Banning CDS

Originally published in the October/November 2011 issue

The recent proposed ban on ‘naked’ credit default swaps (CDS) appears to be another solution from the European Union to handle volatility in markets and stabilise the economy. From the nationalisation of domestic banks to multi-billion euro cash injections into the capital markets, Europe’s politicians and regulators are trying different approaches to deal with the mounting problems. The planned ban is the latest suggestion from EU leaders who are grappling for solutions to stem a European-wide collapse of the financial markets, by cracking down on short selling and sovereign debt speculation.

On 18th October, after over a year of negotiations, representatives of the European Parliament and EU member states agreed controls that will increase transparency and tighten rules on traders’ short selling of bonds and shares and buying credit insurance. These controls include a ban on uncovered short selling of sovereign debt instruments and uncovered or ‘naked’ CDS.

Whilst the ban has been agreed in principal, the agreement must now be ratified. The rules are expected to receive final approval from the European Parliament and EU Finance Ministers over the coming weeks, and a plenary vote in full Parliament is expected to be taken in the third week of November 2011. As it currently stands, the regulation is anticipated to enter into force in November 2012.

Rules of proposed CDS ban
The rules of the new ban, if approved, state:

“A natural or legal person may only enter into a short sale of a share admitted to trading on a trading venue or a short sale of a sovereign debt instrument where one of the following conditions is fulfilled at the end of the trading day:

(a) the natural or legal person has borrowed the share or sovereign debt instrument;
(b) the natural or legal person has entered into an agreement to borrow the share or sovereign debt instrument;
(c) the natural or legal person has an arrangement with a third party under which that third party has confirmed that the share or sovereign debt instrument has been located and reserved for lending to the natural or legal person so that settlement can be effected when it is due.”

Further, the ban states that, “A natural or legal person may enter into credit default swap transactions relating to an obligation of a Member State or the Union only where that transaction does not lead to an uncovered position in a credit default swap”.

The new rules will also include additional reporting requirements for those who do participate in the short selling of stocks. The rules will also require that the short selling will only be allowed if prior arrangements have been made to borrow the stock – this would ensure prompt settlement of trades and reasonable certainty the stock will be available.

Hedge funds are amongst the institutions most likely to be affected by the proposed bans. CDS are widely used by hedge funds and other investors to protect against the risk of governments defaulting on their bonds. This latest measure has been brought in as an attempt to stabilise the economy, and was strongly advocated by Germany and a number of other member states. The move reflects the belief of many EU politicians that hedge funds have driven up government funding costs by placing large bets on sovereign defaults by countries such as Greece through the CDS market. Concerns emerged that investors were not using CDS for the purpose of hedging against the risk of defaults, but instead just as a straight bet. Huge criticism has been levelled at funds for adopting such a strategy. As the likelihood of Greece defaulting increased, the prices charged for the CDS increased – therefore those selling the credit default swaps were profiting out of a nation’s declining economy. It is hoped that banning ‘naked’ CDS will be part of the solution to dealing with the current sovereign debt crisis in the Eurozone.

Curbs counter-productive
However, some countries, such as the UK, have opposed the proposed curbs on the CDS market with the view that it would be counter-productive. There is concern that a ban on naked CDS and uncovered short selling of sovereign debt will reduce the willingness to purchase government bonds as investors cannot get the protection they would get from a CDS at a reasonable cost, increasing the cost of borrowing for governments. This could potentially further contribute to the destabilising of the European economy. Further, the ban will reduce liquidity in the CDS market, leading to increased volatility of CDS prices.

The implications of the proposed ban on the market include serious risks of a number of unintended consequences as banks and investors seek alternatives to hedge their sovereign exposures. This is tacitly acknowledged by the proposed regulations, which give the national regulators of member states the option to lift the ban and CDS curbs temporarily (but for a year or more) where the sovereign debt market is not functioning properly, or is in threat of harm:

“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.”

It remains to be seen exactly how this ban will impact the markets. France will be a key test case for the policy as net outstanding sovereign CDS have ballooned from $14 billion to $25 billion in the last 12 months (source: The Depository Trust & Clearing Corporation) and French sovereign debt is now significantly more expensive than German sovereign debt. For example, one alternative method for hedging French sovereign debt is for banks and investors to short sell French banks stocks, but this has also been banned by the authorities. Therefore investors, such as money market funds and banks, who cannot now hedge country risk effectively may cut French country exposure by rapidly reducing credit lines to corporates and banks. This is poor timing as French banks are already facing a liquidity squeeze and will be required to raise equity under the latest European Banking Authority stress tests.

Bank stocks undermined
That the omens of the new ban are bad is amply demonstrated by the bans put in place by France, Italy, Belgium, and Spain on the short selling of financial stocks earlier this year. This undermined confidence in bank stocks, reduced liquidity in the banking system and did not prevent a tax payer-funded bailout of the Franco/Belgium bank Dexia.

The proposed ban on the uncovered short selling of sovereign debt and ‘naked’ CDS comes at a time when the Eurozone financial system is in a dangerous position and action must be taken. However, whilst politicians may think they have found part of the answer, this measure is an ill-timed tightening of regulatory requirements. As demonstrated by the banning of the short selling of financial stocks in several Eurozone countries in August, such measures do not work and risk making the Eurozone system even more unstable that it is now.