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Tuesday, July 26, 2011

U.S. debt default could spark derivatives market confusion





NEW YORK: AU.S. debt default could send the derivatives market designed to protect bond investors into confusion because a missed Treasury payment may have been deemed too unlikely to be fully planned for in the contracts.

If the United States does default, investors that sold protection in the form of credit default swaps would theoretically need to pay out around $4.77 billion to buyers, based on outstanding net volumes from the Depository Trust & Clearing Corp.

With lawmakers are facing an Aug. 2 deadline to raise the $14.3 trillion U.S. debt ceiling and avert default, some in the industry now question what constitutes a default and whether CDS payments would occur immediately, or if the government would have time to make up a default.

A key issue is whether a grace period for the United States to cure the debt is associated with the credit default swaps, as is sometimes the case with similar derivatives contracts.

"There does not appear to be clarity about grace periods on Treasuries and we are currently researching this issue," David Green, general counsel at trade association theInternational Swaps and Derivatives Association, told IFR, a Thomson Reuters service.

Some market participants said that as the Treasuries themselves do not specify a grace period, payments would be triggered as soon as a maturity or interest payment is missed.

Others, however, said that in this case alternative rules giving three days grace should be implemented.

With the issue unsolved, market anxiety may be heightened over the U.S. debt talks.

But even though there is no transparency over who has sold U.S. protection, any losses are likely to be contained as the outstanding CDS volumes are far below the more than $9 trillion in marketable Treasuries outstanding.

In return for paying out the insurance, sellers of protection would receive the value of the contract in Treasuries, which even if valued below par are still likely to be worth at least 90 percent of their value, traders said.

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