On Wednesday, the European Parliament gave us an idea of what the regulations on short selling and ban on shorting sovereigns via credit default swaps will look like.
Here, FT Alphaville will focus on the regulations concerning CDS. While we will show how the portion of the overall market that is affected might be relatively small, the psychological effect of the ban being put in place is a wildcard. Best then just to get an overview of the situation and make up your own mind.
The two most important questions first.
How big is the sovereign CDS market?
According to DTCC data, as of last week, CDS contracts that reference any single entity totalled $15,422bn in gross notional terms and $1,191bn in net terms. CDS representing sovereigns were 17.4 per cent and 20.8 per cent of those two numbers respectively, so about a fifth of the single-name market references sovereigns.
There are also credit indices for sovereigns – the Markit SovX family plus the Markit CDX.EM. That market has $13,088bn gross and $1,740bn net, where sovereign indices represent 4.2 per cent and 2.6 per cent of the total.
Do CDS influence bond prices?
Over a year ago there was an oft-cited European Commission study that found that CDS and bond prices move contemporaneously, hence the former can’t be said to negatively impact the latter. Since then, however, other papers have come to different conclusions.
One study in particular found that the degree to which CDS spreads lead bond yields depends on the level of stress in the market, with peripheral countries with wider spreads seeing CDS more convincingly lead bond yields. A key point that the researchers made is that while the CDS market may just be a fraction of the size of the bond market (see above), the leverage in the CDS market means that the instruments may be disproportionately influential.
In summary, sovereign CDS are about a fifth of the total single-name market and they *may* have an influence on bond yields, hence the cost at which governments fund themselves.
OK, so…
“Ban them!!” That’s good, right?
If you have exposure to a sovereign and you want to hedge it, then it’ll still be OK to buy protection via a CDS contract. The ban announced on Wednesday covers those cases where a participant in the market has bought protection ostensibly to speculate that the credit will deteriorate rather than to hedge against such a deterioration.
The motive for such a ban is clear if you think that CDS have had a negative impact on the bond market. However, the fact that having a CDS market for a given sovereign being liquid *might* sometimes be a positive, must make it awfully difficult to be a politician..
So while some posit that CDS have had a negative impact on the borrowing costs of peripherals in particular, there are others who are very concerned that banning activity in the market will only serve to exacerbate the problem. It’s not that investors would be prevented from hedging, it’s that certain players in the market may back off in the face of any ban, decreasing overall liquidity, hence making it more expensive for the genuine hedgers.
After all there are surely some investors that have looked at the lengths to which politicians have been willing to go to ensure that a credit event isn’t declared for CDS referencing Greece. They might have thrown their hands up and exited the market for good.
Having our CDS cake.. and eating it
Given that the ban looks set to be “permanent”, it’s funny how the regulation contains a provision for suspending it if/when its presence is deemed to be detrimental. From the FAQs (emphasis ours):
The Regulation includes a requirement for a permanent ban on naked CDS, in order to address the risk that such positions could have a destabilising effect on sovereign debt markets. However, in order to address concerns that such restrictions could negatively affect the liquidity of sovereign debt markets, a competent authority may temporarily suspend the restrictions where it believes, based on objective elements, that its sovereign debt market is not functioning properly and that such restrictions might have a negative impact on the sovereign credit default swap market, especially by increasing the cost of borrowing for sovereign issuers or affecting the sovereign issuer’s ability to issue new debt.
Seems very “have our cake and eat it” but by now, it’s amazing that politicians managed to agree at all on a topic like this.
And all your little macro hedges too
Another huge concession in the ban was to those who were concerned that it would cripple the ability of banks and other participants to use sovereign CDS to hedge in a more general way. From Rt Hon the Lord Roper, Chairman of the Select Committee on the European Union, writing to Financial Secretary of HM Treasury back in March (emphasis ours):
Supporting the continued use of naked CDS, we heard that firms use them to insure against general risk exposure to a country’s corporate and banks, rather than just their exposure to sovereign debt. We recognise that there are intrinsic difficulties in separating genuine insurance from speculation.
Indeed they do, Sir (Lord)! Which is why in the proposed ban we discover this provision:
The assets or liabilities are broadly defined to include financial contracts, a portfolio of assets or financial obligations. Exposures to a sovereign which shall not be considered a “naked” CDS include any exposures to the central, regional and local administration, public sector entities or any exposure guaranteed by any referred entity. Furthermore, exposure to private sector entities established in the Member State should be also included. All exposures shall be considered in this context including among others loans, counterparty credit risk (including potential exposure when regulatory capital is required to such exposure), receivables and guarantees. It also includes indirect exposures to any of the referred entities obtained through among others exposure to indices, funds or special purpose vehicles.
Hence if you are in the UK doing business with Spanish banks and/or companies, if you’d like to take out a general hedge on the Spanish economy by buying sovereign CDS on Spain, be our guest.
Same goes for wanting to hedge loans given to entities in Spain. Or counterparty risk to Spanish banks on derivative instruments, use sovereign CDS for those too. Also if exposed to the Spanish sovereign via an index, e.g. Markit iTraxx SovX Western Europe, that contains other sovereigns as well, go ahead and hedge the Spain-specific exposure by buying protection on that as well (again, via the sovereign CDS).
And the loser of the ban is…
If all of that is permitted, who will the ban on shorting effect? Those who are most likely to be unable to claim a big enough long exposure are probably hedge funds. Thanks to a report by the FRBNY, we have an idea about how much of the market they are (table as edited by FT Alphaville for a post discussing the report’s findings):
The study’s dataset comes from spring 2010, so the numbers may be a bit different now. However, it seems to be the case that hedge funds are a relatively small segment of the market, comprising just 6.84 per cent of all buyers of protection.
Germany, France, we’re looking at you
A final thought to leave you with though.. it’s well known that CDS contracts referencing Germany and France were used by some to bet against a downturn in Europe (as well as a more general economic hedge of the type described above). This is because such contracts used to be very cheap and the two nations are the implicit lenders of last resort — within the Eurozone as well as to the banking sector. Compare and contrast to Italy where a lot of the CDS protection buying originates from banks hedging their counterparty exposure to the sovereign that arises from interest rate swaps.
As further evidence for this trend, CDS referencing Germany have gone from $15bn net notional a year ago to $19bn now while those on France have gone from $14bn to $25bn. Hence if there is one set of entities that will likely see the effect of the ban, it’s Germany and France — two Eurozone sovereigns with borrowing costs that are still relatively low.
It’s impressive that politicians have managed to come to an agreement on ban, and there are also some transparency initiatives that are to be commended, but it seems that the sovereigns most likely to see an impact are the ones that need intervention the least.
Related links:
EU ban on ‘naked’ CDS to become permanent – FT
Reasons not to ban naked sovereign CDS – FT
Crack down on short selling and sovereign debt speculation - European Parliament