The DOs and DON’Ts of credit default swaps (CDS) in the context of the EU sovereign debt crisis

Abstract

The unprecedented global financial crisis and economic downturn that hit the world in 2007–2008 has resulted in the deterioration of budget deficits and has caused an overall increase of sovereign debt levels globally. The turmoil of the banking sector was mitigated by a large infusion of government financial aid, which in turn resulted in a considerable increase in the amount of sovereign debt, thereby undermining the fundamentals of sovereign debt sustainability and producing a severe deterioration in the borrowing conditions. With the European sovereign debt crisis, the structure, legality and enforceability of credit default swaps (CDS) have been tested. In this article we examine what has happened so far and where we now stand on the legal issues around these contracts. The article will focus on the unfolding of the Greek crisis, which ignited the whole debate around the sovereign CDS market in relation to the effectiveness of the instrument. Secondly, the article provides a brief overview of the legal nature of the instrument and the International Swaps and Derivatives Association, Inc. documentation. Thirdly, an analysis of the CDS market is put forward aiming at identifying how these instruments are used in practical terms, as well as the recent market trends. Finally, some concluding remarks and views regarding the future use of CDS and the do's and don’ts of CDS are provided.