CDS: Will New Ban Fuel Self Fufilling Default Prophecy?

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The small market for credit derivatives, credit default swaps (CDS) is opaque and concentrated, two patterns conducive to abusive behaviors.

According to a new research from Rouen Business School, CDSs have served as a “coordinating device of speculation” against sovereign European States during the crisis. To address this issue, as of November 1, investors wanting to trade sovereign CDS in a European Union country must now hold the underlying bond.

Unfortunately, the ban on “naked CDS” is both “ambitious and reckless…  as well as ineffective,” according to Rouen’s Anne Laure Delatte, who headed up the research.

Fundamental factors alone could not explain the European crisis, Delatte said. Meanwhile, the  New research from RBS  found the impact of “market belief” during the crisis, was “significant”. The authors found:

  1. There’s a strong ‘self-fulfilling’ dynamic in the European crisis: fear of default is precisely what leads to default
  2.  The small market for credit derivatives, credit default swaps (CDS) –  insurance instruments that were designed to protect against the risk of a borrower’s default – is the leading catalyst of market sentiment: abrupt movements in the CDS market can potentially generate panic in the cash market.

Delatte noted the pattern was a matter of concern because CDS are traded on a concentrated and opaque market, two features that can lead to abusive behaviors in a climate where, according to the Securities Exchange Commission, 87.2 per cent of CDS trading activity comes from the top 15 dealers.

In particular, there’s a risk of price manipulation, in that a few trades could move prices. The Rouen study suggests that a few trades in the CDS of a sovereign could amplify the impression that the sovereign is in trouble, which would then drive down the bond price.

The manipulator could then benefit by establishing short positions in the cash market.

This issue has attracted much interest in policy circles and has led to the adoption of a ban of naked sovereign CDSs which came into effect November 1.  The prohibition of holding uncovered CDS positions has been debated in both the US and the European Union and, finally abandoned by the US in 2009.

Yet as noted by Delatte and her co-authors, the regulation exempts market makers — yet almost 90 percent of trades are conducted by large investment banks which provide market making activities in the CDS market. (A market participant is considered as a market maker when the volume of transactions is sufficiently large that it commits to price any transactions an end-user may ask.)

More concerning is that the line between market making activities and proprietary trading is often blurred, as market makers have an overall view of the market that gives them a competitive advantage to carry out proprietary trading.

So, “the ban exempts market participants whose activity is precisely the one that it aims to limit”.

Speaking the day before the ban came into effect Delatte said it came with two major risks:

“Firstly, a  false security impression from the regulator while destabilizing speculation is still possible. Secondly, there is a risk the ban will be circumvented by financial innovations, more complex and more difficult to regulate. The development by Market of futures and option contracts on CDS indices in October 2012 is a compelling example.”

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