Why the Greek CDS settlement did not lead to the feared meltdown

Prospects for a restructuring of Greek debt gave rise to: 1/ strong fears of an amplification of systemic risk associated with doubts as to whether the European financial system would be able to cope with a sovereign default; 2/ discussions about whether the credit default swaps (CDSs) would be triggered, which raised questions concerning the role of CDSs as instruments for hedging sovereign risk. However, CDSs on Greek sovereign bonds were indeed settled without precipitating a crisis. Like in the previous settlements, three main factors explain this smooth functioning. First, the fact that settlement only involved participants’ net positions, which greatly reduced the amounts at stake. Second, protection sellers had set aside provisions to cover the amounts required for settlement through regular margin calls, especially in the case of Greece as the default had long been expected. Third, the usual auction procedure that determines the recovery rate ensured that the amounts paid out by protection sellers offset the bond-holders’ shortfall vis-à-vis the face value of their bonds.