SAN FRANCISCO (MarketWatch) -- Trades used to bet on or hedge against sovereign-debt risks have triggered a swift backlash from regulators in the wake of a 9% swoon by the euro in recent months.
The U.S. Justice Department recently asked hedge-fund firms Soros Fund Management, Paulson & Co., SAC Capital Advisors and Greenlight Capital to preserve documents related to trading in the euro, according to a person familiar with the situation. London Markets React to Greek Plan
In addition, U.K. regulator Adair Turner, chairman of the Financial Services Authority, said Tuesday that restrictions on the use of credit default swaps should be considered after these derivatives were used to bet against the debt of euro-zone countries, including Greece.
"Sovereign risk is typically thought of as the chance that the country won't repay creditors. To me, it's the risk of what the sovereign can do to you," said John Burbank, head of $2.7 billion hedge-fund firm Passport Capital, in a recent interview.
"They have been doing anything they want and there's not been any market reaction. But we're starting to see the risk showing up now," Burbank added. "There's really no way for Japan or the U.S. or Europe to run deficits this way without huge fiscal adjustments, which are inherently deflationary. But because they are sovereigns, they can change rules and do anything they want."
Passport isn't betting against the euro and has avoided using credit default swaps to bet against the debt of Greece and other nations in the euro zone.
Sovereign CDS is "vulnerable to governments collectively not wanting these things to happen," according to Burbank.
CDS, a common type of derivative that pays out in the event of a default, were used to bet on or hedge against troubled financial institutions in 2008. Burbank's Passport profited handsomely by using such derivatives to bet against subprime-mortgage securities.
Such derivative investments are now being used by some hedge funds and other investors to capitalize on massive debts racked up by governments, which have spent trillions of dollars trying to cushion the impact of the financial crisis. [How long will it be before they do to America? Wake up Mr. Obama]
This type of trading has focused on Greece and other indebted countries in the euro zone, including Portugal, Italy, Ireland, Greece and Spain. Taken together, the trade has become known by the acronym "PIIGS."
This also has revived old concerns about a possible breakup of the euro zone. The common currency has dropped 9.4% against the U.S. dollar since sovereign-debt concerns were thrust into the spotlight in late November by Dubai World's financial troubles.
Soros Fund Management, headed by George Soros; SAC Capital, run by Steve Cohen; and Greenlight Capital, run by David Einhorn, were among hedge-fund firms that attended a recent "idea dinner" in New York, organized by boutique brokerage firm Monness, Crespi, Hardt & Co., The Wall Street Journal reported last week. Paulson & Co., run by John Paulson, didn't attend
One trader at the dinner argued that the euro is likely to fall to parity against the U.S. dollar, the newspaper reported. That would be a big drop from current levels above $1.35.
The DOJ sent document-preservation requests to Soros, SAC and Greenlight on the same day the report about the "idea dinner" was published, the Journal noted Wednesday.
DOJ spokeswoman Gina Talamona declined to comment, as did a representative at Monness, Crespi, Hardt. Representatives for SAC, Greenlight and Paulson also would not comment.