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On November 1, 2012, the provisions of Regulation (EU) No 236/2012 of the European Parliament and the Council of 14 March 2012 on short selling and certain aspects of credit default swaps came into effect. The regulation bans uncovered short positions in EU sovereign debt through credit default swaps (CDS) and requires that net short positions be privately notified to the relevant national regulator and, at higher levels, be publicly disclosed.
An uncovered sovereign CDS (SCDS) position exists when a person holds a (short) position in a SCDS without either a corresponding (long) position in the sovereign issuer referenced in that CDS or another position with a value that is correlated to the value of the sovereign debt. In order to establish a permitted SCDS position, investors must now hold offsetting risk, such as the underlying sovereign bond or other exposures correlated to sovereign debt. This change raised concerns about the impact on portfolio hedging, the potential for a reduction in SCDS liquidity, and the implications of a reduction in the European Central Bank’s (ECB) bond-buying programme.
As ISDA findings reveal, the liquidity of the iTraxx SovX Western Europe index, the main hedging vehicle for European sovereign risk, has substantially diminished in the period following the announcement of the political agreement on the SCDS ban, and, more acutely, when the regulation became effective.
Several other EU-regulated single-name sovereign CDS (non-constituents of the iTraxx SovX Western Europe index) have declined in terms of average weekly volume and trade count during one or both periods under study. Nearly all non-EU single-name sovereign CDS (elsewhere in Europe, Asia, the Middle East and the Americas) showed increases in both average weekly volume and trade count during the post-regulation period.
Since the regulation became effective, ISDA observes a breakdown of the average correlation between proxy hedges such as the iTraxx Europe Senior Financials index and EU-regulated single-name SCDS from 89 per cent to 37 per cent.