The future of the Credit Default Swap (CDS) market -- used to hedge against the risk of a country defaulting -- may be at risk if these derivative instruments do not pay out after this week's rescue deal for Greece.
An implosion of the sovereign CDS market could lead investors to buy fewer government bonds because they feel they cannot protect themselves, and risks pushing up borrowing costs for governments, especially in the euro zone.
Private sector creditors such as insurers, banks and funds will take losses of 100 billion euros on their Greek debt holdings under a new bailout pact struck this week, sharing the burden of the costly rescue with taxpayers.
But the International Swaps and Derivatives Association (ISDA) -- a bank lobby that also decides whether an event triggers the CDS -- has said it's not likely that the restructuring would lead to a pay-out.
The CDS market is being keelhauled. This certainly isn't going to help, because why would you buy a CDS if there will never be a payout? said one well-placed industry source, referring to the Greek situation.
He projected the sovereign CDS market -- a small corner of the $25 trillion overall market -- could die out in the next year, echoing some bankers' fears.
CDS contracts are a form of protection that entitle bondholders to a pay-out in case of a default. They are also often used by investors who do not own the underlying bonds to bet on the market -- so-called naked CDS.
This has made them unpopular among politicians, who have blamed speculators for exacerbating Europe's debt crisis.
The European Union agreed last week to ban naked CDS on sovereign debt, in a rule that will come into force from November 2012, already putting pressure on the sovereign CDS market even if there will be some exceptions.
A non-payout of the CDS would further take away the credibility of the market -- even if its relevance for Greece is limited: economists have estimated the net payout on Greece CDS, would only be $1.85 billion.
European politicians struck a deal with the banks in the early hours of Thursday after a night of hard-nosed negotiations, that will see them write off 50 percent of the value of their Greek government debt holdings.
The agreement with banks paved the way for a second bailout of Greece, and comes along two other measures: a forced recapitalization of Europe's banks and bigger financing powers for Europe's EFSF bail-out fund.
The International Institute of Finance (IIF) that leads the talks from the industry side said that the deal they struck was voluntary, and that an involuntary deal could have caused a true calamity.
There is the unknown risk of what happens with contagion. You could have hedge funds looking at Spain or Italy after that, which could pile on pressure there and precipitate the quest for assistance, said David Watts, an analyst at CreditSights.
Banks had initially agreed to an offer for a debt exchange that would see them take a 21 percent cut. At the time, politicians and bankers also insisted that the deal had to be voluntary, to avoid a hard Greek default.
But that deal was torn up as it became clear that the conditions in Greece had rapidly deteriorated. The elements of the new agreement are unclear, and will probably have to be hammered out in the coming weeks.
The CDS market still has value for other uses, such as an insurance against a company or bank default. Sovereign CDS are also used as a proxy hedge, for instance for companies that are too small to have their own CDS in a given country.
That has been one of the main drivers of a rise in liquidity. In France, the volume was up 21 percent in the third quarter, according to data from Markit. In Germany, the rise was 14 percent, while volumes in Italy dropped 11 percent.
The problem banks and investors face is that the risk of sovereign defaults in the euro zone -- once inconceivable -- has grown more real in the past two years.
And if one of the main hedging tools disappears, that inevitably means they will be under even more pressure to reduce their exposure and start selling the bonds, pushing up the yield and therefore the financing costs for governments.