LONDON Markets are reassessing the usefulness of sovereign default insurance in light of policymakers' desire to bail out Greece without triggering a payout.
But predictions of a more painful restructuring of Greek debt in the future and the lack of efficient alternative hedges should mean investors are unlikely to turn their back on the $113 billion credit default swap market yet.
"We're not yet impaired and trading at a uselessness discount. But that may change," said William Porter, head of European credit strategy at Credit Suisse.
"If you have a genuine way of really inflicting pain on investors -- which is something we've not seen yet -- with no payment of CDS, then you've got a problem."
European officials are working on a second Greek bailout that pushes some of the burden onto the private sector to appease political concerns about handing over more public money.
This solution looks unlikely to trigger a 'credit event' that would see payment of the net $4.8 billion of outstanding Greek CDS, but rating agencies have warned that it could see Greece's credit rating cut into default territory.
Current proposals by France would see bondholders reinvest at least 70 percent of the proceeds from bonds maturing between now and the end of 2014 into new 30-year Greek debt.
Because participation in the rollover is voluntary, the deal is unlikely to meet the definition of a restructuring laid out by the International Swaps and Derivatives Association which rules on when CDS contracts are triggered.
A non-payout of CDS might disappoint speculators but those holding CDS as a hedge against their bond portfolio still feel the contracts offer protection against more extreme scenarios.
"If you thought that there were legitimate solvency risks further down the line then I believe CDS retains value for that purpose," said Barnaby Martin, credit strategist at BofA Merrill Lynch Global Research.
Nevertheless, there are signs that investor appetite to hold Greek CDS is waning in light of euro zone policymakers' clearly stated intentions to avoid triggering a credit event.
"Sovereign CDS may become less attractive than corporate CDS because governments may have both greater capacity and greater incentive to change the rules retrospectively, and 'cheat' on the contract," said Alan Shipman, financial economist at The Open University.
An investor wishing to take out a Greek CDS contract is currently charged an annual rate of nearly 20 percent -- the highest quoted CDS price in the world -- and also asked to pay 45 percent of the total premium up front.
While current levels seem to imply strong demand for the product, the size of the Greek CDS market has been consistently shrinking. In the week ending June 24 the net payout from a Greek credit event fell by 3.9 percent to $4.8 billion -- or around 1.66 percent of outstanding Greek government bonds.
Liquidity has also suffered in recent weeks, making new positions costly to enter and old ones expensive to exit.
Data from CDS monitor Markit showed the five-day moving average of the difference between what buyers were willing to pay for Greek CDS and sellers were willing to offer has risen to nearly five times the level at the start of the year.
CDS prices could fall further in coming sessions but even if markets are impaired and investors demonstrate concerns over the hedging utility of CDS, speculative trading means the price of protection will not drop far.
Basis trades, which exploit the difference in valuations of risk in the CDS and cash bond markets, have become popular with investors seeking intraday profits and have the effect of driving the gap between the two instruments toward zero.
Thus if the risk premium on Greek debt implied by the bond market stays high, the cost of CDS should also remain high.
The current plans to restructure Greece's debt present a scenario that, while not without precedent in corporate markets, is new to sovereign investors and could see calls for revised contracts to ensure the popularity of CDS as default insurance.
"I don't see any other alternative, or else you simply abandon this product," said WestLB strategist Michael Leister.
ISDA said that it had not received requests from members to alter the definitions but that it was always looking to meet the market's demands.
"I haven't heard members coming to us and saying 'You've got to fix this', but if members do want us to fix it we will obviously look at it because we need (CDS) to remain relevant and useful," ISDA's general counsel David Geen told Reuters.
Perversely, the prospect of a debt rollover which is classed as a default by rating agencies, but by official design did not trigger default insurance could ultimately heap pressure on the peripheral bond markets officials are trying to fix.
"This would increase the investor's perception of risk associated with buying these bonds ... and what they will then do is ask for a higher return," said Michael Arghyrou, a specialist in European economics at Cardiff University.
"No CDS means less insurance, and less insurance means higher spreads."
(Graphics by Vincent Flasseur; Editing by Anna Willard)