The failure of credit default swaps to pay out to bondholders burnt by Greece should spell the beginning of the end for a bond insurance market accused of exacerbating Europe's debt stresses. That it may not underscores just how much investors have learnt to use the much-maligned derivatives for other purposes than purely guarding against default.
The euro zone crisis has also given impetus to the over-the-counter market and investors' need to hedge their investments in bonds - like those of Germany - for which they previously thought such moves unnecessary.
It was easy to cast doubt on the value of CDS in insuring creditors against outright default after the latest proposal to restructure Greek debt with a 50 percent haircut failed to trigger payouts on contracts referencing the country.
Add to this an impending European Union ban on "naked" sovereign CDS trades aimed at investors who don't have ownership of the underlying government debt, and it is little surprise that economists wondered whether the market would survive.
But while parts of the trade appear to be withering, certain segments are thriving. Figures from New York-based Depository Trust & Clearing Corp (DTCC) show active contracts currently worth $27.7 trillion versus around $26 trillion a year ago and the year before.
The gross notional value of sovereign CDS likewise stood at $2.9 trillion in the week ended November 25, up slightly from $2.5 trillion the same period a year ago. One factor in that is that CDS trade is arguably less motivated by the need to hedge against default than the desire to raise or reduce risk exposure to individual markets quickly and more cost effectively. Buying CDS for portfolio positioning takes up less funding than trading underlying cash bonds.
"Very few people buy CDS purely as insurance for default," said Sergio Trigo Paz, chief investment officer emerging markets fixed income at BNP Paribas Investment.
Ironically, it is the fact that few investors trade sovereign CDS for what they were designed for - protection against default - that has attracted the ire of the EU, which blames hedge funds for using these derivatives to bet on falling euro zone debt prices.
Until 2008, CDS only made financial sense as a hedge on developing world credit, benefiting from being among the few instruments that actively trade in economies with little outstanding bonds or tightly managed currencies. But an EMTA survey shows third-quarter emerging-market CDS trading down 30 percent from a year ago, pointing to an underlying shift in trade towards advanced economies including Germany and France.
JP Morgan expects Germany - which is seen bearing the burden of supporting ailing euro zone members - to become the most insured sovereign by the new year, with net notional CDS outstanding on the country outstripping those for Italy.