April 4, 2012 / 3:26 PM / 6 years ago

"Naked" ban deals further blow to CDS

(The following story was first published on the International Financing Review’s website - http//www.ifre.com. IFR is a Thomson Reuters publication.)

By Christopher Whittall

LONDON, April 4 (IFR) - A ban on “naked” sovereign credit defaults swaps trading will be stricter and more far-reaching than market participants had previously thought and could severely damage market liquidity, analysts have warned.

The European Union recently published the final version of new regulation prohibiting participants from using CDS to take outright short positions in sovereigns. The regulation developed in the aftermath of various European politicians blaming sovereign CDS for peripheral bond yields widening during the euro zone crisis, despite a lack of empirical evidence to support these claims.

The details of the rules come at a delicate time for the sovereign CDS market, which faces an overhaul after major flaws in the product were exposed around the Greek CDS auction process. Sovereign CDS flows have dropped by as much as 40% over the past year by some dealer estimates, and many participants have already signalled their intention to significantly reduce their reliance on the product.

The EU regulation - which comes into force on November 1 - looks set to further diminish activity in sovereign CDS, analysts say. Guidelines published by the European Securities and Markets Authority - which will enforce the rules - imply a higher degree of extra-territoriality than previously thought and could deter many participants on both sides of the Atlantic from using sovereign CDS, according to Michael Hampden-Turner, head of credit strategy at Citi.

“The ban looks like it will cover a lot of people, and although ESMA has no US jurisdiction they have made hedge funds and others beholden to report their exposures to them. We know lots of hedge funds are concerned about their positions and most seem to take the view that a single trade is not worth the risk of regulatory contention,” said Hampden-Turner.

“The sovereign CDS market will continue, but it’ll become less liquid, more volatile, harder to trade and less efficient. Italian sovereign CDS already behaves oddly because a lot of CVA hedgers are the same way round. I think we’ll get more of those strange anomalies if you take out some of the market participants,” he added.

The impact on market liquidity could be significant if hedge funds decide to exit en masse. Banks account for a large proportion of sovereign protection demand as a result of their CVA desks, which hedge derivatives counterparty risk. In contrast to these buy-and-hold desks, hedge funds tend to enter and exit positions at far greater speed and usually in far smaller size, providing good liquidity to the market.

“Although hedge funds don’t hold a lot in terms of notional size, the frequency of their activity is helpful for market liquidity. The danger is if they can’t put on the sorts of trades they want that they’ll abandon sovereign CDS altogether,” said Hampden-Turner.

“Any speculating on a short-term widening of CDS spreads or entering into short CDS positions for longer-term investment purposes is going to be forbidden. That’s going to impact market liquidity and it’s not clear who will provide protection to all these banks that need to cover long positions with CDS,” added Christopher Kullmann, a regulatory expert at Nomura.

Several sovereign CDS already struggle to attract trading activity. For instance, the net outstanding notional on Austria, Belgium, Portugal, Ireland and Poland combined is still less than the net positioning on Italy (which has US$21.5bn outstanding), according to the DTCC.

Meanwhile, the Markit iTraxx SovX Western Europe index has seen its net notional nosedive from US$5.2bn in April 2011 to US$1.6bn in mid-March 2012 - figures that are dwarfed by the current positioning on iTraxx Europe Main index of US$65.3bn.

Hampden-Turner signalled the ban is likely to exacerbate the situation in these cases. “There is risk that you past a particular point of illiquidity and it’s hard then to get out of that rut,” he said, highlighting names such as Austria, Poland and the iTraxx SovX index as instruments at risk because volumes are already low.


The rules do allow some flexibility, permitting sovereign CDS hedges provided the institution can demonstrate a positive correlation between its CDS position and the underlying assets it owns.

The ban is still in danger of severely hampering risk management, though, with Kullmann at Nomura citing two specific instances where legitimate hedging activity could fall foul of the new rules.

In the first example, an investor might want to hedge a tail risk event such as significant deterioration in the euro zone crisis by buying French CDS. The logic behind this trade is that French CDS should blow out if the crisis intensifies.

“The issue is the ESMA guidance demands historical correlation rather than future modelled correlation, and French CDS may not have been previously correlated with this scenario. In other words, macro tail risk hedging is going to be more difficult,” said Kullmann.

In the second example, investors may own the debt of some German banks that have a large exposure to Portugal. As a result, they might want to buy Portugal protection to hedge their position. However, ESMA stipulates the exposure the investor is hedging must come from the same country as the sovereign protection it is purchasing.

“This will also constrain investors’ ability to hedge against specific scenarios,” added Kullmann

The ban will force many investors to search for other proxies to hedge their exposures or take views, such as shorting banks, utilities, municipals or other correlated credits, analysts said. Only time will tell whether such strategies will yield efficient hedges going forward (Reporting by Christopher Whittall, editing by Kathy Hoffelder)

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