Some investors were expecting to collect their winnings soon on a bet they made against Argentina’s bonds using financial instruments called credit default swaps.
But a rare challenge to the swaps’ payout process could delay the collection of those profits – and possibly shrink them.
Credit default swaps are designed to pay out when a company or a country defaults on their bonds. An order from a United States federal judge effectively stopped Argentina from making a payment on its main class of bonds that was due by the end of July. As a result, the International Swaps and Derivatives Association, the industry body that helps oversee the credit default swaps market, ruled that the swaps had been activated. It stated that an auction would take place on Thursday to set the exact amount at which the swaps would pay out. But on Tuesday, the association announced that it now expected to hold the auction on Sept. 2.
The association decided on the delay after it received a challenge to the process on Monday. To help set the payout on the swaps, bonds issued by the party in default are submitted into the auction. In the Argentine case, the objectors are disputing whether two series of yen-denominated bonds should be included. Disputes over which bonds are eligible are infrequent.
The complication to the payout process may provide ammunition to critics of credit default swaps. While the swaps often pay out without a hitch, there have been situations when the swaps did not activate for certain investors. This has raised questions about their usefulness as hedges against defaults.
In the case of the Argentine swaps, the challengers may be motivated by a desire to sway the swaps payout more in their favor. By removing the yen-denominated bonds from the auction, the swaps may pay out a lower amount. This would hurt investors that were betting on a default but benefit those who were wagering that Argentina would keep getting money to its bondholders.
An I.S.D.A. committee is now considering the objections. One issue it may focus on is when the disputed bonds were issued. Swaps on Argentine sovereign debt are said to apply only to bonds issued after 2005. The committee may need to determine that the bonds were issued after the cutoff date.
Argentina defaulted on nearly $100 billion of bonds in 2001. In 2005 and 2010, the country swapped the defaulted securities for new “exchange bonds” that were worth substantially less, allowing it to shrink its debt load. Argentina then paid the exchange bonds regularly. But New York hedge funds that owned bonds that were never included in the exchange sued Argentina to be repaid in full. In 2012, Federal District Judge Thomas P. Greisa ruled that Argentina had to pay the hedge funds in full whenever it paid the exchange bonds. The ruling was effective because Judge Griesa also ruled that banks handling bond payments could not pass Argentina’s money to the exchange bondholders without also paying the hedge funds.
Argentina appealed the ruling, but it effectively lost after the Supreme Court declined to take up the case in June.