Greek Crisis May Test the Value of Swaps The restructuring of Greece's debt that is scheduled to start next week may well demonstrate how effective credit-default swaps are. These financial instruments, which played a major role in both the 2008 financial crisis and in the European debt crisis, are meant to pay out if a company or country defaults. But the twists and turns over Greece's debt are revealing their potential limitations for investors who hope the swaps will protect them against losses if Greece defaults. On Thursday, the International Swaps and Derivatives Association, the industry body that decides whether swaps should pay out, said that Greece's proposed debt exchange did not currently activate swaps linked to the country's debt. But the association added that the swaps could activate at a later date. The body's decision reignites the debate over the usefulness of the default swaps. If Greece had simply stopped paying interest or principal on its bonds, the swaps would have paid out. European policy makers, however, decided last year to try to use a voluntary debt exchange for Greece as a way to avoid setting off the swaps. The maneuver was a brusque reminder for investors that there are ways to circumvent the conditions of credit-default swaps. "If a sovereign, and those trying to rescue it, tiptoe around the periphery to avoid triggering the C.D.S., it may impair the effectiveness of the C.D.S. as a risk management tool," said Bruce Bennett, a partner at the law firm Covington & Burling. If the Greek debt exchange damages the reputation of credit-default swaps, banks and other investors that make heavy use of them for protection from losses may have to consider other strategies. And it would add fuel to the political fire over the swaps and speculators. Some European politicians contend that the swaps destabilize financial markets and encourage investors to mount speculative attacks on government debt. European officials have even taken the step of setting up their own version of credit protection, which will be offered by the European Financial Stability Facility, a government-backed rescue fund. Just over $70 billion of default swaps exist on Greek government debt. After subtracting swaps that pay out on a default from those that get paid, the net amount is $3.25 billion. But the small net number masks how much is at stake if the swaps do not behave after Greece's debt exchange as investors planned. One of the decisions of the swaps association on Thursday underscored how swaps can be disconnected from actions that harm investors" economic interests. As part of the Greek debt deal, the European Central Bank will be shielded against losses on the Greek bonds it holds, a move that relegates, or subordinates, the claims of private creditors who hold the same bonds. But the swaps association said the plans to subordinate private creditors do not meet the definition of subordination in the swaps contracts, so they do not have to pay out. The association's 15-member committee behind the decision consists of 10 banks that deal in derivatives and five asset management firms. Most analysts now believe that Greece will opt for an involuntary exchange, using a legal measure to force as many bondholders into the exchange as possible to maximize the country's debt relief. As a result, many market participants believe the swaps will be set off. A voluntary exchange is still possible, however. If more than 90 percent of the bondholders entered the exchange voluntarily, Greece might decide it does not need to force more participation with the legal measure, called a collective action clause. But even if Greece does opt for an involuntary exchange and the swaps activate, the process may not work as planned. The exact amount paid out on the swaps is determined by an auction of Greek bonds. Yet the auction would almost certainly take place after the bonds had been included in the exchange and eradicated. Investors have to submit bonds registered under Greek law by Thursday. After the exchange, investors would have new Greek bonds, worth much less than their old bonds" original value. But it is not clear whether these can be included in the default swaps auction, and, if they can, whether they would settle at the price investors hoped for. Some analysts say that the swaps association will most likely try to work out a solution so that the new bonds can be used in the auction. "I am convinced I.S.D.A. will come up with a mechanism," said Rodrigo Olivares-Caminal, a lecturer in finance at the University of London who specializes in sovereign debt. If that option does not exist, another potential solution may be to use the small amount of Greek bonds that are registered under English law in the auction. Holders of these bonds may not submit them by Thursday. And they will not be subject to the collective action clause, which is only inserted in Greek law bonds. The English law bonds will almost certainly lose value, but they do not have to be submitted to Greece until April 11. That means some may theoretically be available for the default swap auction. Still, this option raises the question of what would happen if Greece did not have any English law bonds. Some analysts do not see anxiety in the market prices for Greek bonds and credit-default swaps. A big divergence between the two instruments would suggest investors are worried about their ability to activate the default swaps. But that is not happening, said Ed Lalanne, a strategist at Macro Risk Advisers. "The prices of sovereign C.D.S haven't been condemning the market to be useless," he said.