Two weeks ago, the Economic and Monetary Affairs committee of the European Parliament voted to prohibit investors taking positions in sovereign credit default swaps unless they own the underlying asset. Last May, as the sovereign debt crisis was at its height, Germany imposed a temporary ban on naked short trading of sovereign CDS and the following month the European Union considered a similar ban for the entire single currency zone.
France and Germany seem favourably disposed to the legislation. The bill, being steered through Parliament by Pascal Canfin, a Green Party MEP for Île-de-France, is expected to become regulation by next year and will make naked short selling “much more complicated” and “effectively ban” the practice, according to Canfin.
Last year, the European Commission said in its report: “The CDS spreads for the more troubled countries seem to be low relative to the corresponding bond yield spreads, which implies that CDS spreads can hardly be considered to cause high bond yields for these countries.” Yet it seems some European politicians cling to the idea that a cabal of fat-cat bankers, generally and conveniently based in perfidious Albion, profit by short selling otherwise healthy and defenceless sovereign credits to the cost of the European taxpayer.
The proposed ban of naked CDS demonstrates a painful ignorance of the way markets operate. If all the short-sellers were taken out of the market, there would be no one with whom the presumably honourable and pristine sellers of protection could trade. Hedge funds would exit the market en masse. The market would become less liquid and transaction costs would be higher. A credit dealer said last week: “A trader’s biggest nightmare is to be caught out of position in an illiquid market.” Even if a trader could get out of a position, the cost might be 60 basis points, rather than the 10bp to 20bp it costs at present. Dealers would simply stop making prices.
So, European lawmakers could kill off the entire sovereign CDS market, rather than just naked deals.
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