has a smaller bond market than Greece, with about €100bn of government debt outstanding. A CDS net payout would also be a relatively small amount of $5.2bn, according to the latest figures from the Depository Trust & Clearing Corporation. Yet, Portugal may be more important than Greece in shaping the sovereign credit default swaps market, say traders. One head of rates at a leading bank says: "Portugal may prove to be the important one for the CDS market. If the country has to use private sector involvement [PSI] in its next bailout, and the CDS process runs smoothly, then that will be a big reassurance for markets over this instrument. A CDS trader says: "The Greek CDS process went smoothly. If Portugal saw a similarly smooth process, then that would increase views that this is a worthwhile product for the use of hedging. The Greek CDS auction, which settled the payout for the country's default, went to plan as CDS and bond prices have signalled this outcome for a long time, say traders. This helped pave the way for an auction that delivered few surprises as the recovery rate, or payout, had been widely expected. Investors delivered physical assets or bonds to settle their credit default swap payout in Monday's action and then a final price was established for those investors that wanted cash in exchange for their contracts. There were several broad categories of debt that were eligible for delivery. These included Greek state-owned institutions that were not eligible in the private sector involvement process, such as Hellenic Railway bonds, a small number of short-term bills, international bonds under English law and new bonds, restructured under PSI. The most important lesson, as far as bankers and investors are concerned, is that there should be a mechanism to settle CDS before bonds are exchanged in future restructurings. The private sector involvement initiative, or PSI, saw old Greek bonds exchanged for a range of new ones with varying maturities out to 30 years. The end result in Monday's Greek auction was not affected by the failure to have such a mechanism. This was because the new bond maturing in 2042, used to set the final pay-out as the cheapest security to deliver, traded at similar levels to old Greek bonds. The price that bonds finally settled at for the pay-out was also accurately forecast by the market, meaning no nasty surprises. By setting a price of 21.5 per cent of par, the final pay-out on CDS was 78.5 per cent of the value of protection written. In other words, every buyer of $10m in CDS protection against a Greek default can expect a payout of $7.85m cash. However, if there were another sovereign default, a quicker CDS settlement may be needed to ensure a similarly smooth process. Indeed, bankers and investors say the CDS trigger for a credit event, jargon that a payout should be made, came late and relied on technicalities, such as a certain percentage of bond-holders agreeing to exchange debt under "collective action clauses." One senior CDS trader at a US bank says: "In the finish, we all knew that Greece was heading for a credit event. It would have made sense to have that credit event happen earlier. Another delay such as that involving Greece, where bondholders had to use new debt in the auction, could lead to shorter-dated bonds with higher coupons being used as the deliverable securities, leading to a lower recovery rate. "This would make CDS settlement look much less fair, questioning it as an effective hedge," says the trader. In the case of Greece, the small size of the payout helped ease tensions. The biggest loser in the payout, according to European Banking Authority data up to last September, was likely to be UniCredit, the Italian bank, which may have to pay out an estimated €240m, small change for most big banks. If a bigger country such as Italy or Spain defaulted on its debt, the story would be different, with larger sums involved and more at stake for buyers of CDS protection. Mr Hampden-Turner says: "It is good to close the door, at least for now, on the sovereign debt story that has dominated headlines, allowing investors to move on. But, that said, there were a number of narrowly avoided pitfalls. For investors and bankers, sovereign CDS has passed its first test with Greece, the world's biggest debt restructuring. But changes may be necessary for the product to pass further ones.