Italy’s Sovereign CDS Worth $10 Trillion

Italy’s recent bond shock showed that the financial derivatives market designed to insure against sovereign defaults hasn’t been killed off by doubts about whether those contracts would pay out when the time came.

The market for sovereign credit default swaps, or CDS, is half the size it was six years ago at the height of the eurozone debt crisis, following a government clampdown and a patchy record as a hedge for a credit event, Reuters reported.

But when the political crisis in Italy began to hammer the country’s huge government bond market, one of the biggest trades was to buy an updated version of the credit insurance contracts, signaling an enduring, albeit changing, appetite for the instruments.

The CDS market as a whole still has a notional value of over $10 trillion, data from industry body International Swaps and Derivatives Association shows.

“During the financial crisis, in some cases it didn’t provide the same protection that was expected,” said Erin Browne, head of asset allocation at UBS Asset Management.

“It may work for a directional view, but we don’t use it as a hedge against default,” she said.

A eurozone sovereign default has been a concern for investors in developed market government bonds as no country within the bloc can print money on its own if faced with debt repayment difficulties.

Even though the European Central Bank has performed that function when it deemed a country’s problems threatened the wider system, the effective Greek default of 2012 underlined the residual risk.

The notional outstanding CDS for eurozone single-name sovereigns has almost halved, but still stands at 510.6 billion, the data shows.

If investors holding a CDS believe a credit event has occurred, they make a submission to ISDA, who then pass it on to a determinations committee for a decision.

This can lead to variable results. In the case of the Greek sovereign debt crisis in 2010, investors eventually received a payout, but there was a long period where they worried Greece would default without triggering the CDS. In the case of Portugal’s Novo Banco, they did not.

Those who assess portfolio risk for funds said they still believe in the ability of CDS to hedge debt holdings—up to a point.