EU to deal severely with CDS; leaders seek ban

BRUSSELS/LONDON Mon May 17, 2010 1:58pm BST

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BRUSSELS/LONDON (Reuters) - European leaders called for a ban and regulators promised to deal "very severely" with credit default swaps on Monday, stepping up the rhetoric and the proposed action against the market.

Greek Prime Minister George Papandreou told Germany's Handelsblatt newspaper, "Angela Merkel, Nicolas Sarkozy, Jean-Claude Juncker and I have suggested in a joint letter to Barack Obama whether the markets for credit default swaps ... should not be closed. The G20 countries want to discuss this."

European political leaders for months have been blaming speculation in the CDS market for increasing the cost of borrowing for Greece, Portugal, Spain and Ireland.

Papandreou's call appeared to go further than anything proposed so far and is likely to meet opposition from banks, companies and investors who rely on credit derivatives.

Meanwhile, European Union Commissioner Michel Barnier told a news briefing that regulators intended to force more transparency on the CDS market.

"I have stated that in October we intend to deal with this matter very severely," he said. "These people don't like to come out in the light of day. We are going to flood them with light."

The euro hit a four-year low on Monday and gold rose after a sell-off on Friday in European stocks, CDS and peripheral government debt, despite a $1 trillion rescue package for the euro zone unveiled earlier in the week.

Buyers of protection use CDS either to hedge against risk in their cash bond portfolios or to make a bet that a company or country will default on its debt.

Papandreou criticized financial markets for overreacting to Greece's debt crisis and accused speculators of helping to provoke panic reactions.

NOT EVIL SPECULATORS

However, European Central Bank council member Ewald Nowotny said that while the CDS market needed reform, there was no need to close it down.

Credit market commentators say officials are blaming the messenger as the slumping CDS market only mirrors real underlying problems of heavy government debt burdens and fiscal deficits.

"The problem isn't evil speculators but that the finances of governments are so bad that your classic long-term investors are either taking risk off the table or are not interested in buying as much," said Gary Jenkins, head of fixed income research at broker Evolution Securities.

The CDS market gives banks, insurance companies and other investors an alternative to reduce their risk exposure rather than just selling government bonds into a falling market.

Special EU programmes last year provided banks with 614 billion euros of one-year funding, much of which was invested in sovereign bonds and most of which comes due on July 1, Jenkins said.

"A huge pile of banks did the same trade, and now they are all offside and looking to sell," he said.

If regulators ban the use of CDS, then the market's aversion to government risk will be reflected in the cash bond market, said Mehernosh Engineer, a credit strategist at BNP Paribas.

"They are trying to mask something that's apparent and that was not caused by the CDS market," he said.

A ban on CDS might act to calm the market somewhat, because derivatives can be more liquid than cash bonds, making it easier for investors to hedge quickly, Jenkins said.

But that effect is likely to be overwhelmed as investors take fright at a retrospective change in the rules, he said. "It would be a huge error. All it would do is spook the market."

(Reporting by John O'Donnell and Jane Baird; Editing by Susan Fenton)

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