The Naked Derivative Exposures of Banks to Sovereigns

Euro_logo_plus_characterLisa Pollack on the Euro crisis in the FT's Alphaville (image from Wikimedia commons):

As spreads of all colours blow out due to the perpetually unresolved sovereign crisis in Europe, FT Alphaville has been wondering what non-fundamental factors are driving these moves. The bond market is in some places broken and in other places potentially being driven by regulation.

To the extent that the market for credit default swaps influences the bond market, we ponder the technicals of these derivatives that reference it. Here we look at the role played by trades directly between banks and sovereigns.

The sovereign CDS feedback loop

Previously we had concluded that the counterparty risk management (i.e. “CVA” desks) at banks serve to push CDS spreads ever wider as spread-widening is taken to mean increased riskiness of a sovereign (as a counterparty to a trade with a bank), leading to buying pressure on sovereign CDS as the bank hedges itself against the sovereign, leading to spreads widening out further and so on. Basel III, when it kicks in, is only going to bake this in further as volatility serves as an input to the CVA recipe too.

So are sovereigns big counterparties to banks? If so, are banks in-the-money or out-of-the-money to them?