Citi is lobbying the European Central Bank (ECB) to consider a scheme to unfreeze the euro zone's sovereign debt market by insuring default risk rather than just offering to buy the bonds directly.
The European Debt Assured Purchase (EDAP) program is designed to complement the rescue package announced by the European Union and the ECB on May 9, a key part of which was the promise to buy troubled euro members' debt.
Using a portion of the 750 billion euros ($921.5 billion) rescue package to remove credit risk can stop forced selling and help restore the markets to normality, Citi argues.
"If the ECB wants the market functioning more efficiently they need another tool, other than the buyback. With EDAPs, the trading of the bonds will remain in the secondary market, where it belongs," said Nazareth Festekjian, head of capital markets products at Citi who wrote the paper.
EDAPs would give existing bondholders the right to tender bonds to the ECB at par if the sovereign defaults, in exchange for a fee.
The bank has discussed its proposals with German authorities, who are the biggest provider of funds for the rescue package, and the ECB.
The moves come as U.S Treasury Secretary Timothy Geithner has urged the euro zone to take action on the debt crisis, which has wreaked havoc in global markets.
The initial strong positive market reaction to the ECB's bond purchase announcement has ebbed away and secondary market liquidity has all but dried up, according to bond traders.
Government bonds are typically bought as a risk-free product but increasing worries that a European country could default has increased the interest rate demanded.
Risk managers are struggling to deal with the credit risk as liquidity in credit default swaps, which allow them to insure against a sovereign default, is low. Therefore, their only effective technique to mitigate risk is selling.
"Do I sell to the ECB today or tomorrow? That's the risk mitigation dilemma of the moment," said Festekjian.
The scheme would involve EDAPs being priced through a transparent market mechanism with an upfront fee set by a Dutch auction and then a smaller annual fee for the remainder of the underlying bond's life.
Unlike the CDS market, there would be no possibility of speculators benefiting from the credit insurance as there is no cash settlement of the EDAP contract, the usage being tied to the real holders of government bonds.
The scheme's proponents argue that, unlike the ECB buying program, this allows market participants to keep capital in the system and avoid the overhang risk whereby the ECB will find it hard to ever unwind its positions.
The ECB has stated that it would mitigate the bond purchases by sterilization via T-bill sales but EDAPs eliminates the possibility of quantitative easing. The ECB would earn fees for providing market participants with credit insurance.
Citi envisages the scheme covering bonds maturing within five years, still leaving a credit risk problem for the holders of longer-dated debt.
EDAPs would leave the ECB at risk should there be a default or debt restructuring of a country such as Greece. But the bank is already on the hook for any bonds it is purchasing now anyway, proponents of the plan say.
Some bank holders of Greek bonds are not able to participate in the ECB'S program because doing so would crystallize mark-to-market losses in their bond portfolios.
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