Thursday, September 27, 2012

European Commission's irrational fear of sovereign CDS markets is politically motivated

The European Commission (European Securities and Markets Authority) continues to press their heavy handed CDS regulations in spite of the objections by the UK and Germany. These two states are particularly annoyed at the EC rules that require a CDS protection buyer to be able to prove that they are engaged in hedging a specific asset (or assets) - prohibiting the so-called "naked CDS". That means one can not buy protection on France for example as a general hedge against a downturn in European sovereign finances or the economy as a whole (see discussion). This is the equivalent of prohibiting investors from buying put options without owning the equivalent number of shares in the underlying stock.
UK/Germany: - We regret especially that the hedging requirements concerning CDS are very narrow and inflexible. This could e.g. hinder investments in member states with illiquid CDS markets significantly and hedging against general economic risks.
So let's take a look at the reasons the EC is so scared of CDS. The explanation we keep hearing is that buying CDS protection can be used to "attack" a sovereign debt market. The evil speculators will use CDS to bring down nations by artificially raising sovereign yields. That is absolute and utter nonsense. All the EC has to do is take a look at the data. The chart below compares gross and net Spanish sovereign CDS notionals with Spanish government debt outstanding.

Source: Fitch

First a few words about the gross CDS number. The gross represents nothing more than the trading volume (with a lag). Here is an example:

ABC Fund
1. buys 10MM protection on Spain from DB
2. sells 5MM protection on Spain to JPMorgan
3. sells 5MM protection on Spain to SocGen

ABC Fund now has zero net Spain CDS exposure and 20MM gross Spain CDS exposure. The more ABC Fund trades, the larger the gross will be because the fund is required to get the best pricing for its investors by using multiple counterparties. That is why as Spain got deeper into trouble and trading volumes increased, the gross grew. In spite of that increase, the gross number is still a fraction of Spain's total debt outstanding. Moreover with the clearinghouse coming online, ABC Fund will be able to net all three positions and the gross notional will collapse.

But in order to influence sovereign bond yields, one needs to put on large net positions - gross notional has no impact on spread/yield. And net CDS positions are barely visible on the chart above (in red circle). A similar relationship between debt outstanding and net CDS notional can be found for Italy (chart below). Claiming that such tiny exposures can somehow threaten the sovereign bond markets is absurd.

Source: Fitch

What is really happening however is that the CDS markets often act as a "canary in a coal mine", pointing to a specific credit weakness. CDS spreads provide transparency, particularly when transparency is not readily available from other less liquid markets. And many EU politicians and bureaucrats hate transparency because it puts their governments' poor practices on display. So they blame the CDS markets for "attacking" their nation. Everything was fine with Greece until those evil CDS speculators showed up.
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