Out of interest how are these markets priced? Also how long ago was it that you worked in this field?
I was a structurer of bond products and credit derivatives up to 2012. Traders set prices, I put the various pieces of the deal together, but I worked closely enough with traders for what I am saying about prices to be accurate. On common sovereign names anyone (who is willing to pay the subscription) can get prices from a company called Markit that was owned by the big investment banks. Traders at these investment banks (still I'm sure) feed their prices for credit protection into Markit. Markit then amalgamates those prices. For individual banks, changes in these prices reflect the risk adjustments to the sovereign risk positions on the books of the investment banks. The price movements are typically pretty small but they are going on all the time. It is most important that this mechanism exist when trouble brews as it allows risk transfer to occur. You can imagine when things were going pear shaped with Greece, some investment banks were holding more Greek risk than they wanted. Other banks, for a price were prepared to take more on.
As well as this CDS market, sovereign risk is traded in the OTC structured product market. The way it basically worked was that an investor (who would typically buy a vanilla bond) wants to increase the yield they receive. Obviously theres no way to do this without accepting more risk. So we would write sovereign risk into the bond that they bought.
A basic bond contains issuer risk of repayment. The yield an investor receives is composed of a) the risk free rate of return on funds b) an additional rate which is the default risk of your issuer. As you move out the risk curve of issuer names the default risk increases and the bonds pays a higher return.
If these two components of the interest rate do not combine to provide the desired yield, then an investor can talk to an investment bank about adding in risks. What you can add is virtually unlimited. The investor receives the higher return, but the bond documents will say that the investor will receive the principal at maturity or upon an Event of Default of X(insert whatever sovereigns name you want). If the Event of Default occurs the investor will receive the principal ie 100% less the percentage drop in value of the specified sovereign assets.
We produced bonds that paid a higher yield because US default risk was included. This is despite the fact that US treasuries are generally regarded as the ultimate risk free asset... but they were not at the time. What constitutes an Event of Default on these swaps and structured products goes way beyond the "hard" default of simply not paying at maturity. As you guys keep saying the sovereign would have choose not to pay if it only borrows in its own currency. But as a country starts to fuck up its monetary system all sorts of things go wrong with its currency value and with funds flowing out of the country. There are certain steps that countries always take to try to fix these problems these steps are well know and are all "Soft" events of defaults. They make the value of the sovereign debt fall in a dramatic fashion but they are not what the lay person regards as a Default. If you think about it from the protection buyer perspective, he doesn't care. They receive the loss on the bond (meaning the reference asset that defaulted), that payment makes them happy and whole.
The problem for the sovereign is that not only has a Default been very publicly called but the sovereign credit rating will be downgraded. There are a bunch of other effects too. This is why these defaults play out so fast. I don't believe even a superpower can stop the ball rolling if they let it start. My view is that the USA and Australia for example can default but almost certainly never will. But it is good that people don't believe it can happen because fiat money is a confidence game.
Also i don't trust what they say, I trust what i see.
