In an open letter of March 8, 2011 addressed to the Chair of the Economic and Monetary Affairs Committee of the European Parliament, Sharon Bowles, and Pascal Canfin, the Committee’s Rapporteur, on the draft EU regulation on short selling and credit default swaps, EDHEC Risk Institute has warned of the dangers of prohibiting “naked” sales of sovereign credit default swaps.

• It will be impossible for intermediaries and ultimately for regulators to verify investors’ holdings of the securities representative of the risk the credit default swaps are assumed to cover.

• This prohibition would make it harder for countries to manage the interest rate risk on their debt actively, as their counterparties would then no longer be able to hedge the country risk of the interest rate swaps they may have entered into. This active management of the yield curve is a major component in the optimisation of the cost of public debt.

• More harmful still is that a very strict definition of a naked sale would keep investors who finance public investment, or companies that enter into contracts with sovereign nations or with state-owned companies, from hedging the default risk of their counterparties. At a time when public-private partnerships and private financing of public infrastructure projects are considered one of the drivers of global growth, making it harder to manage country risk may, at the very least, increase the costs of these partnerships and this financing and, at worst, prove a major hurdle to their development.

• Finally, by making the market for hedging default risk more complex, the markets may be deprived of the debt of countries with low ratings, of investors, and thus of liquidity, which will inevitably increase the cost of this debt.

Full letter