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European politicians have blamed the CDS market for destabilising Greece, and as a result there is a new EU Regulation that restricts the use of ‘naked’ CDSs on sovereign (but not corporate) debt.
The CDS market has drawn great attention from practitioners, regulators and even politicians. Policy-related academic research has increasingly used CDS price data to measure market assessments of the health of borrowers and the likelihood of default. Yet most of the existing research on the market has used data from the early period of its development, and there is little empirical work on the segment of greatest current policy interest, the eurozone sovereign bond market.
Empirical evidence: CDSs and sovereign bond markets in Europe
Portes' empirical analysis confirms that that the two prices are equal to each other in long-run equilibrium. One interpretation is that the derivative market correctly prices credit risk: sovereign CDS contracts written on eurozone borrowers seem to be able to provide new up-to-date information to the sovereign cash market. He finds, however, that in the short run the cash and synthetic markets price credit risk differently. Note also that even if the CDS market prices credit risk ‘correctly’ in the long run, that does not mean that credit risk as priced by either the CDS or the cash market reflects ‘fundamentals’.
Portes also finds that the derivative (CDS) market seems usually to move ahead of the bond market in price discovery, both before and during the financial crisis. But deviations from the estimated long-run equilibrium persist longer than if market participants in one market could immediately observe the price in the other. This suggests imperfections in the arbitrage relationship between the two markets.
There is also an alternative causal interpretation. The CDS market may lead in price discovery because changes in CDS prices affect the fundamentals driving the prices of the underlying bonds. If the CDS spread affects the cost of funding of the sovereign (or corporate), then a rise in the spread will not merely signal but will cause a deterioration in credit quality, hence a fall in the bond price. Such a mechanism could be destabilising. Market funding is not available at a rate less than that required to insure the lender against default (in the CDS market).
Naked CDSs – A case for policy intervention
The overall CDS market, of which these are the dominant component, improves pricing efficiency. The CDS market leads the cash bond market in price discovery and in predicting credit events. Portes' empirical results appear to bear this out. Smart traders in the market reveal information, and the CDS market can provide information when the bond markets are illiquid. He argues, however, that ‘leadership’ may be the result not of better information, but of the effect of CDS prices on the perceived creditworthiness of the issuer.
CDS prices have many defects as information. They are often demonstrably unrelated to default probabilities – as when the German or UK sovereign CDS price rises; or when corporate CDS prices are less than those for the country of residence, even though the corporate bond yield is much higher than that on the country’s government bond. Many highly variable factors influence the CDS-bond spread: liquidity premia, compensation for volatility, accumulating counterparty risk in chains of CDS contracts. And the market is highly opaque, with much information available only to a few dealers.
Naked CDSs do add liquidity to the market. But is the extra liquidity worth the costs? The most obvious cost is the moral hazard arising when it is possible to insure without an ‘insurable interest’ – as in taking out life insurance on someone else’s life.