Thursday, October 11, 2012

Death of a market

Typically a new series of CDS indices is "issued" every six months. The latest series becomes the on-on-the-run (the most actively traded) contract. SovX, which represents indices of sovereign CDS is no exception. But as discussed earlier (see this post), volumes on SovX, particularly SovX Western Europe have collapsed. The chart below from BNP Paribas shows how this market is beginning to disappear. Positions from the older series are still outstanding, but the new series now barely trade.

Source: BNP Paribas

What's causing this decline in the use of this standardized product? On November 1, 2012, the EC ban on buying protection on sovereign debt goes into effect. The law provides some exceptions to allow CDS purchases only in cases where the buyer can prove the contract is used for hedging. Otherwise buying such protection is outlawed (existing positions will be grandfathered). Once again, it is the equivalent of prohibiting investors from purchasing stock put options unless they own the stock.
From Schulte Roth & Zabel LLP (large US law firm): - In the Delegated Regulation clarification is provided as to when a sovereign CDS transaction is considered to be hedging against a default risk or the risk of a decline in the value of the sovereign debt — meaning that it is not an uncovered CDS position. To qualify, a sovereign CDS position must meet the following conditions:
  • It must serve to hedge against either or both risk of default and risk of a decline in value;
  • There must be a consistent significant correlation between the value of the asset or liability being hedged and the value of the sovereign debt referenced;
  • A sovereign CDS position referencing an EU country may be used to hedge any assets or liabilities meeting the correlation test above — provided that the obligor of (or counterparty to) the asset or liability is located in the same EU country as the country referenced for the CDS; and
  • The CDS position must be proportionate to the risks it is hedging. 
On the basis of the prohibition on uncovered CDS, all CDS referable to EU sovereign debt will fall into one of three classes and position holders should be aware that they may need to take action to avoid the CDS being an unlawful transaction.
  1. Those entered into before 25 March 2012: These may be held until maturity (whenever that may be), even if they would result in an uncovered position after 1 November 2012.
  2. Those entered into between 25 March and 1 November 2012: These are still permitted, but have to be unwound before 1 November 2012, unless they fall within the hedging exemption above.
  3. Those entered into after 1 November 2012: Any new CDS referable to EU sovereign debt will not be permitted, unless it falls within the hedging exemption above.
As discussed earlier (see this post), sovereign CDS market is a tiny fraction of the overall sovereign debt markets and has never posed any threat to sovereign yields. Greek bond yields increased because Greece was bankrupt, not because people bought CDS protection on Greece or because rating agencies downgraded its debt. The EC's goal of reducing market transparency to hide fiscal problems is simply not productive. But with this new regulation, the EC has certainly succeeded in killing the SovX index market.
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