Analysts opposed to CDS ban

MEPs and the Polish presidency obtained a controversial ban on naked credit default swap (CDS) trading on October 18 leading a number of analysts to conclude it is ineffective, unjustified and politically motivated.

CDS trading involves purchasing default insurance contracts without owning the related bonds.

MEPs have decided to ban the technique as well as extending the EU’s financial markets watchdog European Securities and Markets Authority (ESMA) powers to restrict short selling by granting it extra powers to require other authorities to introduce exceptional measures to deal with difficult situations.

According to a statement issued by the Economic and Monetary Affairs committee, the new rules will impose greater transparency, increase the powers of the EU’s financial watchdog and virtually ban certain CDS trades, making speculation on a country’s default more difficult.

Both the European Council and the full parliament must now ratify the agreement. A plenary vote in parliament is expected in the third week of November. The regulation is expected to enter into force in November 2012.

Rapporteur Pascal Canfin from France’s Green party said “the majority in Parliament composed of Greens, Socialists and the EPP fought hard to put an end to sovereign debt speculation in Europe.”

“Today’s compromise will make it impossible for a hedge fund to buy Greek or Italian CDS without already owning the bonds of those countries, for the sole purpose of speculating on the country’s default,” he added.

However, a number of analysts have criticised the new rules, claiming that there is little proof banning CDS trades will have any effect on a country’s stability.

Andrew Shrimpton, member at financial advisory firm Kinetic Partners, said the proposed ban on naked short selling sovereign CDS in member states will reduce liquidity in the CDS market.

This could lead to increased volatility of CDS prices, undermine confidence in member state sovereign bonds and make it more expensive for member states to finance budgets, he added.

According to Shrimpton, this has been demonstrated by “similarly ill-timed regulatory tightening” such as the banning by France, Italy, Belgium and Spain of the short selling of financial stocks earlier this year.

France, Italy, Belgium and Spain’s ban “undermined confidence in bank stocks, reduced liquidity in the banking system and eventually led to a taxpayer-funded bailout of Dexia,” he concluded.

Peter Moore, head of regulation and compliance at IMS Group, agrees that the ban doesn’t make much sense.

“The argument that naked sovereign CDS positions exacerbate strained balance sheets of sovereign states is analogous to the argument that short sellers worsen strained balance sheets of corporate,” he commented.

He added that the ban on naked sovereign CDS is not consistent with findings of research commissioned by the European Parliament which found that a ban would harm market liquidity, impair instrument valuation and could ultimately increase borrowing costs for sovereign states.

Research by the German Bundesbank also found that the larger cash bond and sovereign CDS markets were reacting to events as opposed to either dictating or distorting them, he added. This makes yesterday’s announcement “very difficult to comprehend”, Moore noted.

Meanwhile professor of finance at Cass Business School, Ian Marsh (pictured), said there is “probably some truth” in this accusation that speculating a country will default through trading in credit default swaps raises the likelihood of default.

However, he said that “regulators are taking a risk as there is not much hard evidence to back up their view.”

Marsh says there are parallels with regulators’ current actions and the short sales bans briefly introduced in 2008/09.

“Then, bank share prices were falling and regulators banned the selling of shares that the seller didn’t actually own. These bans were rapidly reversed in most countries as they did not help to stabilise bank share prices. Instead, the short sales bans simply made trading shares by those who did own them less easy and more expensive.”

Marsh also warned that banning the speculators will not be costless.

“Excluding by law a whole bunch of buyers of credit insurance will very likely also reduce the supply of insurance. Legitimate hedgers will then find it harder to get insurance or to reduce their cover should they judge that the situation has improved sufficiently.”

“I expect that like the short sales bans, this ban on naked buying of credit insurance will also be quickly reversed,” he asserted.

He concluded that political motives rather than founded economic ones had persuaded MEPs to obtain the ban.

“They want to be seen to be doing something about the crisis. Banning naked CDS writing will seem like a good thing to most of the population. Their other audience is the financial markets who will, I suspect, see this as another instance of the authorities blaming the wrong people and imposing the wrong policies,” he said.

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