The Greece basis trade: What could go wrong?

by Felix Salmon

Reuters
November 22, 2011

Why did Gretchen Morgenson write that column on Sunday about Greek credit default swaps? The answer is that the irresistible lure of writing about CDS lured her into the very murky waters of the Greek basis trade — the trade where you own Greek bonds and then hedge them by buying credit protection on Greece. Now this trade is emphatically not a big deal even in the context of the Greek debt restructuring: it’s probably a couple of billion euros in total, and won’t make much difference either way. But the outcome of the trade is likely to set an important precedent for the sovereign CDS market more generally, so it’s worth looking in a bit of detail at exactly what’s going on here.

Basis trades belong to a set which is relatively common in financial markets: things which are meant to be very safe but which, in fact, aren’t. Merrill Lynch reportedly lost somewhere in the region of $15 billion on basis trades, and at the height of the crisis I proposed that the US government should step in and start buying bond-and-CDS packages as a way to make money and get a bit of price discovery and liquidity into the fixed-income markets.

In theory, basis trades are simple: you buy a bond, which either pays off in full or doesn’t. If it does, you’re golden. If it doesn’t, then any losses you make on the bond can be recouped by profits on the CDS. So long as you buy the bond at a higher spread than the cost of credit protection, you should be guaranteed a modest profit.

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