LONDON, Feb 29 (Reuters) - A restructuring of Greece's colossal debt is widely expected to trigger insurance payouts and investment banks and hedge funds are working out who will be the winners and losers.
If the restructuring goes ahead as planned under the terms of Greece's second international bailout, it could involve Athens forcing some bondholders to accept a much lower value.
Credit Default Swaps (CDS) - financial instruments purchased to insure buyers against default - could offer some solace to those banks, fund managers and institutional investors that would see the value of their bonds dramatically cut.
While there is a growing expectation that the CDS will be triggered, question marks over the pay-out process could mean costly surprises for those who must pay up and for those who might be disappointed by their insurance windfall.
In principle, Greece's debt restructuring deal is voluntary. But Athens has already approved a law with so-called Collective Action Clauses (CACs), which, if needed, allows it to impose the same conditions on all bondholders - willing or not.
A committee of the International Swaps and Derivatives Association (ISDA), consisting of 10 CDS dealers and 5 which are mainly hedge funds, is expected to decide in the coming weeks that the restructuring is a "credit event", which means pay-out on a default insurance contract will be triggered.
The committee could make a decision as early as Thursday at talks about whether more favourable treatment the European Central Bank, one of Greece's main creditors, is getting over other lenders qualifies as a "credit event".
If this is not decided at Thursday's talks, analysts at Credit Suisse and at other banks still expect the CDS to be triggered around March 9 when Greece is expected to use the collective action clauses to impose terms on all bondholders.
Overall, holders of Greek government bonds are facing a 74 percent write off in the value of their portfolios now that paperwork for a 200-billion-euro ($268 billion) debt swap has been sent out to try and tackle the debt crisis.
If the CDS are triggered the maximum that could change hands as a result of a Greek default is $3.25 billion, according to the Depository Trust & Clearing Corporation, a clearing and settlement company. That compares to a net value of the euro zone sovereign CDS market of $109 billion, according to the latest DTCC data.
Many politicians mistrust CDS because of their role in the 2007 finanical crisis when they were used to construct some of the most toxic debt instruments, and due to suspicions that hedge funds used them to derail government finances.
The payout to CDS holders is determined by a complex auction process administered according to ISDA guidelines.
"Even a few percentage points difference is a relatively big deal," said Michael Hampden-Turner, credit strategist at Citigroup, referring to the auction-determined rate.
As CDS contracts are not traded at an exchange, there is little clarity over who has bought the insurance, and which financial market participants stand to foot the bill if a payout is triggered.
Less than a year ago, Europe was adamant that a Greek default should be avoided at all cost for fear it would cause market mayhem, similar to the panic that followed the collapse of investment bank Lehman Brothers in 2008.
Former European Central Bank President Jean-Claude Trichet famously said last July that rating agencies should never openly put a default sign on Greece, and that a payout of default insurance through triggering CDS was equally taboo.
Politicians - and even bankers such as Deutsche Bank Chief Executive Josef Ackermann - were similarly critical.
But the first has now happened, and the second looks likely, without having caused much of a market stir.
Much of that has to do with the relatively small size of the expected pay-out of the CDS, and the fact that the market for highly complicated debt instruments that blew up at the time of the Lehman collapse has largely dried up.
The expected roughly $3.25 billion CDS pay-out looked "completely tiny" when compared to the 100-billion-euro loss for bondholders on the Greek debt restructuring deal, said Alessandro Giansanti, a fixed income strategist at ING Groep.
But even if the numbers are small for international markets, financial consequences for individual players could be big.
In one example of how banks positioned themselves ahead of the recent Greek debt agreement, dealers in late October used a so-called "swap box" trading mechanism, that enabled them to match short Greek bond positions with long ones in a bid to make the unwinding as orderly as possible.
Euroclear, the settlement house that facilitated the newly devised tool, said it was currently looking into whether there was demand to use the "swap box" mechanism a second time.
Hedge fund managers - many of whom are thought to have been buying up Greek bonds in the past few months - are also busily positioning themselves, depending on whether or not they have bought protection on the bonds.
For those who have, a CDS pay-out will not only soften the blow of a default. It will also show that CDS represent a viable financial instrument to protect against governments running out of money to pay their debts.
"It will be positive for the CDS market because it will mean that there is an efficient function of the CDS market," said ING's Giansanti. "If you buy CDS you want to be rewarded if a credit event happens."