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Sovereign bond markets: CDS liquidity benefits sovereign deficit funding

Implications for short-selling bans; CCP should boost liquidity

Short-selling bans on credit default swaps are as yet untested in their effectiveness. All academic studies conducted so far have failed to find a causal link between CDS activity and a rise in government bond yields, and the second-round effects of contagion risk.

Germany’s ban on naked shorting of CDS in May, based on the accusation that it was driving up yields on Greek government debt, proved to be controversial on two fronts: because it wasn’t coordinated across Europe, and because the level of open short positions was a mere fraction of the bonds outstanding.

In the light of this, research published by Fitch Solutions, a division within the rating agency that analyses the role of liquidity on markets behaviour, may have important policy implications as the European Union seeks to impose reform on the derivatives markets over the coming year. Fitch’s research found that the level of liquidity on sovereign CDS was highly correlated with the level of the underlying bond yields.

Liquid yields

In instances where liquidity in sovereign CDS was low, yields on the bonds that they referenced tended to rise, and vice-versa. Liquid CDS markets provide investors with the ability to hedge higher-risk debt, thus playing an important factor in driving demand for the underlying cash instruments.

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