A central policy concern since the onset of the Greek debt crisis in 2010 has been whether sovereign debt restructurings trigger credit default swaps (CDS). CDS are insurance-like financial products whereby a protection seller agrees to pay the protection buyer in case of a credit event on a reference entity (in this case Greece) in return for a premium over a defined period of time. The legal framework for CDS transactions is largely standardized. More than 90 percent of CDS transactions are based on the ISDA Master Agreement. As a mechanism for creditors to hedge against the default of a debtor, CDS are financial instruments to redistribute risk (or, according to their defenders, to shift risk onto those entities willing and capable of better bearing such risks). Over the last two decades, CDS on sovereign debtors became increasingly common.

Greece’s debt restructuring in February/March 2012 was the first to be implemented under the umbrella of a large number of CDS (more than 2.5 billion Euros in net terms).  During the implementation phase of the Greek restructuring in March 2012, several interested market participants raised the question whether the Greek restructuring triggered an obligation for the sellers of CDS on Greece to pay. The Determinations Committee (DC) of the International Swaps and Derivatives Association (ISDA) for Europe, Middle East and Africa, the body established by ISDA and given decision-making power under the ISDA documentation to rule on credit events,  found that a restructuring credit event was triggered on March  9 2012.  The parties to CDS have agreed by contract that a credit event occurs only if the competent DC has said so.

As the Greek restructuring in February/March 2012 demonstrated, the consequences of such expert determinations by DCs can be momentous in financial terms not only for the parties to CDS transactions themselves, but also for the broader public and for taxpayers. A case in point is the Austrian bank KA Finanz, the bad bank split off from Kommunalkredit, the comparatively small Austrian lender to municipalities previously owned by Dexia that the Austrian government nationalized at the height of the global financial crisis. KA Finanz had taken over about 500 million Euros of CDS on Greece from Kommunalkredit. As a result of the payouts following the March 9 decision, the Austrian government had to inject another 1 billion Euros into the bank in order to stave off its collapse.

DCs recruit their members from among financial institutions and investment managers, which will often have positions on either side of CDS transactions. In view of their composition and the considerable practical importance of their decisions, concern has arisen that DC members may be tempted to “vote their own book” – i.e. to reach credit determinations in part based on whether the firm is on the buying or selling side of CDS for a particular reference entity.  For instance, two members of the Steering Committee of the Institute of International Finance  which negotiated the restructuring of Greek debt on behalf of private creditors of Greece, are voting members of the DC for Europe (BNP Paribas and Deutsche Bank). They were net sellers of CDS protection on Greece, meaning that both institutions had to pay out to protection buyers when the credit event occured. Given these concerns about independence of DCs and the right to a fair trial in civil matters under Article 6 of the European Convention, it is an open question whether competent domestic courts could in effect review decisions and potentially overturn decisions of DCs. (more…)

Michael Waibel is a British Academy Postdoctoral Fellow at the University of Cambridge.

On 7 September 2011, the German Federal Constitutional Court gave judgment in three joined cases regarding the constitutionality of German financial assistance to Greece and of its guarantees to the European Financial Stability Facility (EFSF). The Eurozone rescue efforts are widely seen to stand (or fall) with the government in Berlin. Germany is the largest contributor to the Greek rescue and the EFSF with more than 27 percent, or 119 billion €, of the 440 billion € in guarantees and one of only six AAA-rated sovereigns remaining in the Eurozone (alongside Austria, France, Finland, Luxembourg and the Netherlands).

Financial markets breathed a collective sigh of relief once the court upheld the rescue measures, even though few had expected the Court to strike down the laws authorizing the German guarantees. They had waited for word from Germany’s highest court with a mix of anxiety and hope. The decision removed an important source of uncertainty that had weighted on financial markets over the summer of 2011. At the same time, the judgment also raises several questions with regard to German participation in future rescue efforts, and in particular, how far fiscal integration in the European Union may go without infringing the German constitution.

The threat of constitutional review limited the German government’s room for manoeuvre in the Eurozone crisis, slowed down the policy response and explains some features of the ongoing rescue efforts, such as the structure of the EFSF and the requirement of strict conditionality attached to financial assistance to struggling Eurozone economies. The Constitutional Court has been a central player in the drama surrounding the efforts to resolve the Greek debt crisis. In a telling sign of the court’s importance, Chancellor Merkel postponed her intervention in the general budgetary debate on 7 September in the German Parliament to await the court’s ruling.

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Michael Waibel is a British Academy Postdoctoral Fellow at the University of Cambridge.

After losing a disastrous war to the Ottoman Empire in 1898, Greece was unable to service its existing debt or to pay an indemnity. The major European powers, alongside private bondholders pushed for the establishment of an international commission of financial control. Greece reluctantly agreed. The commission, consisting of representatives appointed by Austria-Hungary, Italy, Germany, France, Russia, and Britain asserted direct control over the main sources of Greek public revenue to ensure their debt was serviced. They also imposed other limits on Greek fiscal autonomy such as control over public borrowing and the money supply.

Fast-forward 113 years. Greece is at the epicentre of yet another sovereign debt crisis. On May 2010, Eurozone governments and the International Monetary Fund, in Act I of the newest Greek debt crisis, devised a 110 billion € ad hoc assistance package to prevent a possible default by Greece, but it failed convince financial markets. By covering the Greek wound with one insufficient plaster after another for the past 18 months, the Eurozone doctors have allowed the contagion to spread to major Eurozone economies, such as Spain and Italy. Policymakers have been fighting a rearguard action to get ahead of an increasingly systemic debt crisis that threatens Europe’s decade-old single currency itself.

On 21 July 2011, in Act II of the Greek Debt crisis, the European Council proposed emergency measures to shore up financial stability in the Euro area. These measures include additional financing of more than 100 billion € for Greece, lengthening of maturities and reduction in interest rates to about 3.5 percent on existing programmes for Greece, Ireland and Portugal, plus technical assistance on measures to increase competitiveness and structural reforms designed to boost economic growth.

Eurozone leaders also called upon the private sector to contribute, on a voluntary and exceptional basis, to restoring Greek debt sustainability by swapping Greek bonds maturing between 2012 and 2020. Given the implicit threat of a Greek default, it is doubtful whether the exchange is free from elements of coercion – an important factor for the rating agencies assessing the country’s creditworthiness and for whether credit default swaps, essentially insurance against sovereign defaults, will be triggered. If they are, large payment obligations by banks, insurance companies and others could be an additional channel for contagion.

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