New Greek Debt Risk: Word Games

Euro-zone governments are undecided over what to call any possible Greek debt workout, offering alternatives like a "soft restructuring," or a "reprofiling" of the nation's debt load.

For buyers and sellers of billions of dollars of credit-default swaps on the Hellenic Republic, it's more than mere semantics.

Such terminology will play a part in whether sellers of these insurance-like contracts will have to cough up payouts. And with few precedents in the relatively recent history of the sovereign credit-default swap, or CDS, market, how Greece plays out will be a major milestone.

"I think it's going to be a critical test, frankly, because there are all these questions raging," said Pavan Wadhwa, global head of interest-rates strategy at J.P. Morgan Chase & Co. "No one really seemed to have much of a handle on what, if anything, would trigger a CDS [payout]."

The CDS market has been a lightning rod for criticism, especially from lawmakers who in part blamed credit default swaps for escalating the global financial crisis and nearly toppling insurance giant American International Group Inc. But three years on from the crisis, the market for these instruments remains murky.

Credit default swaps are financial products that work like insurance against a bond default. In theory, if a borrower defaults, the seller of CDS pays the holder. That protection gets more valuable as anxiety grows about the country or company's ability to pay debts.

In practice, it's less straightforward. "There are many ways that Greece can avoid triggering CDS [payouts] in the event that it does do a restructuring," said Mr. Wadhwa. For example, Greece could twist bondholders' arms until they accept a "voluntary" debt exchange. Such "voluntary" exchanges wouldn't likely be a trigger for payments, he said.

On the whole, investors have been paring back their bets on Greek defaults. In the week ended May 20, the net notional value of outstanding CDS contracts on Greece was about $5.34 billion. That's down from about $7.17 billion a year earlier, according Depository Trust & Clearing Corp. data. The number of contracts outstanding increased, however, from roughly 4,000 one year ago to around 4,600.

To be sure, the size of the Greek CDS market pales in comparison the Greek central government's outstanding debt. That was around $454.69 billion in 2010, according to the Organization for Economic Cooperation and Development.

But there are indications European policy makers are paying attention to credit default swaps as they cobble together another approach to stopping the crisis. In a research note dated May 26, RBC Capital Markets analysts wrote that the usage of language such as "re-profiling," "soft-restructuring," and "voluntary" restructuring from European officials indicates they're trying to craft a solution that wouldn't trigger CDS payouts.

That would likely be a boon to the European domestic banking sector, say J.P. Morgan analysts who cite "anecdotal" evidence that European banks would be on the hook for payouts. But it's less than clear what it will mean for the sovereign CDS market as a whole.

After all, if a debt restructuring on the scale of Greece isn't covered by current CDS contracts, "you can rightly ask yourself, 'What do I want with the product in the first place?," said Peter Schaffrik, head of European rates strategy at RBC. "The way it looks at the moment, I think there might be some serious concerns on whether you actually get paid at the end of the day."