We've noted here before the irony that Europe is both (1) screwing with your ability to get paid on CDS on shaky European sovereign debt (sort of) and (2) hoping people will buy more shaky European sovereign debt because they can get tradeable first-loss protection, suspiciously reminiscent of CDS, from the EFSF on those bonds. The further irony is that, at the same time as it's touting the free transferability and liquidity of that first-loss protection as a selling point, Europe is moving to restrict investors from owning sovereign CDS unless they can prove they really need it, to hedge sovereign debt or correlated assets.

Today FT Alphaville has the details on the potential EFSF-issued first loss protection (full Q&A here). The plan would be to let member states who are "under market pressure" to issue bonds along with "partial protection certificates" that would, on a payment default on the underlying bond, pay off an amount equal to the principal loss on the bond, up to some cap. The EFSF is coy on the cap but admits it might be around 20% of the bond's principal. The payoff would be in the form of EFSF bonds, which are currently AAA rated: so if your Spanish bonds, say, only pay off 50 cents on the dollar, you'd get an extra 20 cents face value of AAA rated EFSF bonds of unspecified terms.

Importantly, these certificates would be freely tradeable:

E21 - Doesn’t this scheme segment the sovereign bond market?

The bonds issued by Member States under this scheme will be identical in every respect to existing bonds issued by that country. This is the reason why the partial protection certificate could be detachable and separately traded.

E22 - How does EFSF expect the newly-issued bonds to trade in relation to existing bonds?

The bonds will be identical to existing bonds and are expected to trade in line with them. However the actions of the EFSF in support of sovereign bonds for that country is intended to have a positive impact on investors’ perception of all sovereign bonds issued by that country.

More importantly than that happy language in the last sentence, the certificate will cheapen the rate on any issue that it's actually stapled to, in about the same way that a CDS contract with a 20% payout cap would. So who needs CDS, right?:

E24 - What will be the effect of this scheme on the CDS market for the Member States?

That is a matter for investors, who will have different preferences; the two instruments are not identical. The partial protection instrument offers superior protection as a risk management tool to a CDS in a certain respect, as explained above [because the EFSF is a AAA rated counterparty, while your CDS counterparty is Dexia or something].

If you're hung up on intellectual consistency, you might ask, will Europe ban "naked partial protection certificates"? That is, will you have to prove that you hold Spanish government debt, or other debt correlated with it, in order to buy one of these freely transferable certificates protecting Spanish debt? I don't think there's any official answer on this one way or another - the rules banning naked CDS are in flux and the draft I've seen, which defines CDS to involve running premium payments from the protection holder, more-likely-than-not wouldn't cover this partial protection beast.

But the answer is sort of obviously no. European leaders can turn a deaf ear to claims that regulating who can buy CDS will screw with the liquidity of that market and raise the cost of issuing sovereign debt, as long as that market is more or less private; they are much less likely, though, to take affirmative steps to screw with their own rescue plan. You can bet that, if the partial protection certificates become a reality, they will be freely tradeable in the sense of "actually freely tradeable": if you want to buy one, split up from the underlying debt, you can go right ahead without submitting to a body cavity search by European officials to discover any net short sovereign exposure.

That makes political sense but it's a bit financially screwy - why ban speculators from betting on Spanish default by buying Spanish CDS, but allow them to bet on Spanish default by buying EFSF-sponsored Spanish quasi-CDS? One way to make sense of it is by thinking about the instruments' delta to Spain and, more so, to Europe. Here we can just use "delta" casually to mean "when Europe goes up, does your thing go up a lot or a little, or down a lot or a little, or squiggle around a bit, or other?"

If your model of European policymakers is "they viscerally hate anyone betting against Europe," then the more delta that bet has to Europe going down the tubes, the more hateful it is. Buying Spanish CDS from an American bank - which let's just hypothesize is uncorrelated to Spain, though, maybe not - is a pretty delta-one bet against Spain. Every dollar that Spanish bonds fall should be a dollar you make on your naked CDS. Your rooting interest is against Spain, and Europe, all the way down.

But buying an EFSF partial protection certificate is not quite as clear a bet. Not, mainly, because it's partial - that doesn't really matter if you're buying it "naked"; if you pay $5 for a thing that pays off up to $20 on a Spanish default, then you're still happy to root for a Spanish default, though you do have less incentive to root for a disastrous default than you would if you paid $15 for a thing that pays off up to $100 on a Spanish total burn-it-down-and-salt-the-earth-it-stood-on default.

But because it's still European credit. On a Spanish default, you don't get money - you get an EFSF bond. The EFSF is backed by guarantees from member nations, and as those nations go so goes the EFSF, mostly. As FT Alphaville puts it:

We’ll admit, a trading desk could simply plug in the AAA rating to determine the credit risk of the protection… But this is 2011, not 2006, and we think their risk managers would seriously chew them out for it. Again, this comes back to the wrong-way risk embedded in the EFSF. If Italy does default, it will hit the guarantee structure of the fund pretty horribly. (Hopefully, this is fairly clear by now.) As a PPC holder protected on 20 per cent of a principal write-down, you’re actually perched upon an EFSF equity ‘tranche’ which could be burned though pretty quickly by a country of a significant size defaulting, especially considering the size of defaults that are likely to come before.

You can call it wrong-way risk - and you would call it that, if you were buying it to hedge a European sovereign default. But for a policy maker you could think of it as "a delta much less than one, and at some points less than zero," or maybe as "a quite kooky exotic derivative on linked Spanish and pan-European credit." If you found yourself in possession of a partial protection certificate on Spain, and Spain then had a contained default where it wrote down its debt by 20% or more while the rest of Europe trucked along happily, then you'd be quite pleased with yourself, and your partial protection certificate would go up in value pretty much one-to-one with Spanish bonds falling in value. But if instead Spain had months of convulsions while everyone talked about contagion and spreads on every other European nation gapped wider, then you'd be quite a bit more nervous. Your partial protection might go up in value as Spain started to teeter, but not on a one-to-one basis, and it would likely drop in value as things got worse and the whole edifice started to look shaky.

I doubt that this is explicitly how European policy makers think. (For one thing, I'm not sure that the EU folks writing the CDS rules and the EFSF folks writing the partial protection plan have even met each other.) But you can imagine its appeal: Europe will hunt down without mercy anyone who bets against Europe, but will cut some slack to anyone buying these EFSF thingies "naked" - because they have a good chance of ending up in the same soup as people who went long on Europe.

How badly do you want EFSF first-loss protection? [FTAV]

European Financial Stability Facility Q&A [EFSF]