In some circles at least, credit default swaps have emerged as one of the bogeymen of the global financial crisis.
These contracts, which promise a pay-out if a given company or country defaults on its debts, are blamed by some for helping to stoke the eurozone sovereign debt crisis.
In this version of events, unscrupulous speculators bought sovereign CDSs – even though they did not own the underlying bonds or other relevant securities and thus did not have an “insurable interest” – in the hope of profiting from default. This pushed up CDS prices, heightening the perceived risk of default and in turn driving up borrowing costs for troubled peripheral nations such as Greece, Ireland and Portugal, making default more likely.,
But not everyone agrees which this narrative. “Empirical investigation . . . provides no conclusive evidence that developments in the CDS market causes higher funding costs for member states . . . CDS spreads for the more troubled countries are cheap relative to the bond spreads. This implies that CDS spreads can hardly be considered causing the high bond yields for these
“In the light of the evidence . . . it may not seem entirely appropriate to consider a ban as a permanent rule.”
These words come not from some rabid, free market hedge funder, but from the European Union, in an unpublished but widely leaked document, Report on Sovereign CDS.
Nevertheless, the EU’s Economic and Monetary Affairs Committee voted earlier this month to press for a permanent ban on “naked” sovereign CDS transactions, ie where the buyer does not have an insurable interest to hedge.
“It’s a question of principle. I find it very weird that you can buy a CDS on an asset you don’t have, or to cover a risk you are not exposed to,” says Pascal Canfin, a French Green party MEP and rapporteur for the three political groupings pushing for a ban.
An official close to the negotiations adds: “CDS is a form of insurance and in the rest of the insurance market it’s illegal to take out insurance for a risk that you do not face. Taking out insurance on a neighbour’s car or life throws up obvious hazards.”
A ban would limit the activities of naked buyers of CDS, primarily hedge funds, as well as potentially reducing revenue for those who write (ie sell) CDSs, which include mainstream asset managers as well as hedge funds.
Liquidity for “legitimate”, covered CDS trades might be reduced, potentially raising borrowing costs for heavily indebted states, a perception that leads Sharon Bowles, a UK Liberal Democrat MEP and chair of the Econ committee, who opposes a ban, to warn: “If we get this wrong then we will find the price is paid by taxpayers, not speculators.”
Andrew Baker, chief executive of the Alternative Investment Management Association, further argues that naked CDS trading “provides a valuable service because, at the margin, it provides a signal about the relative attractiveness of instruments that can be protected by CDS”.
Further, Julian Pittam, managing director of Data Explorers, believes naked CDS trading is not as anomalous an activity as it might seem, as market participants have carte blanche to sell futures on assets they do not own.
But Mr Canfin and his allies are convinced of the merits of their arguments. “When you buy naked there is a rise in the price of the CDS and there is a rise in the interest rate and fall in the value of the [underlying] bond. If you are short [both bonds and CDS] you win on the bond side and on the CDS side. You win twice without helping the country to finance its debt and you contribute to a rise in the interest rate.”
Mr Canfin accepts the EU report found no conclusive evidence that movements in CDS prices lead to higher funding costs, but argues “there is no evidence to the contrary either”.
His perception is that “manipulation” of the sovereign CDS market does in fact occur.
“When I talk to traders in London or Paris selling bonds or CDS, they tell me that these kind of activities have been taking place during the Greek crisis. My conclusion is that [manipulation] is done,” he says.
Others are unconvinced. Mr Baker believes underhand activity would be easier to pull off in the realm of corporate CDS, where a malicious rumour could cause CDS spreads to widen. However no tightening of legislation is proposed on the corporate side.
The impact of any ban will depend largely on the definition of what constitutes an insurable interest that it will be permissable to hedge. As well as sovereign debt, the Econ committee’s resolution cites “securities whose price depends heavily on the performance of [a] country”, as permissable assets.
Mr Canfin’s view is that such “proxy” hedging should be limited to assets whose price movements are “highly correlated” to those of the bond underlying the CDS.
As for the argument that banning naked CDS trades would reduce liquidity across the CDS landscape, Mr Canfin argues that if most existing activity is “legitimate” hedging, the impact will be small. Only if the market is largely speculative, meaning there are few genuine hedgers anyway, will the impact be significant.
The committee’s proposals, which also cover new rules on short selling, will now have to be reconciled with the views of the Council of Ministers, which is widely viewed as being less disposed towards a ban.
However, Mr Canfin is determined not to yield on the CDS issue. “The council is divided on this issue, but it’s the top priority for the majority of the political groups in the parliament. It’s not something that we can give up easily.”