Major U.S. and European banks would be exposed to far more risk from the Greece crisis, if they weren't allowed to short the euro and European sovereign debt.
That's because a collapse of Greece's financial system, or further stress on the broader eurozone system would have substantial negative effects on major banks through many parts of their large and varied businesses. They're inherently massively exposed to a Greece/euro crisis. Thus they need some sort of hedge to reduce this exposure.
That's why they are shorting the euro and European sovereign bonds including those of Greece, France, and Germany.
Banks should, by now, be protected, says the London-based market risk head at a large UK bank. "If Greece defaults tomorrow and some bank stands up and says ‘I've lost a billion dollars on Greece', they should fire everybody. Greece is an old story. What we're trying to figure out is what happens next. Is it Portugal? Italy? Spain?"
Large banks will have all kinds of assets and liabilities to balance, many of which have long-Europe exposure but which cannot be removed from the balance sheet. Thus they need ways to hedge these exposures in order to reduce risk.
Faced with this range of possibilities, banks have tried to focus on something they can get their hands around – for example, the possibility yields at the long end of the euro interest rate curve could widen substantially or, conversely, tighten. "There are scenarios where the curve should steepen a lot and ones where you could expel a bad country – which would set a precedent – and I think the long end of the euro curve would look just great as a result. So it really could break either way," says the US bank's market risk head.
His bank has been seeking to hedge a eurozone crisis scenario by shorting the euro. The European bank's risk manager says the institution has been doing something similar, but using German and French bonds as a proxy for the eurozone and shorting them instead. Of course, those hedges might backfire if Germany did choose to walk away from the single currency. "It's another concern. We're very short Germany and France, as I'm sure a number of other banks are," he says.
Thus take away shorting mechanisms from markets and banks would all simply betting on the same long-Europe trade with no way to insure themselves. It doesn't mean they are net-shorting the euro, and hoping that Europe falls into chaos. In fact most global financial institutions probably remain net-long Europe's financial situation regardless of the short-hedges they may have in currency or sovereign bonds, since a collapse of euro economy would probably still be ugly for them even if mitigated from gains on some short positions.
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