19 September 2011

FN: Making the case for EFSF credit default swaps

There is considerable tension in the European Union surrounding both the likely enlargement of its borrowing programme, and the EFSF’s place in the pantheon of European financial bodies. There are enough question marks here to make the EFSF a very different kettle of fish from the EIB. The more debt the EFSF raises and the greater its influence becomes, the more domestic eurozone governments will begin to quibble; and the more questionable its credit becomes, the greater the case becomes for the development of a CDS market.

However, before any of this happens, more outstanding debt is required. The EFSF has raised only €13 billion in three bonds so far this year, probably not enough to support a CDS market. The raison d’être for EFSF CDS is that, unlike many other European supranationals, it is not a safe-haven, risk-free asset. In the present climate, the demand for such assets is enormous, but the EFSF is not one of them. This month, the speaker of the Slovakian parliament and leader of the Freedom and Solidarity Party, which is a part of the ruling coalition, opposed the extension of the EFSF powers. The new powers would allow the EFSF to take over from the European Central Bank the purchase of distressed sovereign bonds and also inject capital into troubled banks.

So far, no eurozone Member State has yet to step out of line. But the tectonic plates are creaking, and as the scale of borrowing required to shore up the eurozone increases, EFSF yields will behave less like those of a supranational agency and more like those of a risk asset. This is why CDS of EFSF should be born, although no one should expect them to trade tight to EFSF bonds. Demand for protection buying is likely to be overwhelmingly greater than demand for protection selling, and this would push spreads out to levels that eurozone officials will blanch at to contemplate.

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