We’ve had bans on the naked short-selling of equities many times before.
But we don’t think we’ve ever seen a ban on naked shorting of credit default swaps (CDS).
That means BaFin’s latest move is a bit of an experiment.
It throws up myriad questions, controversies and points of regulatory debate for an industry that has been under regulatory scrutiny for some time now. The International Swaps and Derivatives Association (Isda), the derivatives industry’s representative body, has given a rather wishy-washy response to the BaFin ban.
But Tim Backshall at Credit Derivatives Research has a much more interesting one.
Here it is:
We have discussed ‘naked’ CDS ad nauseum before when this was supposedly an issue in the US with Lehman et al. We also discussed it when the sovereign scare first started up. In the former case, it seems CDS protection buyers were proved correct in the dismally weak state of the balance sheet and I challenge anyone to describe how Greece does not warrant extremely high spreads (risk premia) given their growth expectations, spending addiction, and huge debt load (with or without further loans). EU Government bond spreads moved before CDS, widened more than CDS, and remain wider than CDS (as CDS has rallied in from recent wides) – so perhaps instead of banning Sov CDS they should propose banning the sale of any government bond once it has been bought.
We want to avoid any inflagrante discussion as we will just go on and on but if one is banned from buying protection on CDS (unless you hold the underlying bond) then presumedly they will also be banning Equity Put buying unless one holds the underlying stock. Some quick sums on DTCC data dn we see over $13bn in German net protection outstanding and well over $400bn across all of the European Sovereigns.
Some perspective: our guess at how much of the CDS market is naked is 70-80%. How does a ban on naked CDS make any sense? So you can’t buy protection unless you are long the bonds – does that mean the person selling you protection has to be short the bonds? And if they are short the bonds, are they naked short the bonds?
Remember the sellers of protection face the FAR higher downside risks (and therefore capital requirements!) – like selling Puts. The loss from the losers far outweighs the gains from the winners in any credit portfolio – so perhaps they are going after the wrong guys? Wasn’t this whole thing started by worries over whether AIG could cover all the regulatory capital super-senior arb it had sold the EU banks?
Implications: Who knows? We don’t know who is banned? Does this stop London-based market makers from trading German financials and EU sovereigns? (I guess we will see tomorrow) but if the gapping wider in IG, HY, and all US FINLs this afternoon is a guide, we suspect no. This ban on one side of the market basically shuts the market down completely in our view (if it extends beyond German domiciled banks – remember how much Deutsche Bank lost on their Cash-CDS basis book?) since who will be capable of making a market?
You call the dealer to buy protection on your ‘owned’ Greek Govt or Deutsche Bank debt – how do they sell you that protection? They would be stuck with a long risk position that would be unable to hedge without owning the underlying bond in which case they would double their exposure in the selling of protection to you? The notional size and illiquidity (think about how many govt bonds get bought and locked away in drawers for big pension/insurance funds) of the bond market will leave the CDS massively vacuous and illiquid in general in our view.
Some questions we have: who is affected (geographically, institutionally, seniority)? What does naked mean (how hedged? how much underlying do you need to own? can you hedge stocks with CDS?)? How can a market be made?
Of course, this could all be smoke and mirrors, but the market’s reaction (more specifically the credit market) definitely appeared more selling based and negative-implications than ‘this is nothing to worry about’. The increase in volumes of protection buying as we widened (but in an orderly sense) suggest more real money hedgers/shorts coming in (although we saw a couple small gaps intraday ringing some gamma hedging bells).
One more point – if they ban naked protection buying on German FINLs and EU Sovs, can we buy protection on ITRX FINLS and SovX? FINLs has much more exposure than just German banks? We saw FINLs outperform intrinsics today, we suggest that this will reverse and the index will gap wider on this news tomorrow morning.
The latest Markit CDS quotes are available here, by the way.
Related links:
Swaps soar on Germany’s ‘act of desperation’- Bloomberg
The benefits of naked CDS – FT Alphaville
Time to outlaw naked credit default swaps – Wolfgang Münchau
What is it with politicians and CDS? – FT Alphaville