EU short-selling ban hits liquidity, hikes uncertainty

Liquidity drained from the sovereign CDS market before the ban took hold this morning – and market-makers are still unsure what they can and cannot do

Credit default swap (CDS) traders say the market is taking the start of the European Union (EU) short-selling ban – which took effect this morning – in its stride so far, thanks to months of preparation, but the position-cutting that occurred during this period has damaged liquidity and market-makers remain unsure about some of the detail of the new regime.

Under the regulation, market participants are prevented from buying EU sovereign CDS unless they serve to hedge a long position in that country’s debt, or assets or obligations which are highly correlated to it. Further implementing legislation clarified that the level of correlation would be tested both quantitatively – achieving a level greater than 70% over the preceding 12 months – and qualitatively, with market participants required to prove a “meaningful” relationship, using appropriate data.

Subject to certain proportionality criteria, the notional of the underlying and that of the CDS does not need to match exactly, although any mismatch has to be monitored and constantly appraised. More detail is expected from the European Securities and Markets Authority (Esma) in the weeks ahead.

“There are so many questions about how you calculate whether a trade is covered or not. We’re still waiting for confirmation from Esma clarifying how you do these calculations,” says one London-based source at a large dealer.

Faced with the prospect of being caught with illegal, uncovered positions, the market has erred on the side of caution. In recent months, liquidity in EU sovereign CDS has collapsed – hitting a net notional of $112 billion by mid-October from a high of $150 billion in August last year, according to analysts at Credit Suisse and JP Morgan. Strategists attribute this partly to a rally in European sovereign credit quality, but also to market participants covering their short positions ahead of the ban – and these new dynamics are expected to persist.

“The technical squeeze we’ve seen recently is likely to continue after today, given the lack of clarity. This isn’t a case of buy-the-rumour-sell-the-fact, where people will come in and put big trades on after it’s out of the way. I think we’ve got a reasonably persistent trend underway,” says one strategist at a large European investment bank.


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