Naked CDS ban may have little impact

Regulation from the European Commission banning naked credit default swaps could turn out to be largely toothless, sovereign credit traders claimed, although concerns over the impact on market liquidity remain.

The rules seek to prevent market participants from taking outright short positions in European sovereign debt through CDS, but traders have noted the regulation should provide ample wriggle room for CDS users.

As well as providing an exemption for market-makers, the rules will not consider CDS to be naked if an end-user is seeking to hedge exposure either to the sovereign debt itself or to assets or liabilities “whose value is correlated to the sovereign debt”.

Among other things, this includes exposure to the central, regional and local administration, public sector entities or any exposure guaranteed by the sovereign in question. Private sector institutions established in the country the CDS is referring to will also qualify. Exposures can be classified as loans, counterparty credit risk, receivables, guarantees, and even indirect exposures through indices, funds or special purpose vehicles.

“What does this mean in one sentence: if you can show correlation [of greater than zero] then you can buy sovereign CDS,” Shashank Khare, a sovereign CDS trader at HSBC, wrote in a note to clients.

Broad exemption

The broadness of the exemption should come as a relief to sovereign CDS users, many of whom feel they have been unfairly vilified during the past two years. As the sovereign debt crisis picked up pace in 2010, European politicians were quick to blame speculators driving CDS wider. By June 2010, German Chancellor Angela Merkel and French president Nicolas Sarkozy called for a ban on naked CDS.

“What does this mean in one sentence: if you can show correlation [of greater than zero] then you can buy sovereign CDS”

Nonetheless, one head of European credit trading at a US bank said many investors would want absolute clarity on the final shape of the regulation before trading sovereign CDS again more freely.

“There’s definitely still a bit of confusion around the rules and how they’re going to be implemented,” he said.

“Sovereign CDS has outperformed over the past two weeks as the rules started to get leaked. Some people would still rather not be on the wrong end of regulatory enquiries so they’ll stay away from the product for the moment, but it’s too early to tell whether there will be a long-term change in liquidity in the market,” he added.

Traders reported a drop in market liquidity when politicians first started lambasting CDS speculators in 2010, with many hedge funds avoiding the instruments altogether as a result.

“If you take any portion of participants out of the market then you potentially drain liquidity. Going into implementation we’ll see if there is a material change in market liquidity and whether that can be connected with hedge funds not wanting to express a short view through CDS,” said the European credit trading head.

The European Parliament and Council agreed the regulation put forward by the European Commission on naked CDS last Tuesday, and expect to adopt it in the second half of November. It is scheduled to come into force in November 2012.